The first sign of a thaw in the two-year bank-lending freeze in Hong Kong, combined with prospects of a bidding war to compete for customer deposits, could soon spell the end of cheap mortgage loans. A report by financial consultants KPMG showed that increased demand for lending may soon allow banks to find alternative lending opportunities to the deeply discounted mortgage loans. Many banks have depended on these until now to keep their business growing. As these more attractive lending opportunities gather steam and soak up excess liquidity in the system - and banks begin as well to compete for deposits in the newly deregulated interest rate environment - a rise in funding costs will also help choke off the supply of cheap mortgage loans. 'The results of our survey show that banks have so far managed to maintain net interest income despite rising interest costs, because surplus liquidity in the system helped keep a lid on interest costs,' KPMG senior banking partner John Harrison said. 'But latest data suggests the fall in lending seems to be coming to an end - just as competition for deposits is set to increase as a result of interest rate deregulation. 'In this new lending environment, as banks find more alternatives to relying on making cheap mortgage loans - and the cost of their deposit funding base rises - it is unlikely that the mortgage price war will continue for much longer.' The remarks, made after a presentation at the Furama Hotel of KPMG's annual banking survey report, follow a warning earlier this week from the Hong Kong Monetary Authority that banks should monitor their mortgage lending more closely because of a rise in delinquencies. HKMA deputy chief executive David Carse warned mortgage delinquencies increased to 1.19 per cent in May from 1.18 per cent in April. 'That is a mild increase, but worth monitoring closely,' he said. The KPMG survey, which drew on the annual reports for the year to December 31 with updated data, where possible, to the end of March, showed that following on a 4 per cent decline in 1998 in bank loans for use in Hong Kong, lending shrank another 7 per cent last year. The steep retreat in lending, combined with an increase in deposits, produced a massive surplus of liquidity in the system, which was captured in liquidity ratios for 1999 ranging from 33.3 per cent to 125.1 per cent. The liquidity ratio, which measures one-month liquifiable assets as a percentage of liabilities also due within a month, is regulated at a 25 per cent minimum by the HKMA. Among the biggest lenders in Hong Kong, Hang Seng Bank's liquidity ratio surged from 40 per cent in 1998 to 65 per cent in 1999. With a massive surplus of funds available and few risk-free lending opportunities, banks began to compete aggressively in the mortgage market, and those with large deposit bases could do so without having to raise funds on the interbank market. The result was that the interest spread was maintained for the industry during 1999 at 2.2 per cent. This was possible because although the return on average interest-bearing assets fell from 8.5 per cent in 1998 to 7 per cent in 1999 - chiefly as a result of the mortgage price war - average interest costs fell from 6.3 per cent to just 4.8 per cent. The KPMG survey showed that in May, some 85 per cent of all new mortgages were priced at below prime, compared with just 2 per cent priced at a discount to prime in December 1998. 'A little more than a year ago, banks were charging 1.5 per cent to 2 per cent above prime for mortgages,' Mr Harrison said. 'Now they are making loans at 1.5 per cent to 2 per cent below prime.' But the successful management of interest spreads, combined with sharply lower bad-debt charges, came to the rescue of the bank profits despite those falling loan books.