Taiwan banks' offshore exposure to account for 24% of system assets by end-2017

The China slowdown remains the key risk for the sector.

According to Fitch Ratings, Taiwan's banking sector will continue to face challenges in the year ahead from economic growth which is only moderate, together with a slowing China. But strengthened capital buffers and stable profitability should mitigate credit risks. Fitch's sector outlook for Taiwan's banking sector remains stable - from both a rating perspective and in terms of the operating environment.

Here're more from Fitch:

The slowdown in China remains the key macroeconomic risk for Taiwan's banking sector, especially in light of the banks' rapidly growing exposure to the mainland. Fitch estimates Taiwan banks' offshore exposure will account for 24% of system assets by end-2017, up 50% from 16% at end-2014. Risks from asset-quality deterioration are likely to build in 2016, with the feedthrough from China being felt both in direct lending to Chinese entities and second-order effects through slowing trade.

That said, Fitch maintains that these risks should be broadly contained. Taiwan banks' China exposure is related mostly to interbank placements, lending to Taiwanese corporates operating in China, and lending backed by Chinese financial institutions. Fitch estimates exposure to indigenous Chinese borrowers is low at around 10%-15%.

Furthermore, Taiwan banks have strengthened their impaired-loan provisions steadily since 2013 - owing in part to a regulator imposed 1.5% provisioning requirement on China and property exposure by end-2015 and 2016, respectively. Strengthening loss-absorption capital buffers has been supported by reasonably strong profitability.

It is also notable that growth in Taiwan banks' China exposure has slowed in 1H15, and may stay at a lower rate if current regulatory limits remain in place and credit growth continues to decelerate in China.

Profitability should decline as credit costs rise from a cyclical trough - RoA and RoE were at 0.7% and 9.9%, respectively, in 1H15. But our core scenario is for the rate of decline to be modest and not to have an effect on ratings.

The principal credit risks facing Taiwan banks are less to do with broader macroeconomic challenges and more pertaining to growing risk appetite for expansion in higher-risk emerging markets and M&A. Offshore expansion beyond China and domestic consolidation is likely to hasten. Execution risks could rise for Taiwanese banks, which do not have a strong track record of overseas expansion. M&A activity could also weigh on capital and profitability while lifting leverage, thereby raising banks' risk profiles.

It is notable that the three Taiwanese banks that Fitch rates on Negative Outlook or Rating Watch Negative - CTBC Bank (A), KGI Bank (BBB), and Yuanta Commercial Bank (BBB+) - are all engaged in rapid overseas expansion, particularly in emerging markets or have recently engaged in M&A activities through their respective parents.

A slowdown in Taiwan's property sector is also a risk that could contribute to asset-quality deterioration. But mortgage risks should be contained, owing to growth having moderated to 1%-2% this year and with adequate collateralisation - average initial loan-to-value ratios for mortgage lending is between 60%-70%.