Asian banks set to turn expectations into reality in 2006

Rating agency says banks are likely to meet its expectations of improving credit profiles.
In 2006, banks across the Asia-Pacific region are likely to meet Standard & Poor's expectations on improving credit profiles. These expectations have already been factored into many regional bank ratings and led to the raising of bank ratings 85 times in 2005. As a result of these rating actions, the outlook on most banks in the region is stable.

Good economic conditions and internal reform efforts over the past two years have laid solid foundations for banks in some of the weaker banking systems of the region to continue to reform themselves in 2006. The Chinese banking system made a strong showing in 2005 on the back of strong government support and a high growth economy, although challenges remain.

Indian and Indonesian banks, like Chinese banks, are benefiting from favorable economic conditions. Japanese banks are making a comeback and reporting some meaningful profit figures, while Korean banks are improving their risk management techniques in consumer lending and rebuilding their consumer banking business models after learning costly lessons in the past.

In Taiwan, the regulatory regime appears to be changing for the better, although politics on the island may prove a stumbling block.

Other banking systems continued their previous trends. The banking systems in Australia, Hong Kong, New Zealand, and Singapore continued to have the lowest risk in the region. While each faces different challenges, including competition in mature home markets, pressure on profitability, and slowing GDP growth, they remain strong and have the ability to meet these challenges. Other systems are steadily reshaping themselves and increasing their focus on risk, although such reforms are likely to be long-term projects.
Stable Outlook

Standard & Poor's outlook on the banking systems of the region, except China, is stable. It has revised its outlooks on its ratings on the banks of Singapore to stable from positive reflecting an improvement in their credit profiles in 2005 that was in line with expectations and the likelihood they will remain stable in 2006.

Standard & Poor's maintains a positive outlook on the Chinese banking system, recognizing strong progress toward sustainable reform of the industry. Although the system remains high risk and weak in many respects, reform is likely to gather pace and improve the system's fundamentals under strong government pressure.

The outlooks on the lowest-risk banking systems in the region are stable. The outlook on the Australian sector reflects the very strong profiles of all major banks and the investment-grade ratings on some banks, as well as Australia's reasonably favorable economic outlook. However, growth is expected to be more subdued, particularly in the property sector, which is showing signs of slowing. New Zealand banks appear well positioned to weather a moderate economic or bank industry downturn.

The maintenance of solid distribution networks, acceptable underwriting standards, and adequate capitalization are expected to support credit quality over the near term.

Singapore's banking system is characterized by improving loan growth, sound liquidity, and stable earnings. The credit profiles of Singapore's banks are strong.

Hong Kong's solid banking system is challenged by pressure on profitability. However, the territory's banks are likely to manage their way through a difficult operating environment as they have in the past.

The banking systems in Malaysia, Taiwan, Korea and Japan are stable. Malaysia's banking system's asset quality and capitalization have continued to strengthen, although margins remain pressured in an industry that is likely to see further structural changes.

Taiwan banks' ability to manage risk is improving, but politics could prove an obstacle to reform. The Japanese banking sector has been recovering gradually since fiscal 2004 (ended March 31, 2005), supported by a stronger business environment, an economic upswing, and ongoing efforts to reduce nonperforming assets.

Improvement in Korea's banking sector is expected to continue over the next several quarters. Supported by strong earnings, the sector is likely to enhance asset quality and capital adequacy.

Indian banks have benefited from reforms in the financial services industry, especially asset rehabilitation measures and loan recovery initiatives. The sector, however, continues to face structural challenges. Better economic conditions in Thailand have led to loan growth and a recovery in property prices, which have strengthened collateral values. In addition, Thai banks have boosted asset rehabilitation measures and capitalization levels.

In the Philippines, the quality of impaired assets, including restructured loans and foreclosed assets, has stabilized due to actions taken by banks to resolve problem loans. Despite weakness in loan growth, the sector's nonperforming asset ratio has remained steady. Indonesian banks are likely to perform steadily as gradual structural reform continues.

Economic And Industry Risk

Standard & Poor's defines economic risk, in the context of a banking system, as the risk level of a country's economy as it affects financial institutions, as opposed to the country's own credit quality. Included are the economy's strength, diversity, and volatility; the financial health of the corporate and individual sectors; and the government's ability to manage the economy through boom and recessionary periods.

The industry risk category contains many elements, and, for any system, there will be both positive and negative factors. Although it is difficult to say which factors will outweigh others in any one system, generally Standard & Poor's gauges the dynamics of the financial services industry and the extent to which those dynamics lead to more or less risk for debtholders or counterparties.

Standard & Poor's has revised its economic and industry risk assessments in six countries (see Table 2) to reflect reforming efforts by banks and regulators, improvement in the financial profiles of corporate sectors, and in some markets, strong systemic support. In addition, the Hong Kong banking sector has joined Singapore and New Zealand as one of the lowest industry risk systems. Its robust performance in a difficult operating environment over a prolonged period proved that it has the ability and the flexibility to manage problems.

Economic risks

The revision of the economic risk score of China's banking sector primarily reflected the Chinese government's improved ability to manage economic cycles and the improved performance of the Chinese corporate sector.

Stabilization of macroeconomic conditions and economic recovery underpin revision of the economic risks of the Indonesian banking sector to high from very high. The recovering economy, although still volatile, is expected to provide a better operating environment for the country's bank sector.

The economic risks of Australia, New Zealand, Singapore, Japan, Hong Kong, Malaysia, Taiwan and Korea remain moderately low to moderate, reflecting the diversity and flexibility of their respective economies and strong corporate sectors.

India benefits from strong growth in its economy, but structural constraints remain. Philippines and Vietnam remain the systems with the highest economic risk in the region, as a result of the countries' below average economic conditions and the financial positions of their governments.
Industry risks

The revision of the industry risk score of China's banking sector primarily reflected the improving financial profile of the sector, the strengthening of the regulator's supervisory capability, and the improving risk management capability of some key financial institutions.

A $180 billion government financial support package given to three large but fragile state-owned commercial banks boosted the sector's financial profile considerably. Foreign investment and IPOs provided additional strong flows of much needed capital.

However, the banking system still faces tough, long-term challenges, including building a risk culture, strengthening corporate governance, and institutionalizing changes in various aspects of its operations. In addition, continuous reform of the country's corporate sector is a key factor in banking sector reform.

Standard & Poor's has revised the Indian banking system's industry risk to moderately high from high because of improving credit fundamentals and a strengthening regulatory environment.

Indonesia's banking sector continued to improve structurally, with an infusion of foreign management expertise and information technology systems. The improvement is most apparent at the country's major private commercial banks. Consolidation is also reshaping the industry landscape, although there are still more than 100 banks.

The industry risk for the Japanese banking sector has improved largely due to diminished asset erosion risk. Supported by the robust economy and diminishing deflationary environment, Standard & Poor's considers that the operating environment for the industry has begun to improve, evidenced by progress in debt reduction by companies and a long-term slide in land prices coming to an end in some areas.

The Korean banking industry is likely to benefit from strengthened credit policies that are expected to help stabilize credit costs. Stabilizing household credit, which may face slow growth for some time, reduces the potential risk of household loans. In addition, there has been some material structural progress. Ongoing improvement in corporate disclosure and accounting transparency may translate into reduced credit risks for Korean banks, although corporate governance at chaebols is still an issue.

Taiwan's banking sector's industry risk improved to moderate from moderately high on the back of a more coherent regulatory regime and an increasingly pragmatic approach by the banks themselves. However, the financial sector regulators still come under occasional political pressure to make concessions that could be counterproductive to ongoing reforms. Nevertheless, consolidation has improved the consistency of regulatory oversight.

Standard & Poor's revised its assessment of the industry risk of Hong Kong's banking sector to moderately low from moderate, recognizing the robust performance of the sector during a prolonged difficult operating environment. A culture of reasonably prudent business expansion, good financial discipline, and an effective regulatory regime are the bedrock of the system's robustness.

Elsewhere, Australia, New Zealand, and Singapore remain in the lowest risk category at low to moderately low. This position is underpinned by strong regulatory regimes, good financial system infrastructures, and high levels of transparency.

The banking systems of Malaysia, Korea, Japan and Thailand are relatively high risk and at different stages of reform. In Japan, low profitability, weak capitalization, and asset concentration remain fundamental weaknesses. Philippine and Vietnam remain the highest risk systems in the region because of weak fundamentals and their underdeveloped regulatory regimes.

Gross Problematic Assets

Standard & Poor's estimate of the potential gross problematic asset (GPA) range for a given banking system is based not only on an assessment of the economic and industry risks of the sector, but also additional data analysis, together with discussions with regulators and banks. Problematic assets, in this context, include overdue loans, restructured assets (where the original terms have been altered), foreclosed assets, and nonperforming assets sold to special-purpose vehicles.

The GPA estimate speaks to the depth of potential problems a system may face in a reasonable worst-case scenario. Admittedly, the assumptions behind these scenarios are severe. GPA estimates are grouped into six buckets for ease of reference├╣5%-15%, 10%-20%, 15%-30%, 25%-40%, 35%-50%, and 50%-75%.

In 2005, Standard & Poor's revised the GPA range of four banking systems. Both banking systems of China and Indonesia moved from 50%-75% to 35%-50%, largely reflecting improvements in fundamentals, including stronger corporate sectors, strengthening regulatory regimes, and improving ability to manage risk.

The GPA range of the Korean banking system moved to 10%-20% from 15%-30%, reflecting a stabilizing economy and ongoing efforts to strengthen credit infrastructure and risk management. In recognition of the Hong Kong banking system's ability to manage credit risk in a reasonable worst-case scenario, the GPA range was lowered to 5%-15% from 10%-20%.

Most of the banking systems with estimated impaired asset ratios at or below 5% (Australia, Hong Kong, New Zealand, Singapore and Taiwan) are likely to maintain their asset quality in 2006. While the quality of Taiwan's banking sector's consumer loans has deteriorated, the scale of the loans is relatively small.

Consequently, the impact on the sector's overall asset quality and impaired assets is unlikely to be very significant although the sector's profitability is likely to suffer. The systems of Japan, Korea, India, and Malaysia are also likely to see an improvement in asset quality in 2006 as the economies of these countries continue to perform well.

China and Thailand have high impaired asset ratios, which are likely to improve in 2006 as banks and governments continue to focus on asset quality. In China, the degree of improvement will depend largely on government action. Banks saddled with large amounts of impaired assets do not have the resources or the ability to conduct large-scale write-offs of impaired assets, so government support will dictate the speed of write-offs. Strong loan growth is likely to reduce the Chinese banking sector's impaired asset ratio. However, latent risks brought by rapid expansion remain.

The Indonesian banking sector's impaired asset ratio is unlikely to change much, despite efforts to improve it. Standard & Poor's estimates aggregate NPLs rose in 2005 due to more stringent asset classification norms. The Philippine banking system's asset quality is likely to remain weak but stable. A practice of amortizing losses from disposals of NPLs over long periods and protracted nature of liquidating collateral continues to weigh on the system's asset quality.

[The article is an extract from RatingsDirect, Standard & Poor's Ratings web-based credit research and analysis system ( To learn more, please click on About RatingsDirect.]
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