This should help to deter future speculative attacks on the Hong Kong dollar. However, we have to acknowledge that the possibility of short term interest rates shocks does exist under the currency board mechanism and the banks therefore need to take this into account in the way in which they run their business and manage their balance sheets. 21. Bearing this in mind, I draw three main supervisory lessons from the regional crisis and its impact on Hong Kong: • First, it is important for banks to maintain a strong balance sheet that can withstand the interest rate fluctuations to which I have referred and maintain the confidence of the public. Banks in Hong Kong score well in this respect but it is not something that can be taken for granted. I think that it is true to say that some banks did expand their loan books too rapidly during the mortgage boom in 1997. As a result, loan to deposit ratios came under some strain. The banks were also exposed to growing interest rate risk because a substantial proportion of their assets are linked to best lending rate while their liabilities are linked to HIBOR. This has been a reminder of the need to maintain sound fundamentals: high capital adequacy and liquidity ratios; prudent loan classification and provisioning; and sound risk management. • A second and related lesson from the region is that banks need to beware of excessive lending to finance overheated asset markets.
BIS Review 28/1998  ˝  -5-  18. The latter point needs some further elaboration. As you will be aware, Hong Kong’s monetary policy is built around exchange rate stability in the form of the link between the Hong Kong dollar and the US dollar. This is backed up by the currency board system which requires the monetary base of the banking sector - the notes and coins in circulation and the clearing balances held with the HKMA - to be fully backed by foreign currency. When the Hong Kong dollar is under pressure as it was at the end of October 1997 and again in January of this year, the HKMA buys Hong Kong dollars from the banks in exchange for US dollars and the monetary base shrinks. This tightening of liquidity will in turn cause interest rates to rise, perhaps sharply so. This will choke off the inflows and restore stability to the exchange rate. 19. It is important to realize that this is an automatic process and that the HKMA has no room to maneuver to prevent the rise in interest rates from taking place. To do so would run counter to the basic principle of the currency board and would risk prolonging any attack on the Hong Kong dollar. 20. I think that there is now a better understanding of how the currency board system works. In addition, our determination to adhere to the system and to defend the linked exchange rate has been clearly demonstrated.