Hong Kong banks face liquidity squeeze

The forecast in Hong Kong is gloomy, according to KPMG's latest banking survey (AFP)

Hong Kong’s banking industry posted decent profits in 2010 as economic growth recovered to pre-crisis levels and unemployment and inflation stayed low, but the future does not look so bright.

However, the rising supply-demand mismatch for Hong Kong dollar loans and tighter regulation have raised concerns about liquidity, while the banks’ reliance on strong loan growth could lead to a deterioration in asset quality, according to KPMG’s Hong Kong Banking Survey 2011, released at a media briefing on Monday.

Total profits in the banking sector rose to $126 billion in 2010, up from $96 billion in 2009. The increase was mainly driven by better non-interest income, and the reduction in impairment charges and operating expenses, while net interest income contributed just $4 billion of the $30 billion increase.

Although banks in Hong Kong continued to enjoy strong revenues during the first half of this year, persistent low interest rates have eroded net interest margins, said Martin Wardle, a partner at KPMG China, commenting on the current easy monetary policy in Hong Kong.

“Liquidity is coming down, but it is still above the statutory liquidity ratio,” said Wardle. Liquidity ratios had dropped to around 37% by June this year, down from 54% in December 2009. The statutory ratio that financial institutions must maintain is 25%. “There are no immediate concerns, but liquidity is coming down and that is a challenge for the banks in terms of profitability.”

Another factor affecting liquidity in Hong Kong is the demand-supply mismatch in cash. On the supply side, customers’ expectations of renminbi appreciation has led them to swap their Hong Kong dollar deposits for renminbi, while, on the demand side, continuing low interest rates have driven up Hong Kong dollar loans. “The growth in local currency deposits has lagged behind HKD loans,” KPMG said in the report.

“While expectations of currency appreciation remain, transfers to renminbi will continue to erode some of the liquidity in Hong Kong’s banking system,” said Elie Lai, partner at KPMG China, commenting on the effect of the renminbi’s movement on Hong Kong’s finance industry, “Conversely, if the RMB does not appreciate, it would not be favourable to Hong Kong in terms of its longer term prospects as an offshore renminbi centre.”

The increasingly restrictive regulations also constrain liquidity. “Banks face increasing regulations and compliance requirements,” said Wardle. “Regulators are requiring them to raise their regulatory reserve ratios.”

KPMG’s survey also highlights the fact that banks have been reliant on strong loan growth to offset the continuing decline in net interest margins. Net interest margins plummeted to around 1.2% in the second quarter this year, down 40% from the first quarter in 2008. The pace at which loans have grown has increased the risk of higher bad debt charges.

“Looking ahead, many uncertainties remain for banks to develop a clear strategy for their Hong Kong and Asian businesses,” Wardle added.