In the past, most banks in Hong Kong followed the lead of the major note-issuing banks when setting their mortgage margin and were careful not to undercut the market. However, many banks have decided to break ranks recently. What caused this?

In April 2001, the HKMA implemented the final phase of interest rate deregulation. In practical terms, banks were now free to set their deposit and lending rates. But, as Hong Kong's banking industry is dominated by a few major players, banks continued to follow the norm when setting their prime lending rates (the most common used index for pricing residential mortgages). When the US Federal Reserve began raising interest rates in June 2004, every bank obediently followed the banking cartel.

In September last year, HSBC and Hang Seng Bank sent a strong message to the banking community by setting their prime index rate 25 basis points below the other banks. Initially, most banks hoped the interest rate differential would be short-lived.

Now, a year later, many bankers agree HSBC and Hang Seng have purposely kept this differential to remind other banks not to compete for loans through margin reduction. Nevertheless, banks competing for residential mortgage business have compensated for this index differential by offering other financial incentives.

At the peak of the previous price war early last year, banks offered low mortgage margins and extremely attractive cash rebates. In February that year, the HKMA issued guidelines on cash rebates to stem the unhealthy lending practice. Not surprisingly, the market responded by curtailing such excessive practice. Now, a year and a half later, the market is again heading towards uncharted waters.

Banks have little choice but to continue competing for loan business (especially mortgages) by cutting prices to maintain market share. For the first seven months of this year, bank deposits of all currencies had outpaced loan demand by more than HK$180 billion.

While many welcomed this excessive liquidity, the stark reality is simple: either banks lower their pricing or invest their excess deposits in the global fixed-income or equity markets. Historically, Hong Kong banks had no need to maintain large investment portfolios and their treasury departments operated as short-term cash managers.

In recent years, banks have had little choice but to manage their overwhelming surplus of deposits as institutional asset managers amid dwindling loan demand.

However, as has happened overseas, when banks deviate from their core business of deposit-taking and lending, the result is not positive. First, the source of bank funds is typically short-term with an inherent duration mismatch between assets (loans) and liabilities (deposits). Second, as the debt capital markets are underdeveloped in Hong Kong, banks invest in securities abroad, which increase balance sheet risks (credit, currency and structured).

The dilemma facing banks in Hong Kong is compounded daily. While the borrower is subsidised by excessive liquidity, many market professionals wonder how long the subsidies will continue to the detriment of the banking industry. When will mortgage rates (or margins) finally reach bottom?

Not long ago, senior banking officials stated firmly that mortgage margins would not pierce the sacrosanct floor of prime minus 2.75 percentage points. However, as the industry's loan-deposit ratio continues to decline, banks have few choices but to continue to cut pricing. This greatly benefits the consumer but maintains downward pressure on bank margins.

Leland Sun Li-hsun is the chief executive of Pan Asian Mortgage