Hong Kong banks suffer from liquidity and credit quality risks

The banks were somewhat reliant on strong loan growth but though loans for domestic use have grown, almost 25% of the total loan book is now for use outside of Hong Kong.

According to KPMG’s latest Hong Kong banking survey, despite a strong performance for 2010, Hong Kong’s banking sector faces liquidity and credit quality concerns as well as an impact from the current European debt crisis.

KPMG’s 23rd annual report of the sector, notes that 2010 was characterised by sustained loan growth, rising asset prices, low levels of bad debts and significant increases in the sale of investment products.

However, while the first half of 2011 saw a continuation of these favourable conditions, continuing low interest rates have placed further pressure on net interest margins, making it difficult for banks to grow revenue to offset rising wages and other costs. Banks will increasingly focus on operational efficiencies, offshoring and
managing costs.

Martin Wardle, Head, Financial Services, KPMG in Hong Kong, says: “Banks face increasing regulations and compliance requirements. Basel III rules for example, will require them to raise their capital and meet new liquidity requirements. In addition, regulators are requiring them to raise their regulatory reserve ratios. We are also likely see restructuring of bank balance sheets in order to meet these new requirements.”

In addition, the report notes that Hong Kong dollar liquidity is increasingly becoming a more pressing concern for banks. The growth in local currency deposits has lagged behind HKD loans as customers have favoured the appreciating renminbi. In turn, the tightening of liquidity has helped to bring some pricing power bank to the banks and added to the upward pressure on deposit rates as lenders compete for funds.

Total bank assets increased by HKD1.7 trillion, or 15 percent, to HKD12.3 trillion during 2010, with gross advances to customers growing by a strong 29 percent. With total customer deposits growing by a more restrained 7.5 percent the loan to deposit ratio increased from 52 percent to 62 percent.

The ranking of licensed banks by total assets remains unchanged from 2009 and there is only one new entrant to the top ten rankings by net profit after tax, demonstrating that well-established banks continue to dominate.

Licensed banks recorded better asset growth than during the 2009 recovery from the global financial crisis, with the Hong Kong operations of the large mainland banks generally growing their assets the fastest. Although most performance measures, including cost-income ratios have remained largely stable in 2010 when compared to 2009, customer loan to deposit ratios are the exception, having increased in most banks.

Elie Lai, Partner, KPMG China, says: “One of the factors working in Hong Kong’s favour is its preeminent position as an offshore RMB market. It has the most liquidity, the highest trade settlement volumes and a number of RMB-denominated financial products. However this also brings some risks. While expectations of currency appreciation remain, transfers to RMB will continue to erode some of the liquidity in Hong Kong’s banking system. Conversely if the RMB does not appreciate, it would not be favorable to Hong Kong in terms of its longer-term prospects as an offshore RMB centre.”

The survey also highlights that banks have become somewhat reliant on strong loan growth to compensate for compressed net interest rate margins. The recent announcement that the US will maintain historically low interest rates until at least 2013 has meant that banks may have to wait longer before they see margins improve.

Loan impairment charges are at exceptionally low levels and the pace at which loan portfolios have grown has increased the risk of higher bad debt charges, although the report notes that there appears to not have been any relaxation of underwriting standards. However, although loans for domestic use have grown, almost 25 percent of the total loan book is now for use outside of Hong Kong.

Martin Wardle concludes: “Looking ahead, many uncertainties remain for banks to develop a clear strategy for their Hong Kong and Asian businesses. A reassessment of growth strategies may affect Hong Kong given its status as a regional hub and gateway to China, although we expect to see additional entrants and consolidation in the local banking sector as mainland banks use Hong Kong as a headquarters for their international operations and a pool of banking expertise.”