ASEAN banks must brace themselves for a bumpy road to financial integration

Although it is progressing.

It has been observed that financial integration within the Association of Southeast Asian Nations (ASEAN) is progressing, but the process won't be entirely smooth.

According to a release from Standard & Poor's Ratings Services, this insight is contained in its recently published report titled "ASEAN Financial Integration: The Long Road To Bank Consolidation."

Full integration could spur the emergence of major banks that can compete with large banks outside the region, said the release.

Better economies of scale would also make financial systems within the region more efficient. Along with the improvement of financial infrastructure in each country, Standard & Poor's believes the integration will make the banking sectors more resilient to external shocks.

"We don't expect the integration to be entirely smooth because, as countries liberalize their banking industries, competition will intensify--trends that not all local players welcome," said Standard & Poor's credit analyst Chris Lee.

"Integration will also increase the risk of contagion and spillover effects within the region; when one system gets in trouble, it will affect other systems too. In addition, the varying pace of liberalization and divergent regulatory frameworks among ASEAN countries complicate the industry's consolidation."

Here’s more from Standard & Poor's Ratings Services:

We expect the formation of the ASEAN Economic Community (AEC), which is scheduled to take effect in 2015, to liberalize the flow of goods, services, investment, capital, and skilled labor between the countries. Greater intra-ASEAN trade could encourage banks to expand regionally to better serve their clients.

Central bank governors have endorsed the ASEAN Banking Integration Framework (ABIF) to achieve multilateral liberalization in the banking sector by 2020. This will pave the way for future integration of the ASEAN banks, and banks are already preparing to leverage the opportunities from increased trade flows in the region.

The major banks in Malaysia and Singapore have been the most active in expanding regionally. Thai banks are also expanding, although they are focusing more on the Greater Mekong subregion. Indonesian and Philippines banks, on the other hand, are playing defense and strengthening their domestic networks.

Banks in ASEAN are mostly small by global standards and don't have the scale and footprint to compete effectively with global behemoths. In particular, the fragmented banking systems in some countries, such as Philippines, Indonesia, and Vietnam, have a large number of small financial institutions with weaker financial profiles than their global peers. These systems would find it difficult to compete if the larger banks join the fray.

"In our view, ASEAN's financial system still has a way to go to meet its goal of integration by 2020. The uneven pace of financial liberalization in different countries, along with significant divergence in regulatory frameworks, could complicate cross-border mergers," Mr. Lee said. Standard & Poor's believes national regulators will proceed with gradual financial liberalization and ensure that domestic banks are strong enough to compete before they allow for full liberalization.

Stumbling blocks to liberalization and integration remain. Acquisition costs have been a significant obstacle in many deals. Characteristics that are specific to certain countries, such as strong family ownership of the banking sector in the Philippines and strong labor unions in Malaysia, also make industry consolidation more difficult.

Standard & Poor's view of the financial performance and credit profile of banks in ASEAN, excluding Malaysia, remain stable. We expect banks to grow their loan books prudently in the next few quarters, considering the higher capital requirement under Basel III and generally improving discipline in loan underwriting.

"We believe asset quality will remain a major risk factor in ASEAN banks' credit profiles. Tighter monetary policy in the U.S. and a subsequent increase of interest rates could trigger similar hikes in ASEAN markets. Households and companies with heavier debt-servicing burdens will be more vulnerable to such shocks," Mr. Lee said.