Why risks remain for Asia's top banks

Asia’s banks have been in a sweet spot this year: operating performances, asset quality, and credit quality are all relatively stable, and macroeconomic and financing conditions continue to be favorable. But some threats loom. 

One concern is that risks may accelerate following a protracted period of high leverage and low interest rates. Indeed, risks emanating from the U.S. are increasing in the context of the ongoing China-U.S trade dispute and rising interest rates and spreads, and a possible turn in the U.S. credit cycle.

Key risks affecting the Asian region overall include those associated with trade interruption and geopolitical tensions, asset price volatility and liquidity pullback, and China's debt overhang.

Not surprisingly, risks and vulnerabilities affecting Asia's financial institutions overlap with these top regional risks. The more prominent key risks that threaten financial institutions include high private-sector indebtedness (including in China, Hong Kong, Australia, Korea, Singapore, Malaysia, and Thailand); elevated property prices (including in China, Hong Kong, Australia, and New Zealand), and the potential for rising U.S interest rates.

Turning U.S. credit cycle may hurt
A turn in the U.S. credit cycle, which may affect asset prices and liquidity, may have spillover effects, especially on Asia’s emerging markets. In the interim, however, some of Asia's emerging-market banking systems are progressively improving their financial strength, albeit from a high-risk starting point in many cases by global standards.

Still, high debt levels and asset prices across the region, and less-certain bond markets, are a backdrop for the potential emergence of a low-probability, but high-impact, negative scenario on Asian banks. A sharp correction in asset prices, particularly if associated with a pullback in market liquidity, would likely lead to a revision of our base case and cause negative ratings momentum.

Government support remains intact, for now
It’s not all doom and gloom for Asia’s banks. Many Asian countries will likely retain the flexibility of the government bailout option as a primary support mechanism, in the short to medium term. Hence, we believe extraordinary support for many systemically important private sector banks in Asia is most likely to be forthcoming from governments in a banking crisis.

Government support is a key rating factor for Asia banks. Any transition by Asian governments to bank resolution and crisis management frameworks that imply a lower likelihood of government support—as occurred last year in Hong Kong—may trigger bank downgrades.

Steady profitability prospects
Profitability should remain relatively stable during the second half of 2018 across most of the region. Favorable economic conditions during the first half kept overall profitability trends for Asia’s major banks steady.

However, net interest margins continue to be under competitive pressures in many countries, and we would expect this trend to continue in the second half of 2018. Further, slightly lower economic growth for fiscal 2018 compared with fiscal 2017 in some key markets should temper banks' profitability, albeit Asian growth overall continues to be robust by global standards. 

Banks can withstand moderate weakening in asset quality
Similarly, asset-quality trends are likely to remain relatively stable across most of the top banks in Asia. Many can weather some diminution in asset quality without affecting the ratings.

Still, asset quality will be a more likely driver of bank credit quality in the Asian banking sector over the next six-to-18 months compared with most other rating factors. In recent times, nonperforming asset (NPA) trends have been stable or slightly improving in some developed markets, including in Japan and Korea.

Meanwhile, NPA trends slightly deteriorated in some markets, most notably India. Asia’s emerging market banks, in particular, may be more vulnerable to asset quality deterioration over the next six-to-18 months due to the knock-on effect from a tightening in the U.S. credit cycle.