Speculation has been mounting that the digital yuan will be used to displace the US dollar and circumvent sanctions. In retaliation, financial institutions can be targeted whereby US dollar payment or financial system access can be sanctioned. If the United States weaponizes the dollar, the digital yuan will not provide sanction protection beyond the status quo. The digital yuan’s true innovation is the ability to manage capital controls and facilitate financial liberalization. Being a programmable currency, the digital yuan enables Mainland China to open its economy more expeditiously than would normally be possible, while providing the regulatory levers to manage monetary and financial stability. Mainland technology companies are instrumental in the circulation of the digital yuan through electronic payment platforms. These same technology companies have recently established virtual banks and stored value facility payment platforms in Hong Kong. This chapter argues that technology is introducing new risks into Hong Kong’s banking system which pose a material risk to financial stability. To manage these risks, financial data supervision and infrastructure is required which currently does not exist. With the recent growth surge and volatility in cryptocurrency markets, the current approach of neglecting financial stability supervision is erroneous and reckless.

During the 2008–9 global financial crisis, credit default swaps created conduits in the financial system which facilitated the transmission of systemic risk. In response, the Financial Stability Board recommended over-the-counter derivative clearing through a central clearing counterparty. Although the Securities and Futures Commission is the designated supervisor and resolution authority for Hong Kong’s central clearing counterparty, OTC Clear, its supervisory ambit, capacity, and powers are insufficient to mitigate systemic risk and manage financial stability. This chapter argues that a securities supervisor is not the optimal supervisor or resolution authority for OTC Clear. Central clearing counterparties require credit and liquidity risk management which aligns more with banking supervision and central banking. This is supported by the dominance of foreign exchange and interest rate derivatives being traded in Hong Kong. The optimal resolution authority for OTC Clear is the Hong Kong Monetary Authority, being the resolution authority for systemically important banks, having monetary authority expertise that aligns with foreign exchange and interest rate risks, experience in mitigating credit and liquidity risks, and being designed to manage financial stability.

Supervisory models evolve with financial markets. To address the evolution of financial markets and institutions, new supervisory structures have been developed. This chapter analyzes systemic supervision under the integrated, functional, and Twin Peaks models, and systemic composite bodies to elucidate their strengths and weaknesses when managing financial stability. Models examined cover those in Hong Kong, Mainland China, the United States, United Kingdom, Singapore, Australia, South Africa, and the Netherlands. Systemic oversight between traditional central banks and integrated micro-prudential supervisors is subject to supervisory underlap. This was the core weakness of the United Kingdom’s integrated model and is a regulatory flaw inherent to the institutional, sectoral, and functional models. Composite systemic bodies are imperative for supervisory models consisting of central banks that are not unified with prudential supervisors or divided among multiple supervisors. The Twin Peaks model does not need a composite systemic body because this is the role of the systemic peak supervisor. Neither does a unified fully integrated supervisor because the role is internalized. However, competing objectives within a fully integrated supervisor can produce bias and conflicts, eroding systemic supervision and financial stability.

In the wake of the 2008–9 global financial crisis, the G20 devised a framework for a sustainable recovery based on international cooperation. An agreement was reached to ensure that inter alia macro-prudential and regulatory policies would support sustainable economies by preventing credit and asset price cycles from becoming forces for financial destabilization. The G20 recognized the importance of striking a balance between micro- and macro-prudential regulation to control risks, and to develop tools to monitor the build-up of systemic risk in the financial system. This chapter argues that the design of the supervisory structure is instrumental in striking the appropriate balance between these regulatory disciplines. Clear mandates and supervisory judgement are necessary to control this interdependent relationship. Regulatory underlap, gaps, and arbitrage can surface when the supervisory structure does not harmonize with legal infrastructure. To mitigate these regulatory flaws causing financial instability and producing unsustainable economies, supervisors must have sufficient capacity, expertise, awareness, and discretion. Attaining financial stability and a sustainable economy requires the supervisory structure or model, and the supervisor’s capacity and expertise to be harmonized with the legal infrastructure.

Banks can become illiquid when wholesale funding markets to not function for extended periods of time. Illiquidity quickly transforms into insolvency if liquid assets or cash flows cannot cover banks’ maturing liabilities. Since the 2008–9 global financial crisis, a new financial stability consensus has emerged whereby central banks began implementing unconventional liquidity tools. This chapter comparatively analyzes Hong Kong’s sectoral supervision with the integrated, functional, and Twin Peaks models when implementing unconventional liquidity tools. The macro- and micro-prudential characteristics of unconventional liquidity tools necessitate systemic supervision by central banks and banking supervisors. Effective systemic supervision of unconventional liquidity tools cannot be presumed merely by the presence of a systemic supervisory agency. Underlap can weaken systemic risk objectives and mandates when implementing unconventional liquidity tools because supervisory roles can become uncertain. In this context, Hong Kong’s composite systemic supervisor, the Financial Stability Committee, may not be able to properly coordinate member financial supervisors. Uncertainty can lead to tensions between Financial Stability Committee members, impeding systemic supervisory effectiveness. Tensions coupled with uncertainty can produce macro-prudential and systemic supervisory flaws when managing funding and market liquidity, heightening banking system instability.

Banks fail when an illiquidity event depletes capital reserves. Liquidity is sourced from assets that can readily be transformed into cash or from wholesale funding markets and central banks. Basel III strengthens bank balance sheets by allowing supervisors to release capital and liquidity reserves during times of market liquidity stress. This chapter analyzes the implementation of the Basel III capital and liquidity reforms in Hong Kong, banking sector stability during the 2008–9 global financial crisis and the Covid-19 pandemic, and systemic supervision. Hong Kong is a unique international financial centre because it is overwhelmingly populated by domestic systemically important banks. Universal banking and Basel III compel banking sector supervision of Hong Kong’s securities and insurance sectors, despite falling outside the supervisory design of the Hong Kong Monetary Authority. This chapter argues that different supervisory structures and models affect the regulation and supervision of financial stability in Hong Kong’s banking sector. Insurance and wealth management products in the banking industry can produce systemic risks that might be overlooked by the Hong Kong Monetary Authority. Supervisory bias towards the banking sector in conjunction with cross-sectoral underlap could cause financial instability and a systemic banking crisis in Hong Kong.

Since the 2008–9 global financial crisis (GFC), financial stability policies have been concerned with regulatory tools, not the supervisory structures that manage those tools to achieve financial stability. There were very few jurisdictions that did not let this good crisis go to waste by taking the initiative of reforming their supervisory structures, and fewer still changed their supervisory model. Undoubtedly, the underlying premise from the GFC was that the financial system is robust yet fragile in so far as financial instability can inconspicuously and rapidly spread causing a financial crisis. Interconnections between the financial system components converted systemic risk absorbers into amplifiers that destabilized financial institutions, including those seemingly unexposed and prudently administrated. Banks were particularly vulnerable to systemic risk from maturity mismatches, the levered nature of the business model, and being highly susceptible to credit and liquidity risks.

This chapter provides a brief financial history of Hong Kong’s financial regulation and financial crises between 1841 and 1997. In the beginning, financial markets were subject to market-based regulation and the British colonial legal influence. Hong Kong took a long time to embrace financial regulation. The chapter argues that Hong Kong’s financial markets and the origins of financial regulation have developed, evolved, and shaped in response to a series of financial crises. Hong Kong underwent extensive market and regulatory change when the first modern banking crisis and stock market crash battered the economy between the mid-1960s and the early 1970s. The deposit-taking company and banking crises of the 1980s provided the impetus to develop the current regulatory and supervisory architecture. By 1997, subsequent regulatory reforms had shaped this architecture to resemble other developed financial centres, with the banking, securities, and insurance sectors having a designated supervisor and ordinance.

Prior to the 2008–9 global financial crisis, regulatory and supervisory frameworks were not designed to manage the orderly failure of systemically important financial institutions. Governments were compelled to bail out these institutions to mitigate a deeper financial and economic crisis from developing. In response, the Financial Stability Board formulated an internationally endorsed financial institution resolution framework. The regulatory attributes of the Hong Kong Monetary Authority strengthen its role as the lead resolution authority in the banking sector. This chapter argues that supervisory gaps and underlap undermine the effectiveness of the resolution regime and the Hong Kong Monetary Authority acting as a resolution authority. Cross-border resolutions pivot on coordination and intent between jurisdictions. During a banking crisis, multiple bank subsidiaries entering into resolution will severely stretch the resources of Hong Kong’s resolution authorities. Moreover, small credit institutions, are not captured by the regime. Historically, small credit institutions have caused several systemic banking crises in Hong Kong. Moneylending markets have grown exponentially over the past decade with the emergence of FinTechs and TechFins. Consequently, Hong Kong’s moneylending market is becoming a financial stability risk because a substantial portion are inadequately regulated and fall outside the resolution regime.

Managing banking sector liquidity in financial crises has historically depended on deposit protection and the lender of last resort. Deposit protection assuages market panics by guaranteeing that depositors will be paid if a bank fails. The lender of last resort is a capital injection to preclude a failure when an illiquid yet solvent bank has exhausted all other funding sources. This chapter analyzes deposit protection, the lender of last resort, and how different supervisory structures influence the implementation of these bank stabilization tools. Moreover, certain structures can adversely affect supervisors from fulfilling their financial stability mandates. Hong Kong is susceptible to a supervisory coordination failure from a statutory friction that prioritizes monetary over banking stability. A tension is created within the Hong Kong Monetary Authority which could compel the Financial Secretary to usurp control during a financial crisis. This tension exposes the Hong Kong Monetary Authority to macro-prudential underlap which could undermine its financial stability mandate. Despite these flaws, the statutory mandates of the Hong Kong Monetary Authority complement Hong Kong’s deposit protection and lender-of-last-resort policies, which have performed faultlessly over the past 20 years. However, neither approach has been sufficiently tested during this period.

Since the 1997 handover to Mainland China, Hong Kong has endured pandemics, recessions, and financial crises. Hong Kong’s financial supervisory architecture performed relatively well following the speculative attacks on the Hong Kong dollar and the Hang Seng Index during the 1997–8 Asian Financial Crisis, the liquidity crunch in the 2008–9 global financial crisis, and the economic shutdown from the Covid-19 pandemic. There have been no major supervisory failures or financial instability despite several international financial assessments and reviews recommending structural reforms. This chapter argues that these recent crises call for Hong Kong’s financial supervisory architecture to reflect on the financial system, rather than wait for a market failure to incentivize a redesign. The ongoing financial system integration with Mainland China is placing more reliance on supervisory coordination and cooperation to manage financial stability. Hong Kong is critical to Mainland China’s financial market liberalization and internationalization which will be a key driver of financial market growth in the future. As an international financial centre, Hong Kong is actively involved in market and regulatory developments. Hong Kong has taken a leading role to ensure its financial markets evolve and are fertile to embrace prevailing market trends.