ALTHOUGH the reporting season is not over, it is already clear that the banking sector has passed its peak in terms of the pace of its profit growth. What remains to be seen is how banks prepare for the looming tough times, and the interim results are illuminating in this regard. Smaller banks seem to have outperformed their bigger brethren, with the results of the larger institutions disappointing. Banks that have been trying hard to reduce their reliance on interest income have seen their efforts paying off. It is also clear that smaller banks' higher profit growth may have resulted from their starting from a lower base. ''They have fewer funds to lend and therefore focus more on short-term financing that is self-liquidating in one to three months, such as trade finance,'' executive director (banking supervision) of the Monetary Authority Albert Cheok said. Bigger banks with extensive network and strong deposit bases tend to be more involved in lucrative mortgage lending, reaping profits from the 8.25 per cent interest rate. Mr Cheok said that while lending related to the highly speculative property market could generate big profits, it was a more volatile area than trade finance. Furthermore, bigger banks with sufficient deposit back-up tended to run larger loan books, putting themselves at the mercy of cyclical fluctuations in the interest margin. ''Banks which are particularly reliant on interest income are more prone to the effect of cyclical changes in margin spread. Once the margin is squeezed, they will not get as much return as before,'' Mr Cheok said. These banks are usually the net lenders in the inter-bank market, where they can deploy their surplus funds. Any changes in the interest level will affect their income from this source. ''By contrast, smaller banks by nature are net borrowers in the inter-bank market and therefore are less reliant on lending at good rates,'' he said. Analysts attributed the lower profit growth of bigger banks such as Hang Seng Bank and Bank of East Asia to narrower interest margins, slower loan growth and deposit growth. Hang Seng Bank chairman Sir Quo-wei Lee admitted that the bank's far-from-satisfactory interim result was more due to lower interest income from funds placed in the market. ''On the other hand, smaller banks are more flexible and are free to take risks,'' Credit Lyonnais regional banking research director Laura Grenning said. That flexibility has been reflected in Union Bank's interim result. The 38.8 per cent profit growth was due primarily to an increase in mortgage loans. Its managing director, David Yau, said Union Bank, which could afford to have a closer look at each applicant's background, had moved to fill the gap left by big banks when they cut back mortgage loan growth. The Monetary Authority has long been advising banks to diversify sources of revenue. ''Compared to other financial centres, the activities of Hong Kong banks tend to be narrowed into three to four major functions - property, trade finance, inter-bank transaction and investment,'' Mr Cheok said. To overcome the cyclical volatility of income, more fee-based income had to be developed and banks should be operated on a cost-effective basis, he said. The only big bank with a good interim result was Standard Chartered Bank. Discounting the charge for bad debts, profit growth was 35 per cent. Non-interest income accounted for 29 per cent of total revenue and the bank's determination to raise that figure to 40 per cent attests to the importance of diversification. While Hang Seng Bank decided to go with the tide and pledged to increase fee income, Ms Grenning predicted it would take time for substantial earnings from that source to be generated.