Why regulation may reset course for APAC banks

What factors may influence the credit quality of financial institutions this year?
Overall, the credit quality of the region’s banks remains sound and is expected to remain so in 2015. The median issuer credit rating of the financial institutions we rate in Asia-Pacific is A-, with about 80% on a stable rating outlook. Even so, there are a range of factors that may change our view. These include high private sector debt, rising or already high property prices in some countries, a slowdown in local economies, and a potential disorderly market response to US monetary policy tightening. And for Asia-Pacific banking systems, 2015 is shaping up as a watershed year for regulation. Indeed, issues relating to government support of banks may have a big influence on the sector’s ratings and outlooks this year.

How important is government support to banks in the region?
It’s very important from a ratings perspective. Asia-Pacific currently has a high proportion of banking systems (14 of 19 rated banking systems) whereby we view a government as "highly supportive" toward its country’s banking sector. Private-sector banks in these systems typically receive rating uplift above their stand-alone credit profile (SACP). Hence, any change to levels of government support, including implementation of senior creditor bail-in rules, could have negative ratings momentum, as has occurred recently in other regions. In February, Standard & Poor’s took various rating actions on certain U.K., German, Austrian and Swiss banks following a review of those banks' government support.

What’s the chance of imminent changes to government support of banks in Asia-Pacific?
The probability of widespread change in the short term is relatively low. It isn’t yet clear whether banking systems in Asia-Pacific will ultimately embrace trends emerging from the US and Europe concerning alternative solutions to the traditional government support model. What is clear is that the removal of government support is likely to have a negative rating impact, should it occur. Even a modest diminution in government support toward banking sector creditworthiness, all other rating factors equal and unchanged, may cause negative ratings momentum for some Asia-Pacific banks.

Which banking systems are you watching closely?
In Australia and Hong Kong, consultations are underway in both markets on the topic of potential other resolution regimes and related matters. However, in both cases it is unclear whether policymakers will adopt new rules related to government support. In contrast with Australia--where the largest banks are domestically owned--three of the four largest banks in Hong Kong are owned by U.K. parent banks. Government support for banks in the U.K. is currently under review and has resulted in recent negative rating actions for certain banks. In some other Asia-Pacific jurisdictions, such as Singapore, where there are not yet any concrete plans in place for alternative resolution regimes, we will monitor for continuing congruence of regulatory developments with our current opinion of "high" government supportiveness.

How significant are property risks for Asia–Pacific banking?
Although viewed a low-probability outcome, our scenario for a major disorderly property adjustment in China would have a high impact. Such a scenario would likely lead to significant spillover effects for the economies and banking sectors in China, Taiwan, Hong Kong, Japan, Korea, and Singapore. More generally, sensitivities concerning the property sector are an intermediate risk factor for many Asia-Pacific banking markets. For banks in Australia, New Zealand, Singapore, Malaysia, China, and Hong Kong, a plunge in real estate prices is a key risk factor because home loans and real estate-related loans account for a significant percentage of bank lending.

Among other risks, should we be concerned about slowing economies?
We believe that there is a relatively low probability in most of the region's banking systems of an economic slowdown in 2015 that is significantly worse than our current downside scenario. Recent external developments in the form of stronger consumer spending in the U.S. and lower global oil prices mean things are looking up for Asia-Pacific overall, although the economic data is yet to reflect these tailwinds. The impact of the slowdown is intermediate for most of the banking systems, but potentially higher for India and Vietnam. Outside of Asia-Pacific, an intensification of risks in the eurozone and Russia could hurt banking sector creditworthiness, as the region remains dependent on global trade. Also, eurozone stress could result in higher wholesale funding costs for some banks in Australia, New Zealand, and to a lesser extent Korea.

Is the credit downturn for Chinese banks bottoming out?
The credit downturn in China's banking sector is likely to deepen this year, and signs of distress are spreading to more industries. Loan growth is moderating, credit losses are rising, and interest margins are compressing as China's financial reforms accelerate and monetary policy eases. In addition, sources of funding - for some banks at least - are shifting further toward the wholesale segment. The downturn is now entering its third year, and we believe the bottom of the cycle may take another two to three years to materialize. Despite the worsening downturn, a drastic deterioration in the credit profiles of Chinese banks remains unlikely, unless China's property market sharply declines. Significant buffers in the economy, favorable government policies and the financial flexibility of major banks still underpin our stable outlook on the sector. The country’s big banks are on a stronger footing to withstand the current economic conditions because they have enhanced their capitalization through modest and diversified credit growth and retained profits, and they have largely preserved their funding and liquidity strength.

Is the outlook for Indian banks improving?
A reversal in the trend of rising nonperforming loan ratios for India's banks is likely to take time. The new government has promised development and good governance, and a lot will depend on its ability to keep its promises and improve the economy. We expect the profitability of Indian public sector banks to remain weak, and banks' credit costs to remain elevated. That's because of under-provisioning for nonperforming loans, slippages from standard restructured loans, and a higher provisioning requirement for fresh restructured loans effective April 2015. Capitalisation is a key constraint for some public sector banks in India. We believe that rated private sector banks are better placed than their public sector peers to meet Basel III capital requirements.

What about rising interest rates?
We envisage that tighter monetary policy in the US and subsequent run-up of market rates could trigger interest rate hikes in global and local markets. We see this scenario as more likely impacting some countries, including Singapore, the Philippines, and Hong Kong. By contrast, some other countries, including China, Korea, Thailand, India, and Australia, have cut rates recently, with the likelihood of a U-turn less likely in the short term. In our opinion, Indonesia is the Asia-Pacific banking sector that may be the most likely to experience a negative impact on banks’ credit quality from higher interest rates.

The author of this article is Gavin Gunning, a senior director of financial institutions ratings at Standard & Poor’s Ratings Services