Current Condition and Outlook

Table 1 [ PDF 12.7KB | 1 page ], which summarizes Moody's average bank financial strength ratings, is similar to the assessment of the leading credit agencies and investment banks regarding the outlook for the banking system in Asia. The table reflects several downgrades and downward changes in outlook for major banking systems in 2008 and thus far in 2009. Rating agencies expect substantial pressure on loan quality to be the biggest threat for most banks in Asia. For this reason, they indicate that further rating actions will most likely result from credit impairment, lower profitability, and potential capital reduction. It remains to be seen to what extent credit quality will deteriorate across the region as corporate profitability declines and as banking systems dominated by government ownership implement fiscal stimulus plans. Previous slowdowns that led to a decline in asset quality led to higher provisions and lower profits (Box 1 [ PDF 12.7KB | 1 page ]).

Other pressure on revenue will come from a number of sources, such as lower volume of trade finance and wealth management sales and less investment banking activity. The possibility of a shrinking capital base might lead to reduced lending and credit contraction. Is this scenario plausible? This paper says that it is, unless policymakers manage the situation very carefully.

What is the current condition of the region's banking systems? The following analysis is based on the standard supervisory framework of banking risks: CAMEL, with the addition of sensitivity to market risk. Using this methodology, ratings are assigned for each component in addition to the overall rating of a bank's financial condition.¹ The key findings for CAMEL are based on data in the Financial Stability Indicators (FSI) of the Global Financial Stability Review (International Monetary Fund [IMF] 2009a).²

Capital Adequacy. To be adequately capitalized under US federal bank regulatory agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 4%, a combined Tier 1 and Tier 2 capital ratio of at least 8%, and a leverage ratio of at least 4%. To be well capitalized per agency definitions, a bank holding company must have a Tier 1 capital ratio of at least 6%, a combined Tier 1 and Tier 2 capital ratio of at least 10%, and a leverage ratio of at least 5%. As shown in Table 2 [ PDF 13.7KB | 1 page ], the banking systems in Asia have capital ratios that can be considered as well capitalized. The ratio of bank regulatory capital to riskweighted assets ranged between 8.2% and 16.8% in 2008. The high ratios in Indonesia (16.8%), Philippines (15.5%), Singapore (14.3%), and Thailand (15.3%) are particularly notable, comparing favorably with Australia (10.9%) and Hong Kong, China (14.3%). In the People's Republic of China (PRC) the ratio made a formidable recovery from 2003 (-5.9%) to 2008 (8.2%).

The banking systems of Japan and the PRC account for 84% of Tier 1 capital in the region; for this reason, they warrant special attention. There are two distinct concerns with respect to the PRC and Japan: rapid growth of credit in the PRC and the quality of capital in Japan.

In the PRC, the concerns derive from the size and unusual pace of bank lending and the resulting structure of bank loans outstanding so far this year. In the first three months of 2009, the PRC's banks extended yuan4.58 trillion (US$640 billion) in new loans—nearly as much as all new lending for 2008 and equivalent to around 70% of the nation's gross domestic product (GDP) for the quarter. There is considerable concern that the surge in lending could compromise asset quality and add to the financial risks in the system.

In Japan, the concern is that the three biggest financial groups—Mitsubishi UFJ, Sumitomo Mitsui, and Mizuho—are undercapitalized. According to Macquarie Research (2009), the problem is not the quantity but the quality of capital. Macquarie Research's calculations of one broad measure of capital suggest that the banks' capital ratios are low and that a large part of capital comes from sources that either are not permanent or resemble debt rather than equity: half of banks' base of Tier 1 capital relies on unrealized mark-to-market gains in equity holdings (breakeven Nikkei 9,000) and deferred tax assets. Further, the ratio of tangible common equity to tangible assets is 3.6% for Japanese banks, compared with 4.2% for European banks and 4.6% for US banks (i.e., the epicenter of the banking crisis). The financial turmoil abroad has already harmed highly leveraged sectors in Japan, such as real estate investment, as evidenced by the flight of foreign funds, bankruptcies among real estate firms and real estate investment trusts, and the fall in property prices. Therefore, Macquarie Research concludes that, in order to offset projected bad-loan losses and raise Tier 1 ratios to 6 or 8%, Japanese banks will need to mobilize billions of dollars in capital.

Asset Quality. Asset quality has improved markedly in the region (Table 3 [ PDF 12KB | 1 page ]). For example, in the PRC, nonperforming loans declined from 20.4% in 2003 to 2.5% in 2008. Similarly, in Japan, nonperforming loans declined from 5.2% in 2003 to 1.5% in 2008. Credit rating agencies, however, expect substantial pressure on the quality of loans to be the biggest threat facing most banks in Asia. It remains to be seen to what extent credit growth actually slows across the region, as state-owned banks in systems dominated by government ownership may well play a significant role in implementing fiscal stimulus plans. In countries like the PRC and Viet Nam, banks appear to be advancing substantial volumes of loans to boost their economies. The extent to which governments in East Asia, such as the PRC, are pressing banks to increase their lending to certain sectors could create credit quality problems for the banks at a later date. For example, the stimulus in the PRC has its own risk. The rate of increase for bank loans outstanding for the previous 12 months rose from 14.5% in September 2008 to 18.8% in December 2008 and to 24.2% in February 2009. Rapid growth in credit almost always has been associated with compromises in the quality of loans and might lead to impaired credit in the PRC. At the same time, direct government assistance to banks will ultimately provide support.

Adequacy of Reserves. The biggest threat for most banks in Asia is the substantial pressure on the quality of loans as a result of the global crisis. The increase in nonperforming loans might lead to lower profitability, and higher provisioning might lead to considerable erosion in Tier 1 capital, with implications for future lending. In the intermediate term, the problem is not the current level of capital or nonperforming loans, but the buffer needed to sustain future losses through the allowance of loan losses. A desirable ratio of reserves to nonperforming loans is 100%. For example, in the United States only recently, during the crisis, has the ratio dropped below 100%. The allowance for loan losses in the region ranges from adequate to inadequate. As shown in Table 4 [ PDF 9.7KB | 1 page ], coverage ratios are low in Japan (24.9%) and India (52.6%), prudent in Indonesia (98.5%), Malaysia (86.9%), Philippines (84.1%), and Thailand (86.5%), and very high in Singapore (119.9%) and Korea (155.4%).

Earnings. In Japan, banks operate in a highly competitive environment with low profit margins. For example, in Japan, the return on equity was 6.1% in 2007 and 1.5% in 2008 (Table 5 [ PDF 12.4KB | 1 page ]). In countries such as the Philippines (9.6% in 2008) and Thailand (7.3% in 2007), banks are invested largely in government debt. The rates of return on assets are similarly modest.

Liquidity. The business models of most Asian banks were originally, and continue to be, based on deposits and thus are safer than wholesale funded banks due to a more stable source of funds. Reliance on wholesale funding has only played a significant role among Australian and Korean banks. Therefore, liquidity (loan to deposit ratios) appears to be adequate in most of the region, with the exception of Korea, where the ratio of loans to deposits is high.

Sensitivity to Market Risk. A sixth component—a bank's sensitivity to market risk—was added to CAMEL in 1997, and the acronym was changed to CAMELS. European and US banks had and have considerable exposure to credit and market risk due to the "originate and distribute" model ( separation of credit underwriting from credit monitoring) and are now moving to less risky business models. As mentioned, most Asian banks' business models were less risky to start with. Table 6 [ PDF 16KB | 1 page ] provides a snapshot of the risks in the region's banking systems.

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