Institutions are reluctant to raise interest rates due to a low loan to deposit ratio and excessive liquidity in the system Hong Kong's small banks face a steady squeeze on lending margins as funding costs are forced higher by rising interest rates, but the need to compete with bigger rivals prevents them from raising lending rates, analysts warn. Local banks last week fell into line behind a decision by market leader HSBC to leave deposit and lending rates unchanged after the United States Federal Reserve raised its Fed Funds' target rate by 25 basis points to 1.25 per cent. The move ended a four-year retreat that took the benchmark rate to a 45-year low, and marked a long-awaited turning point in the easy money cycle in the US. Hong Kong rates typically track US rates closely to support the currency peg. However, Hong Kong bankers had warned in the run-up to the US rate increase that since there was abundant cash in the system and they had not matched all the changes to US rates on the way down, they would not necessarily match changes on the way up. CLSA banking analyst Dominic Chan said banks were reluctant to raise rates because of a low loan to deposit ratio in the industry of 85 per cent. Another issue was excess liquidity in the banking system - the so-called aggregate balance, which is usually about HK$500 million but is now $35 billion. If interbank liquidity remained abundant, local banks would not have to raise rates after the next move by the Fed, Mr Chan said, adding this would favour mid-cap and larger banks such as Bank of East Asia and Bank of China (Hong Kong). DBS Vickers analyst Tony Liu said liquid banks would benefit most as they generated higher returns on surplus deposits, which they lent to smaller banks through the Hong Kong Interbank Offered (Hibor) market - where rates were rising, albeit at a slower pace than in the US. 'Our analysis indicates large banks such as Hang Seng, BOCHK, and Bank of East Asia will benefit from a [Hibor] rate rise,' he said. 'Smaller banks such as Wing Lung and Liu Chong Hing will also benefit due to their substantial excess capital and free funds. Dah Sing would be hardest hit due to its above average exposure to fixed-rate assets, which more than offset the positive impact on free funds.' Goldman Sachs analysts Roy Ramos and Darwin Lam said they expected HSBC to delay raising its prime lending rates - a tactic they label 'big banks revenge' - as Hibor funding costs for smaller banks began to rise but customer rates were left unchanged. Rising Hibor rates - the price which smaller banks must pay to raise funds from their bigger rivals - would lead to a 50 to 75 basis-point squeeze in prime/Hibor spreads, they forecast. This would help big deposit-taking institutions with surplus funds to lend, such as HSBC, Hang Seng, Standard Chartered, BOCHK, Wing Lung and Bank of East Asia. But it would be seen as neutral for Wing Hang and negative for Dah Sing Financial and DBS Hong Kong. The key to this outcome would be a gradual rise in Hibor, but a brake on increases in customer lending rates - an outcome that Goldman Sachs said was the most likely. 'Our view is that massive excess liquidity [including spillover from China], plus still muted credit demand, will conspire to keep Hibor rates still appreciably below Libor [the London Interbank Offered Rate],' it noted. Goldman Sachs has trimmed its Hong Kong banking sector earnings per share estimates on average by 3.3 per cent this year and by 6.9 per cent next year to take into account the changed rate cycle, as well as continued lacklustre loan growth, with commercial and China-related loans an exception. Debt markets monitor Basis Point reported earlier this week that new loan syndications for the Hong Kong/China market recorded one of the lowest growth rates in the Asia-Pacific. At US$10.21 billion for the first half of this year against US$8.56 billion, the rise was accounted for almost entirely by the two biggest deals signed just days before the June 30 cut-off - a HK$7 billion deal for Kerry Properties and a HK$6 billion deal for Hang Lung Properties. Without these contributions, the syndication market would have shown no growth over the first six months of last year.