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.

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.

Financial crises have a tendency to expose the financial system’s inability to absorb large systemic shocks, the critical role of liquidity channels, and financial institutions with fragile balance sheets. Pinpointing the causes of systemic risk challenges supervisors because the range of risks are virtually unlimited. This chapter argues that the definition of financial stability must be revisited to enhance the efficacy of financial supervision by drawing upon the lessons learnt from the 2008–9 global financial crisis. Defining systemic risk requires a real-time perspective of risk transmissions between the financial system components. Supervisors should appreciate financial agglomeration, the interconnectedness of the financial system, and behavioural economics when regulating systemic risk. Liquidity mismatches that destabilize financial institutions’ balance sheets and the capacity to raise funding can cause financial instability. The inability of the Hong Kong Monetary Authority to control monetary policy constrains its power to fully manage these liquidity risks. Mitigating financial instability caused by systemic liquidity risks requires an understanding of prudential regulation and the management of monetary policy to stabilize bank balance sheets. Financial architecture must be properly utilized by supervisors to restore the orderly and rational functioning of the financial system.