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The global banking industry experienced a period of considerable turmoil in the past year as a number of banks collapsed. These developments were shocking partly because of the speed of the collapse of several of the banks involved, as well as the fact that many of them had previously been large and successful players in their market. 

Although most of the issues that led to the collapse of these banks are not directly relevant to Hong Kong banks, there are still lessons on risk management for all financial institutions to bear in mind. 

Reasons for the collapse

One of the triggers for the collapse of the affected banks was the macroeconomic environment. Central banks around the world have rolled out an unprecedented programme of interest rate hikes over the past year in an effort to bring inflation under control.

A side effect of this policy has been a significant impact on the value of bonds, in particular longer term bonds, which lost market value of as much as 30%. For banks that were holding a large amount of these bonds and similar types of securities, this would become a major issue.

The reason that some banks were holding so many of these bonds was due to their high level of deposits. The boom of the past few years had resulted in a huge inflow of deposits to banks during 2020 and 2021. Some banks chose to invest a lot of these deposits in long-term mortgage-backed securities and bonds, but this meant that they were highly vulnerable when interest rates rose and the fair value of the bonds dropped. 

At the same time, as the global economy cooled in 2022 and the amount of deposits shrunk, banks needed to adjust their balance sheets and sold some of the available-for-sale (AFS) securities at a loss. Customers were spooked by this unexpected development, and many of them rushed to transfer their deposits.

Good practice for banks

From the experience of the collapse of several banks, some reminders of good practice can be taken on board.

On the asset side, banks should remember that focusing too much investment in longer term bonds, without hedging their assets, means they will be more seriously affected by the impact of interest rate rises. 

On the liability side, banks should be alert to concentration risk. Similar types of customers demonstrate similar behaviours, which becomes a problem if certain customers want to make large withdrawals. This includes have too many customers concentrated in the same industry, or customers with high levels of deposits that are not covered by their respective government’s insurance level for bank deposits. 

Associated with concentration risk is reputational risk. When customers are concentrated within a certain type or sector, they can often also communicate with each other and share news or concerns easily and quickly. Such a highly concentrated customer base means that reputational rumours will have a bigger impact than on banks with a much broader customer base. 

Another area to look out for is a mismatch in the duration of assets and liabilities. A mismatch is normal practice for banks so they can gain a higher return on their assets, but banks should take care that it doesn’t start to grow far beyond industry norms. 

Some other key issues that banks could consider include governance. Banks must pay close attention to all the regulatory demands in the jurisdictions where they operate. However, in cases where regulations have eased, banks should perhaps consider the impact from a risk perspective and check whether lower regulatory demands may have other consequences for their operations. Banks should also ensure that they have a well-resourced Risk Management function that has the expertise and knowledge to flag up any issues sooner rather than later.

Key risk lessons

There are still important lessons that all financial institutions can learn from the issues that affected many of the collapsed banks. Firstly, banks should pay close attention to their balance sheet and monitor the asset and liability mismatch, including the interest rate risk and the duration of the balance sheet. Hong Kong banks should strengthen their Asset-Liability Committee (ALCO) oversight and responsibilities.

Secondly, banks should be aware that any concentration in types of borrowers is a red flag, while deposits that rely too much on a specific industry is another cause for concern.

A third point that banks should consider is the disconnect between accounting and risk regulation. From an accounting perspective, some assets are measured at amortised cost, meaning that they are valued at the initial purchase cost, not at fair value. But when these assets are sold, they can only be sold at market value. This could end up being a lot lower than the initial cost. Banks should be aware of this possible disconnect to ensure that they have a realistic view of the market value of their assets, especially when those bonds could potentially be the source of liquidity to cover large cash outflow.

While the global banking turmoil seems to have eased, there may be wider repercussions. There has been a significant move of deposits out of smaller banks to larger banks. This pattern could affect the property sector as most commercial real estate loans in the US are held by medium and small banks. If a significant number of customers move their deposits, this could potentially trigger a crisis in commercial real estate loans, and in turn lower the price of commercial real estate. 

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