Announcement: Moody's: Deteriorating Operating Conditions Weigh on Hong Kong's Banking System

Moody's Investors Service says that its outlook for the Hong Kong banking system over the next 12-18 months is negative.

"We expect a more challenging operating environment for Hong Kong banks in the coming 12-18 months, because of the weak growth in global demand, and also because the banks' borrowing costs are higher, owing to further monetary tightening in the US," says Sherry Zhang, a Moody's Analyst.

"This situation will pressure the system's asset quality and profits, and test its resilience, given the territory's elevated property prices and the banks' growing linkages with Mainland China," adds Zhang.

The negative outlook for Hong Kong's banking system also reflects Moody's expectation that large banks in the territory will receive less support from the Government of Hong Kong (Aa1 negative), under the territory's proposed operational resolution regime.

Moody's conclusions were contained in its just-released report on Hong Kong banks titled, "Deteriorating Operating Conditions, Rising Asset Pressure Keep Outlook Negative".

The negative outlook is based on Moody's assessment of five drivers: Operating Environment (deteriorating); Asset Quality and Capital (deteriorating/stable); Funding and Liquidity (stable); Profitability and Efficiency (deteriorating); and Systemic Support (deteriorating).

With the operating environment, Moody's says that the challenging conditions for the banks have led Moody's to assume a baseline scenario of muted GDP growth for Hong Kong of 1.2% in 2016 and 1.5% in 2017 from 2.4% in 2015. This assessment is in line with recent economic reports showing marked slowdowns in the export of goods, as well as tourism and retail sales activities; all of which reflect weak external demand, in particular, from Mainland China.

The territory is also set to see gradually rising borrowing costs because under the currency peg, any tightening in US monetary policy will lead to higher interest rates in Hong Kong. The impact of the higher costs will be magnified by current high private sector leverage.

On asset quality and capital, Moody's report says that problem loans will increase from current low levels because the combined effects of a slower Hong Kong economy and likely higher interest rates will add pressure on loan delinquencies.

As for the banks' capital positions, they will remain supported over the next 12-18 months by low asset growth and earnings retention; the same drivers that underpinned the banks' broad improvement in reported capital metrics in 2015.

As for profitability and efficiency, Moody's says that the banks' profitability will be pressured by lower interest income and higher credit costs. In addition, the banks will see lower non-interest income in 2016, driven mainly by lower brokerage fees, as domestic stock market activities retreat from their peak in mid-2015. Meanwhile, credit costs will rise modestly because of the pressure on asset quality.

Liquidity will remain ample but will tighten gradually, because broad monetary conditions in Hong Kong are affected by the US policy cycle. The banks also face money market volatility because of the cross-border fund flows between Hong Kong and Mainland China.

Nevertheless, the downside risks are mitigated by the banks' large and stable customer deposit base and low loan-to-deposit ratio. The banks also hold large amounts of liquid assets to support their ability to meet significant increases in cash outflows.

Moody's rates 17 banks in Hong Kong, which together accounted for 68% of total domestic loans at end-2015. The three largest banking groups — which are also rated by Moody's — have captured a 46% combined market share of domestic loans. These three groups are: 1) The Hongkong and Shanghai Banking Corp. Ltd and its subsidiary, Hang Seng Bank; 2) Bank of China (Hong Kong) Limited; and 3) Standard Chartered Bank (Hong Kong) Limited. Numerous mid-sized and small banks account for the remaining 32% of total domestic loans.

Moody's has maintained a negative outlook on Hong Kong's banking system since June 2013.