Managing financial stability and liquidity risks in Hong Kong's banking system : what is the optimum supervisory model?

Abstract

The 2007-8 global financial crisis brought to the fore a new era of liquidity risk. Governments around the globe were forced to intervene to preclude a complete collapse of their respective financial and banking systems. The failure of financial supervision was in part caused by segments of the financial system being either inadequately regulated or unregulated. Thus far the international response - including in Hong Kong - has focused on regulatory tools. However, does this approach reflect the prudent management of liquidity risks which threaten financial stability? This thesis will analyse the optimum supervisory model to manage the financial stability of Hong Kong’s banking system when exposed to substantial liquidity risks. The key elements necessary - financial stability, liquidity, and financial supervision of the banking and monetary systems – will be analysed to form a theoretical basis to determine the optimum supervisory model.

Supervisory and regulatory issues influencing the relationship between financial supervision and the regulatory toolkit shall be examined in detail under three broad themes, the unified sectoral supervisory structure, integrated and cross-sectoral supervision, and systemic supervision. Unified sectoral supervision will concentrate on the issue of central banking and whether this should be unified or separated from banking supervision when managing market liquidity.

The analysis reveals that the HKMA’s constrained monetary policy powers impairs the capacity to manage financial stability. Further market liquidity tools can be successfully implemented by a central bank without a banking supervisory ambit. A unified structure was beneficial to mitigate co-ordination frictions between supervisors.

There was no perceived advantage between the Integrated and Sectoral supervisory models when planning the implementation of market liquidity facilities. However the HKMA’s cross-sectoral supervisory ambit is subject to structural biases with the supervision of hybrid financial instruments suffering from micro-prudential underlap. This flaw can adversely affect the supervision of universal banks’ liquidity ratios. The HKMA is susceptible to a market conduct bias similar to the United Kingdom’s Integrated model.

The HKMA does not capture systemic liquidity risks outside the banking system. Systemic macro-prudential supervisory underlap and frictions arise between the HKMA and the Financial Stability Council. The HKMA’s supervision of banks’ short-term liquidity ratios is impeded by systemic cross-sectoral micro-prudential underlap. Supervision of OTC derivative financial infrastructure is constrained by the SFC’s and HKMA’s systemic macro-prudential supervisory underlap. This underlap encapsulates all financial sectors outside the HKMA’s supervisory ambit, notably the shadow banking system. Renminbi infrastructure is subject to a systemic macro-prudential underlap between the HKMA and the People’s Bank of China. Micro-prudential Renminbi banking supervision is inhibited by a supervisory underlap between the HKMA and the China Banking Regulatory Commission.

Despite the HKMA’s supervisory structure reflecting Hong Kong’s banking and monetary systems, the design is structurally flawed when exposed to substantial liquidity risks which threaten financial stability in the banking system. On balance, the optimum supervisory model to manage liquidity risks in Hong Kong’s banking system is the Twin Peaks model.