Topic H: Money and Banking
Banks: Functions and Services
Ever wondered what a bank really does with your money after you deposit it? Or why your parents might go to HSBC, but a large corporation might use a different kind of financial institution? This chapter explores the roles that banks play in the economy, from everyday retail banking to the central banking institutions that manage the financial system in Hong Kong.
What are Banks and Why Do They Matter?
At its simplest, a bank is a financial intermediary. That is a middleman for money that connects people who have surplus funds (savers) with people who need funds (borrowers).
The Core Function: Financial Intermediation
Think of a bank like a bridge for money:
- On one side of the bridge are savers (depositing savings into bank accounts).
- On the other side are borrowers (such as families buying flats or entrepreneurs financing business expansion).
Commercial Banks: The Banks We Use Every Day
A commercial bank is a profit-seeking financial institution that provides banking services to the general public and business firms.
Examples in Hong Kong: HSBC, Hang Seng Bank, Bank of China (Hong Kong), Standard Chartered Bank.
Main Functions of Commercial Banks
1. Accepting Deposits: Banks accept funds from customers for safekeeping and liquidity, offering interest on savings and time deposits.
2. Making Loans and Advances: Banks lend out a portion of deposited funds to borrowers at a higher interest rate than the deposit rate, earning net interest income.
3. Credit (Deposit) Creation: Commercial banks create new bank deposits through the process of lending under a fractional reserve banking system.
Other Services Provided by Commercial Banks
- Payment and Settlement Services: Facilitating transactions via cheques, credit cards, debit cards, and electronic payment systems such as the Faster Payment System (FPS).
- Foreign Currency Exchange: Converting Hong Kong Dollars into foreign currencies for travel or international trade.
- Safe Deposit Boxes: Providing secure storage for valuable physical items.
- Wealth Management and Insurance: Providing investment advice, securities trading, and insurance products.
Deposit Creation (Credit Creation)
Under a fractional reserve banking system, commercial banks are required to keep only a fraction of their total deposits as reserves (cash in vaults and deposits with the central bank) to meet withdrawal demands. The rest can be lent out.
Key Terms in Deposit Creation
- Actual Reserves: The total reserves a bank currently holds.
- Required Reserves (Legal Reserves): The minimum amount of reserves a bank is legally required or prudently needs to hold: \(\text{Required Reserves} = \text{Total Deposits} \times R\), where \(R\) is the required reserve ratio.
- Excess Reserves: Reserves held above the required level: \(\text{Excess Reserves} = \text{Actual Reserves} - \text{Required Reserves}\). Only excess reserves can be used to make new loans.
The Deposit Multiplier Formula
When a bank makes a loan from excess reserves, the borrower spends the funds, and the recipient redeposits the money into the banking system, enabling further lending. This multiple expansion leads to:
\(\text{Maximum Deposit Multiplier} = \frac{1}{R}\)
\(\text{Maximum Total Deposits Created} = \frac{\text{Initial Deposit}}{R}\)
\(\text{Maximum Change in Money Supply} = \Delta \text{Deposits} - \text{Cash Inflow}\) (if an initial cash deposit was shifted from public circulation into the bank).
Assumptions for Maximum Credit Creation
- There is no cash leakage: the public deposits all loaned money back into the banking system without holding additional cash.
- Banks hold no excess reserves: banks lend out all available excess reserves completely.
- There is sufficient demand for loans from qualified borrowers.
The Central Bank: The Monetary Authority
A central bank is the primary monetary authority responsible for overseeing a nation's monetary system, managing the money supply, and supervising the banking sector. Central banks do not accept deposits from or make loans to the general public.
Key Functions of a Central Bank
1. Banker to the Government: Managing government accounts, receiving tax revenues, and handling government payments and debt issuance.
2. Banker to Commercial Banks & Lender of Last Resort: Holding settlement accounts for commercial banks and providing emergency liquidity to solvent banks experiencing short-term liquidity distress to prevent systemic failure.
3. Issuing Legal Tender Currency: Managing and issuing official banknotes and coins.
4. Formulating and Implementing Monetary Policy: Managing interest rates, exchange rates, and the monetary base to maintain price stability and macroeconomic stability.
5. Prudential Supervision: Regulating and supervising commercial banks to ensure the safety and soundness of the financial system.
Banking in Hong Kong: Structure and Regulation
Hong Kong does not have a single institution titled "Central Bank". Instead, central banking functions are performed primarily by the Hong Kong Monetary Authority (HKMA), in conjunction with selected commercial note-issuing banks.
Central Banking Functions in Hong Kong
- Hong Kong Monetary Authority (HKMA): Established in 1993, the HKMA maintains monetary and financial stability, operates the Linked Exchange Rate System, manages the Exchange Fund (HK's official reserves), and regulates the banking system.
- Note-Issuing: The HKMA issues the HK\$10 banknote (paper and polymer) and all coins on behalf of the HKSAR Government. Banknotes in denominations of HK\$20, HK\$50, HK\$100, HK\$500, and HK\$1,000 are issued by three commercial note-issuing banks:
- The Hongkong and Shanghai Banking Corporation Limited (HSBC)
- Standard Chartered Bank (Hong Kong) Limited
- Bank of China (Hong Kong) Limited
Hong Kong's Three-Tier Banking System
Under the Banking Ordinance, deposit-taking institutions in Hong Kong are classified into three tiers based on minimum deposit amounts, deposit terms, and business scope:
1. Licensed Banks (持牌銀行)
- May accept deposits of any size and any maturity.
- The only tier permitted to operate current and savings accounts (chequing facilities).
- Examples: HSBC, Hang Seng Bank, Citibank (Hong Kong).
2. Restricted Licence Banks (有限制牌照銀行)
- Principal business includes merchant banking and capital market activities.
- May only accept deposits of HK\$500,000 or above.
- No restriction on deposit term/maturity.
3. Deposit-taking Companies (接受存款公司)
- Often associated with licensed banks and engage in specialized consumer finance or trade finance.
- May only accept deposits of HK\$100,000 or above.
- Must have an original term to maturity of at least 3 months.
Summary Table: The Three Tiers
Licensed Banks:
- Minimum Deposit: Any amount (no minimum)
- Minimum Maturity: None
Restricted Licence Banks:
- Minimum Deposit: HK\$500,000
- Minimum Maturity: None
Deposit-taking Companies:
- Minimum Deposit: HK\$100,000
- Minimum Maturity: 3 months