The Operation of the Moratorium on New Bank Licenses on the Hong Kong Banking System 1965-81

31 Pages Posted: 23 Aug 2007 Last revised: 9 Aug 2022

Date Written: October 1, 2006

Abstract

This working paper was written by Catherine R. Schenk (University of Glasgow).

In the mid-1960s two major institutional changes decreased the freedom for competition among banks in Hong Kong. In 1964, in response to a supposed 'interest rate war' the Exchange Banks Association (the precursor to the Hong Kong Association of Banks) was able to negotiate an Interest Rate Agreement that applied to all banks operating in the colony. Secondly, in May 1965, after two waves of banking crisis in February and April of that year, the government imposed a moratorium on new bank licenses. Both restrictions were retained (in amended form) until 2001. The longevity of both of these anticompetitive regulations in Hong Kong had a profound impact on the development of the banking system in the 36 years they were in force.

This paper investigates the operation and impact of the moratorium on the banking system of Hong Kong. It will first show how the regulation of price competition in Hong Kong led to calls from banks for further protection from non-price competition and how this became specifically aimed at foreign banks. Secondly, the paper will discuss the changes in the operation of the moratorium and how it influenced foreign acquisition. This turned out to be an inadequate solution to poor governance partly because the barriers to entry increased the bargaining power of local banks in the acquisition process. Finally, the paper assesses the moratorium's impact on the expansion of deposit taking finance companies outside the prudential regulations of the banking system, and how the regulation of these new institutions was only reluctantly introduced by the government. The general conclusions are that the moratorium and the interest rate agreement together decreased the regulatory breadth of the government, and reduced the incentives for mergers and acquisitions that might have improved governance. Evidence of fraud and poor governance immediately after the lifting of the moratorium show that it was not an effective cure for the governance problems of the Hong Kong banking system. Barriers to entry were not a substitute for effective prudential supervision.

In the mid-1960s two major institutional changes decreased the freedom for competition among banks in Hong Kong. In 1964, in response to a supposed 'interest rate war', the Exchange Banks Association (the precursor to the Hong Kong Association of Banks) was able to negotiate an Interest Rate Agreement that applied to all banks operating in the colony. Interest rate cartels were not unusual in the 1960s; similar arrangements existed in both the USA and the UK. However, these countries abandoned interest rate controls in the 1970s, while Hong Kong maintained their Interest Rate Rules in amended form until 2001. Secondly, in May 1965, after two waves of banking crisis in February and April of that year, the government imposed a moratorium on new bank licenses. The large banks had lobbied for this restriction since the banking crisis of 1961. Hong Kong finally lifted the barriers to entry of foreign banks in 2001. The longevity of both of these anti-competitive regulations in Hong Kong had a profound impact on the development of the banking system in the 36 years they were in force.

The official rationale for the moratorium on new bank licenses in 1965 was to enhance stability by encouraging consolidation in the banking sector. Forty years later, the relationship between stability of banking systems and concentration is still the subject of debate. On the one hand, a comparison between the historically unstable US system, with a proliferation of small banks, and the relatively stable systems of Canada and Europe, where a few large banks dominate, suggests that 'big is beautiful'. Large banks might be more stable because they are better able to diversify risk. Moreover, in a less competitive environment they might accumulate larger profits and be less prone to engage in risky behaviour. Allen and Gale have also argued that it is easier for a government to supervise and enforce prudential supervision in a system with a small number of banks.4 On the other hand, the dominance of a few large banks might lead to a situation where they become 'too big to fail' and thus induce moral hazard. Large banks may also have complex and opaque operations that make supervision more challenging. International evidence has also suggested that systems with greater market share for small banks have more lending to SMEs.

Recent empirical research suggests that barriers to entry by foreign banks do not enhance the stability of banking systems. The presence of foreign banks may increase the quality of the banking system through the import of managerial and technological efficiencies. Where banks are subject to sound regulatory and supervisory jurisdictions this may also transfer to the host centre. On the other hand, foreign banks may face more information obstacles to lending to local SMEs, an issue that could have particular relevance for Hong Kong, where SMEs dominated the manufacturing sector.

Theoretically, a moratorium could encourage consolidation through foreign acquisition (since this becomes the only method of entry to the market), but it would also decrease the incentive for horizontal consolidation if the moratorium (and the accompanying interest rate agreement) raised profits to a comfortable level. One of the goals of lifting the interest rate rules in 2001 was to encourage the merger of smaller banks in Hong Kong.7 The HKMA also reported in 2000 that it was encouraging bank mergers through public statements and private discussions with individual institutions at the same time that barriers to entry for foreign banks were being lifted. David Carse, Deputy Chief Executive of the HKMA, noted in a report to the BIS that the reasons why the banking industry had not consolidated during the 1990s had to do first with ownership structures (family control or a large proportion of minority shareholders), secondly because profits were healthy so there was no pressure for consolidation, and thirdly because large local banks did not want to increase their market share further. These factors could all be reinforced by the anticompetitive regulation operating during this period.

This paper investigates the operation and impact of the moratorium on the banking system of Hong Kong. It will first show how the regulation of price competition in Hong Kong led to calls from banks for further protection from non-price competition and how this became specifically aimed at foreign banks. Secondly, the paper will discuss the changes in the operation of the moratorium and how it influenced foreign acquisition. This turned out to be an inadequate solution to poor governance partly because the barriers to entry increased the bargaining power of local banks in the acquisition process. Finally, the paper assesses the moratorium's impact on the expansion of deposit taking finance companies outside the prudential regulations of the banking system, and how the regulation of these new institutions was only reluctantly introduced by the government. This shows that the three-tiered system in place today was devised as early as 1974, although it was not introduced until 1981. The general conclusions are that the moratorium and the interest rate agreement together decreased the regulatory breadth of the government, and reduced the incentives for mergers and acquisitions that might have improved governance. Evidence of fraud and poor governance immediately after the lifting of the moratorium show that it was not an effective cure for the governance problems of the Hong Kong banking system. Barriers to entry are not a substitute for effective prudential supervision.

Suggested Citation

Institute for Monetary and Financial Research, Hong Kong, The Operation of the Moratorium on New Bank Licenses on the Hong Kong Banking System 1965-81 (October 1, 2006). Hong Kong Institute for Monetary and Financial Research (HKIMR) Research Paper WP No. 12/2006, Available at SSRN: https://ssrn.com/abstract=1008237 or http://dx.doi.org/10.2139/ssrn.1008237

Hong Kong Institute for Monetary and Financial Research (Contact Author)

(HKIMR) ( email )

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