Europe crisis poses risks to Asia-Pacific banks, but impact is manageable

By Standard & Poor's | 21 February 2012

Ritesh Maheshwari, managing director and Asia-Pacific head of financial institutions ratings at Standard & Poor's, discusses the effect of the European debt crisis on Asia-Pacific banks.

What are the implications of the European bank downgrades for banking groups in Asia-Pacific?
While our rating actions reflect the interconnected risks between Europe's sovereigns and its banking system, they don't have an immediate direct and material impact on Asia-Pacific bank ratings.

The various risks from the European crisis include losses from direct exposure to European sovereigns or the private sector, slowdown in exports to Europe or global slowdown resulting in lower economic growth, and global financial market tightening due to European banks' deleveraging to counter capital demands in their home operations.

Currently, the outlooks on 79% of Standard & Poor's Asia-Pacific bank group ratings are stable, backed by a number of factors, including relatively solid growth prospects in the region, good capitalisation, strong franchises, and stable funding.

A notable exception, however, is Japan, where we have negative outlooks on the ratings on a majority of the banks, reflecting Standard & Poor's negative outlook on the sovereign rating.

What are some of the scenarios that may prompt Standard & Poor's to revise its views?
Under our base-case scenario, we assume that: the global economy will avoid a severe recession but not escape a mild recession; the Economic and Monetary Union (EMU) will grow at an anaemic 0.4% in 2012; the U.S. economy will escape a recession; and China will manage to secure a soft landing with about 8.0% growth in 2012.

However, if the eurozone's debt woes lead to a more severe global recession, it could prompt us to lower our assessments of Asia-Pacific banks, including those for their risk positions and capital and earnings.

Considering the export-oriented structure of the Asia-Pacific region, a more pronounced global economic slowdown could have a larger impact on the region's overall economy and the credit profile of the Asia-Pacific banking industry. Under this scenario, which differs from our base-case scenario, we would consider negative rating actions on the banking sectors of relevant Asian-Pacific countries.

We may also consider negative rating actions if stresses in the eurozone cause a market dislocation and result in funding difficulties for Asia-Pacific banks. If confidence in global financial market weakens and European banks reduce their assets in the region, that could increase pressure on Asia-Pacific banks' asset quality and funding.

Finally, if the macroeconomic conditions and the funding environment of the Asia-Pacific banking industry worsen beyond the assumptions in our Banking Industry Country Risk Assessments (BICRA), we would review our BICRA scores across the region. That could lead to changes in the anchor ratings on some countries. As for the extent to which bank ratings would be affected by such revisions, that would depend on the banks' stand-alone credit profiles, the extensiveness of system/government support, and individual banks' responses to the changing economic environment.

What is the exposure of Asia-Pacific banks and economies to Europe?
Asia-Pacific banks generally have very limited investment exposures to the euro sovereigns under pressure in the bond markets (Greece, Italy, Ireland, Portugal and Spain, collectively known as GIIPS).

A slowdown in exports to Europe or global slowdown caused by the European crisis will result in lower economic growth in Asia-Pacific. This in turn would likely impede credit growth and fee-based activities and increase credit losses causing weaker profitability for banks.

We have seen exports decline in late 2011 in various countries such as Taiwan, Korea, Singapore, and Japan. European countries are generally important trade partners for Asia-Pacific countries as 10%-20% of their total exports are shipped to the eurozone. In particular, China and Vietnam's exports rely highly on trade with Europe.

We currently hold the view that the region's banks will be able to absorb higher credit costs with their profits. Our view is based on the relatively sound profiles of the region's corporate and household sectors, as well as the growth prospects for domestic demand. In addition, shifts to a more accommodating monetary policy in China, India, Indonesia, and other countries could also mitigate a surge in credit costs to some extent.

What are the implications of European banks pulling out of Asia-Pacific?
Following the 2007-2009 global financial crisis, European banks aggressively expanded cross-border lending in the Asia-Pacific region. If European banks drastically cut back such exposures, it could worsen funding conditions for some banks, place additional pressure on corporate and public sectors, and hamper economic growth. We expect European banks to prioritise their core markets in Europe and apply tight lending standards on cross-border exposures. Furthermore, European banks could face increased pressure to reduce their assets in the region if the sovereign debt crisis deepens.

The impact of asset consolidation by European banks will vary among countries and sectors in the Asia-Pacific region. Generally, Asia-Pacific banks have large portions of liabilities made up of stable core deposits, and reliance on wholesale funding is low. On the other hand, banks in Australia, New Zealand, and Korea are relatively more dependent on wholesale funding and are more exposed to global market volatility. Being financial centres, Hong Kong and Singapore are most prone to squeeze in capital markets by European banks' retreat.

A surge in funding costs could constrain banks' profitability, as a softening economic environment would limit adjustments in lending rates. However, Asia-Pacific banks are gradually reducing their dependence on wholesale funding.

Does the pullback by European banks signal new business opportunities for Asia-Pacific banks?
While asset consolidation by European banks could lead to higher credit costs, on the other hand, it could also create opportunities for Asia-Pacific banks to boost their presence in local and global markets. For example, several Japanese major banks recently purchased assets from European banks.

We expect more banks in the region to seek growth opportunities in overseas markets. However, we also believe rapid expansion will be constrained, given an increasingly difficult economic environment, uncertainty about the stability of the foreign-currency funding market, and higher capital requirements under the Basel III regulatory capital framework.

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