Taiwanese banks, mostly private-sector ones, face increasing risks from leveraged products due to the depreciation of the Chinese yuan, Fitch Ratings says.

Latest financial reports reveal Taiwanese banks' rising exposure to potential customers' defaults on leveraged products called "target redemption forward" (TRF), which are caused by the sudden depreciation of the Chinese yuan or renminbi this summer.

Fitch believes the associated financial impact is containable. Nonetheless, the exposure highlights domestic banks' weakness in risk governance and opportunism as they seek higher growth and earnings opportunities amid the highly competitive banking sector in Taiwan. Rising risk appetite is the main downward rating pressure for the majority of Taiwanese banks.

Fitch estimated that under an unlikely scenario of the renminbi depreciating by 10% (from 6.35 CYN/USD), Taiwanese private-sector banks, which represent 49% of the sector's total assets, could incur an aggregate loss of TWD79bn (around 0.4% of their assets or 5% of their equity). The estimation is based on an assumption that TRF holders fail to honour 40% of overall losses.

Fitch forecasts Taiwanese banks' return on assets to be 0.6% for 2016, marginally down from an estimation of 0.7% for 2015. The forecasts have incorporated weaker sales of forex hedging products due to tightened risk control over its derivatives sales. Earnings of derivatives sales amounted to around 14% of the banks' net profits. Under our stress scenario, the banks would be able to absorb the losses, but not without significantly eroding their already modest returns.

Taiwanese banks generally demand collaterals in deposits or cash to cover 60%-70% of mark to market losses on a daily basis. Buyers of TRF that bet on the Chinese currency could fail to honour losses if the renminbi weakens abruptly, resulting in an increase of provision charges at Taiwan's banks. Most of the TRF contracts were sold in the -6.50 range against the dollar and will mature in 1H16. The renminbi rate was 6.4 at 4 December 2015, down 3% from this summer.

Fitch-rated Taiwanese banks indicated only a small number of clients had difficulties to top up collaterals after the sudden renminbi depreciation in August 2015. The associated losses due to clients' default have so far been small.