People’s Republic of China–Hong Kong Special Administrative Region
Financial Sector Assessment Program-Stress Testing the Banking Sector-Technical Note

This Technical Note on Stress Testing the Banking Supervision was prepared in the context of the Financial Sector Assessment Program (FSAP) for the People’s Republic of China–Hong Kong Special Administrative Region (HKSAR). Bank liquidity tests focus on sudden, sizable withdrawals of funding and the sufficiency of existing assets to withstand those shocks under stressed conditions. The stress test results confirm a high degree of resilience of the sector. This reflects the strength of the banks at the starting position, which reduces their fundamental vulnerability to shocks. Banks in HKSAR hold very high levels of capital, are very profitable, and have a low level of asset impairments amid stable funding profiles. The Hong Kong Monetary Authority is encouraged to continue its integration of risk-based supervision in the development of stress test scenarios for macroprudential policy and surveillance. Banking supervisors routinely conduct stress tests and, from time to time, modify relevant assumptions in order to support thematic reviews of identified vulnerabilities against emerging risks.

Abstract

This Technical Note on Stress Testing the Banking Supervision was prepared in the context of the Financial Sector Assessment Program (FSAP) for the People’s Republic of China–Hong Kong Special Administrative Region (HKSAR). Bank liquidity tests focus on sudden, sizable withdrawals of funding and the sufficiency of existing assets to withstand those shocks under stressed conditions. The stress test results confirm a high degree of resilience of the sector. This reflects the strength of the banks at the starting position, which reduces their fundamental vulnerability to shocks. Banks in HKSAR hold very high levels of capital, are very profitable, and have a low level of asset impairments amid stable funding profiles. The Hong Kong Monetary Authority is encouraged to continue its integration of risk-based supervision in the development of stress test scenarios for macroprudential policy and surveillance. Banking supervisors routinely conduct stress tests and, from time to time, modify relevant assumptions in order to support thematic reviews of identified vulnerabilities against emerging risks.

Introduction1

A. Background and Objective

1. The stress testing exercise of the FSAP for HKSAR comprises a comprehensive vulnerability analysis of the banking sector.2 The stress test exercise—as part of the FSAP mission’s analysis of financial stability—determined the capacity of the banking sector to absorb realization of key macro-financial risks based on the assessment of capital adequacy and sufficiency of liquidity under stress. It was aimed at examining the system-wide resilience to shocks over the medium-term, uncovering vulnerabilities to any rapid deterioration in the macroeconomic environment and, more generally, identifying potential threats to financial stability.

2. This note presents the methodology and results of a detailed examination of solvency and liquidity risks. It follows a multi-pronged approach, reflecting a critical assessment of a large variety of possible vulnerabilities that can affect the viability of individual institutions and system-wide risks in the sector. In this context, different stress tests are combined into a comprehensive analysis of the sector’s vulnerability to a considerable economic contraction, including a substantial rise in unemployment, a sharp depreciation of real estate prices, and rising funding pressures. The objective of these tests is to determine the capacity of the banking sector—using mid-2013 financial data—to absorb any realization of key macro-financial risks. Solvency tests consist of a BU stress test by the selected local banks and a cross-validation through several TD tests, undertaken jointly by staff of the HKMA and the FSAP team.

3. Solvency tests are complemented by TD liquidity stress tests using supervisory data and parameters specified by both the HKMA and the FSAP team in the context of different approaches (Figure 1). These liquidity stress tests cover both the local banks and the largest foreign branches in the sector. The analysis relies on the prudential assumption that sufficiently high individual capital levels and liquidity buffers lower systemic risk. Given that institutional viability might be insufficient to maintain financial stability during times of extreme stress, one of the stress tests also considered the impact of joint tail risks on system-wide solvency conditions. Overall, the various stress tests conducted for FSAP cover around 50 to around 70 percent of the banking sector’s total assets—depending on the type of analysis—accounting for up to 78 percent of total deposits and 66 of total loans). The two TD solvency stress tests cover more than 99 percent of all locally incorporated licensed banks (“local banks”) (Table 9).

Figure 1.
Figure 1.

Hong Kong SAR: Macroprudential Stress Tests of Banking Sector

Citation: IMF Staff Country Reports 2014, 210; 10.5089/9781498322638.002.A001

Notes: The “combined basis” of a bank means the position of the bank’s Hong Kong office (solo basis) plus its overseas branches, while the “consolidated basis” covers the combined basis plus the bank’s subsidiaries; local bank=locally incorporated, licensed bank. The reference to “enhanced top-down” stress test emphasizes the fact that banks submitted their own (confidential) data (following review by the HKMA); this is typically not the case in top-down exercises, which are normally completed based on supervisory data.
Table 1.

Hong Kong SAR: Risk Assessment Matrix

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Table 2.

Hong Kong SAR: Stress Test Matrix (STeM) for the Banking Sector—Liquidity

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Table 3.

Hong Kong SAR: Stress Test Matrix (STeM) for the Banking Sector—Solvency

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Table 4.

Hong Kong SAR: Financial Soundness Indicators of the Banking Sector, 2007–13

(In percent unless otherwise indicated)

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Sources: Bankscope, HKMA and IMF staff calculations.Notes:

Calculated for all authorized institutions on HK office basis, unless otherwise indicated.

Locally incorporated authorized institutions.

HK office basis.

Consolidated basis. The “combined basis” of a bank means the position of the bank’s Hong Kong office plus its overseas branches, while the “consolidated basis” covers the combined basis plus the bank’s subsidiaries.

Combined basis. The “combined basis” of a bank means the position of the bank’s Hong Kong office plus its overseas branches

In percent of total customer deposits. Calculated for licensed banks.

Calculated for Hong Kong’s four largest banks on consolidated basis

All authorized institutions

WEO data was used for 2013H1 Hong Kong GDP data.

Table 5.

Hong Kong SAR: Economic Activity under Different Scenarios

(annual percentage change, unless otherwise indicated)

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Sources: HKMA and IMF staff estimates and calculations. Note: Interest rates shown for 2013 above are recorded as of end-June 2013.
Table 6.

Hong Kong SAR: HKMA Solvency Top-down Stress Test-Detailed Assumptions

(Scenario Analysis)

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Table 7.

Hong Kong SAR: Liquidity Stress Test—Maturity Mismatch Analysis

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Sources: HKMA and IMF staff estimates and calculations.
Table 8.

Hong Kong SAR: Systemic Contingent Claims Approach—Comparison of Total Assets for Locally Incorporated Licensed Banks (“Local Banks”) and Respective Listed Entities

(In millions of HKD, end-June 2013)

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Sources: Bloomberg, Bankscope and IMF staff calculations.Notes: * The share of the locally incorporated bank (“local bank”) serves as scaling factor for the implied assets derived from the equity price and the implied equity volatility as inputs to the estimation of market-implied expected losses within the SCCA framework. A similar scaling is applied to adjusted liabilities as default barrier (Jobst and Gray, 2013). Note that the amount of total assets shown for HSBC as locally incorporated bank excludes Hang Seng Bank Ltd.
Table 9.

Hong Kong SAR: Overview of Sample Banks in the Solvency and Liquidity Stress Testing Exercise

(as of end-June 2013)

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Sources: Banks’ disclosure statements, HKMA, and IMF staff calculations.Notes: The subsidiaries of HSBC and Bank of China in Group 1 are shown separately but are excluded from the reported sample coverage on a consolidated basis in order to avoid double-counting.

The “combined basis” of a bank means the position of the bank’s Hong Kong office plus its overseas branches, while the “consolidated basis” covers the combined basis plus the bank’s subsidiaries; reporting on a solo basis refers to the operations of the Hong Kong office only. The consolidated reporting of the TD stress test includes the banks marked (#) and (##) for subsidiaries of Bank of China (HK) and HSBC Ltd., respectively;

Based on Jobst and Gray (2013). Banks marked (*) are subject to an adjustment of their market-implied asset value/asset volatility as the equity price/equity volatility relates to the group-wide performance (which is dominated by activities outside HKSAR);

Apart from the ICF tests and solvency-liquidity linkage analysis, the Basel III standard liquidity measures (LCR and NSFR) are calculated for the purpose of analysing the banking sector’s liquidity conditions. It covers a selection of locally incorporated banks on a consolidated and/or combined basis, and foreign branches on a solo basis, which in aggregate accounts for about 60 percent of the banking sector in terms of total assets;

This part of the liquidity stress test includes approaches by both the HKMA and the IMF on a solo basis;

Banks liquidity conditions are tested on a consolidated basis using a pre-defined set of credit and market risk shocks affecting their solvency condition, based on Wong and Hui (2009). Bank of China’s consolidated reporting includes the two banks marked (#) while HSBC’s consolidated reporting for this test excludes Hang Seng Bank (##), which has been tested separately.

Foreign branches are also referred to as “non-locally incorporated, licensed banks”;

The number in parentheses indicates the number of firms in each category, which have been excluded from the stress test;

The 39 locally incorporated institutions comprise two locally incorporated licensed banks, 13 restricted license banks, and 24 deposit-taking companies. Since six deposit-taking companies are subsidiaries of the locally incorporated licensed banks in Group 1, these subsidiaries’ assets are removed from the total consolidated firms outside the scope of the stress test.

4. Key risks over both the short- and medium-term are incorporated into the design of the stress tests. The assessment is completed by considering three key channels of stress affecting bank balance sheets from a creditor perspective: (i) impairment charges (credit losses, other losses from held-to-maturity assets) and mark-to-market (MtM) valuation changes of fixed income securities (financial and government bonds) in both the trading and banking book3; (ii) changes in pre-impairment income, including changes in funding costs; and (iii) changes in risk-weighted assets (RWAs). The impact of general conditions affecting risk factors, such as rising risk aversion in capital markets (via market-implied risk measures) and upcoming regulatory reforms (Basel III) are examined. The stress test also incorporates specific risk factors, including cross-border developments (such as sovereign risk) and foreign currency risk in order to determine the capacity of banks to absorb the manifestation of macro-financial stress, without identifying individual institutions.4 The findings are to be used flexibly, given the forward-looking perspective and the objective of identifying emerging vulnerabilities under extreme but plausible stress scenarios. The completion and reporting of findings have been closely coordinated with the HKMA.

5. The purpose of the stress test exercise differs from that of supervisory stress testing. The multi-period FSAP stress test exercise is designed and completed for surveillance purposes, with a medium-term focus. The exercise typically involves very severe stress scenarios to assess the overall resilience of the banking sector. The results of the stress testing exercise have no immediate supervisory implications but provide input into a broader analysis undertaken by the FSAP, forming the basis for policy discussions with the authorities. This is different from the routine capital reviews undertaken by the authorities, which are aimed at identifying potential capital needs as part of the capital adequacy assessment under Pillar II, and for which management actions may be required. No management action would be expected as a result of the FSAP stress tests.

6. The banking sector is large and concentrated with several banking groups (Figure 2). The sector comprises 201 institutions—156 licensed banks, 21 restricted license banks, and 24 deposit-taking companies—with assets equivalent to 705 percent of GDP. The assets are concentrated in four banks, which account for almost half of the consolidated assets of the banking sector. The sector has been growing rapidly over the recent years, driven by mortgage-related lending and increasing exposure to non-financial corporates in Mainland China. Lending to the corporate sector represents around half of the banking system’s total lending, while property-lending accounts for about a third (Figure 6). Banks are primarily funded by customer deposits, which account for 71 percent of local banks’ total liabilities at end-2012 (Figure 3). In recent years, the aggregate loan-to-deposit ratio has increased as some banks issued certificates of deposits in the wholesale market to diversify their funding sources. In contrast, foreign branches in general rely more on interbank deposits and borrowing from their parent banks, with customer deposits representing a much smaller part of their total liabilities (31 percent).

Figure 2.
Figure 2.

Hong Kong SAR: Structural Features of Hong Kong Financial Sector

Citation: IMF Staff Country Reports 2014, 210; 10.5089/9781498322638.002.A001

Sources: Bankscope, HKMA, Australian Prudential Regulation Authority, Bank of England, China Banking Regulatory Commission, European Central Bank, Financial Supervisory Service of Korea, Japanese Bankers Association, Monetary Authority of Singapore, Reserve Bank of India, United States Federal Reserve Board, and IMF staff calculations.Notes: 1/ The number for Hong Kong includes all authorized institutions on the Hong Kong office basis.2/ The assets of the four largest banks in Hong Kong account for around half of the industry total on consolidated basis.3/ The “combined basis” of a bank means the position of the bank’s Hong Kong office plus its overseas branches, while the “consolidated basis” covers the combined basis plus the bank’s subsidiaries.
Figure 3.
Figure 3.

Hong Kong SAR: Banking Sector Developments

Citation: IMF Staff Country Reports 2014, 210; 10.5089/9781498322638.002.A001

Sources: HKMA and IMF staff calculations.Notes: 1/ Data for locally incorporated banks is on combined basis. The “combined basis” means the position of the bank’s Hong Kong office plus its overseas branches, while the “consolidated basis” covers the combined basis plus the bank’s subsidiaries.2/ Hong Kong office basis.3/ Loans exclude non-bank loans; deposits include deposits and saving certificates; data for locally incorporated banks is on combined basis and on Hong Kong office basis for foreign bank branches.
Figure 4.
Figure 4.

Hong Kong SAR: Banking Sector Soundness

Citation: IMF Staff Country Reports 2014, 210; 10.5089/9781498322638.002.A001

Sources: HKMA, IMF FSI database, and IMF staff calculations.Notes: 1/ All authorized institutions on Hong Kong office basis.2/ Capital adequacy ratio and Tier 1 capital adequacy ratio for locally incorporated authorized institutions (AIs) on consolidated basis; return on assets for all AIs on Hong Kong office basis; NPLs to gross loans for all AIs on combined basis.3/ Locally incorporated licensed banks on combined basis; leverage refers to capital divided by total assets.4/ Asset-weighted average for the four largest banks on consolidated basis.5/ All locally incorporated authorized institutions on combined basis; the “combined basis” of a bank means the position of the bank’s Hong Kong office (solo basis) plus its overseas branches.
Figure 5.
Figure 5.

Hong Kong SAR: Banking Sector Performance

Citation: IMF Staff Country Reports 2014, 210; 10.5089/9781498322638.002.A001

Sources: HKMA and IMF staff calculations.Notes: 1/ Asset-weighted averages of 19 Group 1 banks on a combined basis; the “combined basis” of a bank means the position of the bank’s Hong Kong office (solo basis) plus its overseas branches.2/ Asset-weighted averages of 19 Group 1 banks on a combined basis; interest income and expenses are expressed in percent of total assets; net interest margin is scaled to total customer loans.3/ Combined basis. Retail banks comprise all the locally incorporated, licensed banks plus foreign bank branches that engage in material retail banking business; classified loans are net of specific provisions/individual impairment allowances.4/ All authorized institutions on Hong Kong office basis.5/ Consolidated basis; the “combined basis” of a bank means the position of the bank’s Hong Kong office plus its overseas branches, while the “consolidated basis” covers the combined basis plus the bank’s subsidiaries. Position as of December 2012.6/ Locally incorporated, licensed banks on a combined basis.
Figure 6.
Figure 6.

Hong Kong SAR: Banking Sector—Lending and Deposit Composition

Citation: IMF Staff Country Reports 2014, 210; 10.5089/9781498322638.002.A001

Sources: HKMA and IMF staff calculations.Notes: 1/ All authorized institutions on a Hong Kong office basis. Mainland nonbank loans refer to external claims on non-bank customers in Mainland China.2/ Deposits at licensed banks on a Hong Kong office basis; unadjusted for foreign currency swap deposits.3/ All authorized institutions on a Hong Kong office basis.

7. Liquidity risks for banks are generally low (Figure 10). While banks are not reliant on wholesale funding, it is desirable for banks to develop alternative term funding sources at longer maturity tenors to augment the large deposit base, which creates considerable maturity mismatches beyond one year. Asset encumbrance is relatively low, with total unencumbered liquid assets remaining stable relative to the amount of short-term liabilities.

Figure 7.
Figure 7.

Hong Kong SAR: Banking Sector—Lending and Deposit Trends

Citation: IMF Staff Country Reports 2014, 210; 10.5089/9781498322638.002.A001

Sources: HKMA and IMF staff calculations.Notes: 1/ All authorized institutions. Hong Kong office basis.2/ All authorized institutions on a Hong Kong office basis. Non-financial corporate deposits and household deposits are estimated from the results of LCR QIS for December 2012 by the HKMA.3/ Deposits with all authorized institutions on a Hong Kong office basis, adjusted for foreign currency swap deposits.
Figure 8.
Figure 8.

Hong Kong SAR: Macroeconomic Assumptions under Different Stress Test Scenarios (1)

Citation: IMF Staff Country Reports 2014, 210; 10.5089/9781498322638.002.A001

Sources: HKMA and IMF staff estimates and calculations.Notes: For the BU solvency stress test, the commercial real estate prices and residential house price are used. The chart above refers to residential house prices only (which form the basis for the modelling of commercial property prices.
Figure 9.
Figure 9.

Hong Kong SAR: Macroeconomic Assumptions under Different Stress Test Scenarios (2)

Citation: IMF Staff Country Reports 2014, 210; 10.5089/9781498322638.002.A001

Sources: HKMA and IMF staff estimates and calculations.Notes: Best lending rate refers to the rate quoted by HSBC. Interest rates for 2013 above are recorded as of end-June 2013.
Figure 10.
Figure 10.

Hong Kong SAR: Liquidity and Short-term Funding

Citation: IMF Staff Country Reports 2014, 210; 10.5089/9781498322638.002.A001

Sources: HKMA and IMF staff calculations.Notes: 1/ For the HKMA Liquidity Ratio (7-day test) and HKMA Enhanced Liquidity Test, 19 local banks and 8 foreign branches are included. The ratios are specified as total inflows (including liquid financial assets and non-cumulative cash inflows) as a percentage of total outflows.2/ Sum of unsecured open maturity retail deposits as well as similar liabilities with a remaining maturity of less than 1 year. Secured and long-term (> 1 year) financing are not included. Total debt includes all unsecured/secured retail and wholesale financing.3/ Sum of unsecured open maturity wholesale (i.e., non-retail) deposits and unsecured bonds as well as similar liabilities with a remaining maturity of less than 1 year. Intra-group, secured, long-term (> 1 year) and retail financing are not included. Total debt includes all unsecured/secured retail and wholesale financing.4/ Callable (unsecured) wholesale funding includes all unsecured wholesale deposits and bonds with an open maturity or maturing within one week. Intra-group, secured, medium-term (> 1 week) and retail financing are not included. Total debt includes all unsecured/secured retail and wholesale financing.5/ Unencumbered assets include all unencumbered cash and unencumbered central bank/HKMA-LOLR eligible, repoable, marketable and re-usable financial assets, measured at market value and before prudential haircuts.

B. Synopsis

8. Comprehensive and stringent stress tests of the banking sector have been conducted in close cooperation with HKMA staff. Both solvency and liquidity stress tests are based on the mid-2013 financial data of the key institutions as well as the macroeconomic projections and financial market information available at that time. Up to 19 local banks and eight foreign branches were included in the stress tests.5 The FSAP’s close collaboration with the HKMA and banks meant that granular supervisory information as well as banks’ own internal data were used in the tests, in addition to publicly available information.

9. The objective of the stress testing exercise was to assess the resilience of the banking sector to solvency and funding shocks under different macroeconomic scenarios. The stress test considers the sector’s vulnerability to a renewed economic contraction, including a substantial rise in unemployment, a sharp depreciation of real estate prices, and declining profitability from lending due to competitive pressures on lending rates and rising funding costs. Also the impact of general conditions affecting risk factors, such as rising sovereign risk and upcoming regulatory reforms are examined.

10. The solvency tests are based on three scenarios, determined in collaboration with the HKMA. The scenarios comprise a baseline scenario and two adverse scenarios, specified contingent on the projected economic growth paths of HKSAR, Mainland China, and the United States. These have been identified as the core economies influencing the macro-financial linkages affecting the performance of the banking sector. Hurdle rates are applied according to the Basel III implementation schedule.

11. Cross-border effects are considered in all macroeconomic scenarios. Assumpt