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Risks ahead for Asian banks, says S&P

Asia's banks could face more hurdles in 2014, particularly in maintaining asset quality, writes Naoko Nemoto, managing director, financial institutions ratings, at S&P.

What are the key risks faced by the region’s banking sector?
Slower growth and tightening monetary conditions in China could have spillover effects in the region. The Federal Reserve will also likely continue tapering its quantitative easing program, and this could lead to more volatile foreign exchange and interest rates.

Many banking systems in Asia-Pacific are also more susceptible to external shocks because both household and corporate debt have risen to unprecedented high levels.

Substantial inflows of capital and low interest rates amid global monetary easing have supported high credit growth in the region, but we expect such conditions to hit a turning point in 2014.

We expect credit costs to rise, in particular from sectors with excessive indebtedness. Nevertheless, we believe a sharp increase in credit costs is unlikely because the region will benefit from a gradual recovery in the global economy. Regulators in many countries have also taken preemptive measures over the past few years to cool the expansion of property-related loans and asset inflation.

Profitability of Chinese banks was under pressure last year, is that likely to continue in 2014?
Chinese banks' loan quality and profitability will slip further in 2014 as the country's policymakers are likely to keep market liquidity tight and liberalize the financial sector. We expect return on assets for Chinese banks to lower to 0.8%-1.0% in 2014 from 1.2%-1.3% in 2013. Nevertheless, we expect the credit profiles of major banks that we rate in China to remain adequate in the next 12 months.

Banks remain heavily exposed to debt-laden local government financing platforms and manufacturers saddled with overcapacity because China's decade-long construction boom is cooling. However, the decline in loan quality is unlikely to be severe. A stabilising domestic economy and pragmatic policy responses to deal with emerging risks should limit the rise in non-performing loans.

How would a potential hard landing in China impact different markets within the region?
Our scenario for a hard landing in China has GDP growth decreasing to 5%, leading to significant negative spillover effects for the economies and banking sectors in China, Indonesia, Japan, Korea, Taiwan, and Hong Kong.

China is the most important trading partner for those countries, and a hard landing in China would lead to recessionary conditions in these countries that could severely hit the asset quality of their banks. Hong Kong banks have relatively high direct exposure to China and would thus suffer significant credit losses on those loans. New Zealand and Indonesia would be adversely affected through collapsing commodity prices in not only a hard-landing scenario but also in a general economic slowdown.

By contrast, the banking sectors in the Philippines and India would be less affected because of these countries' low dependence on exports to China. But we believe the prospect of such a scenario unfolding is low.

What happens if the US monetary policy tightens?
Tighter US monetary policy could trigger interest rate hikes in global and local markets. We see a relatively high probability of an interest rate hike in Singapore and Hong Kong because both countries have managed the stability of their currencies through short-term rates that follow market rates in the US.

Meanwhile, we see an intermediate likelihood of an interest rate hike in India and Indonesia, which have current account deficits, because the central banks in these countries are motivated to raise interest rates to defend against currency depreciation and to curb inflation.

However, both the Indian and Indonesian monetary authorities adjusted interest rates last year, which reduces the probability of a sharp rise in interest rates, in our view. Our base-case prospect for the entire region is for any rise in interest rates to be gradual and predictable.

What about risks stemming from the Eurozone?
Re-intensified risks in the eurozone could impair banking sectors in Asia-Pacific because the region is generally susceptible to global trade and Asia-Pacific countries ship 10%-20% of their total exports to the eurozone.

Asia-Pacific banks have limited direct exposure to eurozone countries, and the impact of an escalation in eurozone risk would be lower than that of a hard landing in China. That said, eurozone stress would likely result in higher wholesale funding costs for banks if it caused dislocation in global markets. Banks in Australia, New Zealand, and Korea depend somewhat more than others in the region on wholesale funding, which is more tightly linked to global market conditions.

Is capital adequacy a concern for the region’s banks?
We recently conducted a survey of 47 large Asia-Pacific banks based on their risk-adjusted capital framework, and results indicate that Asia-Pacific major banks show resilience in their capital adequacy. The majority of large Asia-Pacific banks are higher than 7% or are close to the borderline metrics that we assess as “adequate” capitalization.

The average risk adjusted capital ratio of Asia-Pacific’s major banks is slightly lower than the average of the global top 100 banks, as the ratio is suppressed by high economic risk and higher capital charges for the risk assets of banks in some countries. In high-growth banking systems such as China, India, and Vietnam, banks also face constant challenges to strengthen or maintain their capital ratios. Banks in Australia, Singapore, and Hong Kong have relatively high RAC ratios, while banks in Vietnam, Japan, and Thailand have weaker than average RAC ratios.

What is S&P’s current rating distribution for the region’s banking sector?
Our outlooks on 71.5% of our Asia-Pacific bank group ratings are stable (see charts one and two). In Japan and India, however, we have negative outlooks on most bank ratings, reflecting our negative outlook on the sovereign ratings in contrast to our stable outlooks on the other sovereign ratings in the region. We revised the outlooks on four Malaysian banks to negative from stable in November 2013 to reflect growing economic imbalances in the country, such as higher property prices and rising household debt.

The author, Naoko Nemoto, is managing director, financial institutions ratings, at S&P.

Chart one:

Chart two:
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