Asia-Pacific's major banks are different from global peers in one important aspect. They would likely receive extraordinary government support in the event of distress, and this feeds through to ratings in the form of notching uplift. Banks in the U.S. and western Europe would be more reliant on additional loss-absorbing capital (ALAC) in times of distress. ALAC, likewise, can result in ratings uplift.

This distinguishing factor deepens the ties between Asia-Pacific banks and sovereign credit quality. That means banks are more sensitive to worsening government finances, and sovereigns to losses at banks. We discussed the intertwined outlooks for both sectors at a recent conference.

This session took place on the second day of the conference. Those interested can replay the conference by clicking here for day one; and here for day two. A synopsis of this conversation is below.

Our Panel Discussion

Christopher Lee: What's the outlook for Asia-Pacific banks, keeping in mind turmoil seen elsewhere this year? Are contagion risks still a concern for Asia-Pacific banks given bank failures and rescues earlier this year in the U.S. and Europe?  

Gavin Gunning:   A good spot to start may be our ratings and outlook distribution. We rate banks across 18 countries in Asia-Pacific with most rated banks based in the developed markets. As you can see (chart 1a), the median rating is solidly in the investment-grade 'A-' rating category.

Chart 1a

Chart 1b

In terms of distribution, you might be wondering why our net rating outlook bias is slightly on the positive side (chart 1b), given the amount of risks hitting banks at the moment.

It's because we retain our view that industry risk in the Australian banking sector is improving, driven mainly by better funding trends compared with pre-pandemic averages. There's a one-in-three possibility of an improvement in our starting point for all Australia bank ratings--which is the anchor derived from our Banking Industry and Country Risk Assessment (BICRA).

Putting Australia aside, the net outlook bias across the region is neutral--that is, most rating outlooks are stable. This is underpinned by our macro views of a moderate economic expansion in the region and credit loss pain that is absorbable at current rating levels.

Chris, you mentioned contagion risks--I should state upfront that we are typically very cautious about contagion risks. This is because of the significant linkages and interconnectedness between banks and banking systems. It is also because--as previous banking crises have indicated--contagion risks can have a significant gestation before manifesting. But our latest view is that contagion risks from the U.S. regional banking failures, and the Credit Suisse takeover by UBS in Europe, are now moderating. Risks are now much less likely to spill over onto Asia-Pacific banks.

Besides contagion from external banking events, the four other key risks we've identified are:

• Our economic base case does not hold, meaning interest rates move up or stay higher for even longer, there's much weaker-than-expected economic growth, or job markets get hit.
• High leverage in the corporate and government sectors exacerbates asset-quality problems or limits government capacity to support if conditions take an unexpected downturn.
• Further pain in property. China is not the only country on our radar. The property sector in Vietnam, for example, is under significant stress. Further, a higher-for-longer rates environment puts most banking jurisdictions on watch, especially those with high household sector debt such as Korea, Australia, and New Zealand.
• Banks face ongoing risks associated with digitalization, climate change, and cyber which will challenge banks' business models and risk management capabilities.

Lee: We saw a very rare Asia-Pacific sovereign default last year--in Sri Lanka--and Pakistan has been downgraded to the 'CCC' category. Do you see more downgrades among ratings in the region? 

Kim Eng Tan:  External pressures were the main catalyst for Sri Lanka's default. Both Sri Lanka and Pakistan increased external debt significantly during the prolonged period of low global interest rates. These countries now face "higher for longer" financing conditions and this, along with elevated oil prices, hurts fiscal and external metrics. The same pressures, if persistent, could also trigger negative rating actions in other Asia-Pacific sovereigns.

We have only one negative sovereign ratings outlook--on Bangladesh. This government's commercial external debt didn't jump during the easier-financing period, but the country's current account deficit expanded just before the pandemic, on higher domestic investment. More recently, the central bank also lost a lot of its foreign exchange reserves as pressures on its exchange rate mounted. These developments weakened the external metrics and weakened the government's credit quality sufficiently for the ratings outlook to be revised to negative.

Most rated sovereigns in this region are investment grade (see table 1 in the Appendix). These sovereigns are not facing quite the same kind of external pressures as the three South Asian states we've highlighted. And they are on course to repair damage to fiscal metrics during the pandemic years. That said, if external conditions deteriorate a lot, we could see negative trends, especially for governments that subsidize oil costs.

Lee: A key point of difference between systemically-important banks in Asia-Pacific is that many of them get ratings uplift and hence benefit because of government support. Whereas in the U.S. and Europe any ratings lift is from ALAC. Why is this and do you anticipate that this scenario will continue?  

Gunning:   That's a great question because there are some meaningful differences between regions. For the majority of banking systems in Asia-Pacific (14 of 18), we see governments as supportive toward systemically important private sector commercial banks (see chart 2).

This means that we see extraordinary government support--in the unlikely event it would be required--as the most likely support mechanism for private sector, systemically important commercial banks. In contrast, banks in North America and Western Europe mostly rely on ALAC instruments to protect against distress. Extraordinary government support is only a likely form of support in two of 24 jurisdictions in these regions.

Chart 2

Does this mean that we don't recognize the loss-absorbing characteristics of ALAC securities in Asia-Pacific, or government support in its various forms in other regions? The answer is clearly no. However, we do seek to identify and delineate between support mechanisms for investors by offering our views as to the most likely forms of support. And our view--which we expect will persist for the foreseeable future--is that for most systems in Asia-Pacific we see extraordinary government support as more likely for systemically important private sector commercial banks. For some other regions we see ALAC securities as the more likely go-to for extraordinary support.

Why is this aspect of our analysis important? Because banks can receive ratings uplift from either the amount of extraordinary government support, or ALAC; or indeed other forms of support (see boxes in Appendix, titled, "What is additional loss-absorbing capacity (ALAC)?" and "Our ratings support framework for financial institutions?"). As one example, in China, large banks with varying degrees of likeliness of government support get from 1 to 4 notches of rating uplift (see tables 2 and 3 in in Appendix for uplift notches on top Asia-Pacific and Western European banks).

Lee: What is the likeliest threat to the stability of sovereign rating trends in the region?  Tan:

During COVID and post-COVID, external pressures and fiscal deteriorations put pressure on government ratings. Further deteriorations in these areas could weaken credit support even more. What could trigger that worsening?

• If inflation remained high, causing interest rates to head back up again. This trend would hurt external metrics and in some cases could also lead to new or expanded subsidies, dragging on fiscal positions.

• A sharp increase in oil prices. This is not our base case. Oil prices have come down from the peak of last year. The recent rebound was engineered by producers, which should not be too worrying because it is in their interest to maintain economic stability in their important markets. However, if we had a supply shock--say from something related to Russia-Ukraine war--that would be dangerous. If prices jumped back up well above US$100 again (they are currently pushing towards US$90/barrel) then improvements in fiscal and external metrics since 2023 could reverse--and some on stable outlook could reverse as well.

Lee: The financial-institutions team doesn't see credit losses peaking until 2024. How does this stack up against the broadly stable outlook for the sector?  

Gunning:  Yes, we recently revised up our credit-loss forecasts. Globally, we expect credit losses to rise 15% this year, and then a further 5% in 2024--peaking at US$814 billion.

The momentum is slightly different for Asia-Pacific banks. We forecast credit losses will rise 7% this year and 9% in 2024 to about US$528 billion. The key jurisdiction driving credit losses is China (see chart 4). This is given the vast size of the country's banking system, combined with rising strains in property and other sectors.

Our ratings and outlooks already reflect these expected losses. Clearly, if a scenario outside our base case emerges--likely because of the four risk factors I identified earlier--credit losses would be even higher. This in turn would negatively impact our rating outlooks.

Chart 3

Lee: Governments in the region have seen their debt burdens increased over the pandemic period. Do you expect that to constrain their ability to provide support to banks and other government-related entities that run into financial troubles? 

Tan:   Asia-Pacific government debt burdens have indeed increased a lot in the past half-decade. We've had COVID, we've had a sea change in interest rates. Indeed, alarm bells would be ringing if we focused just on change in debt burdens for Asian governments—because some of the biggest government debt increases have come from them (see chart 4a):

Chart 4a

Keep in mind that these increases came from relatively lower bases. If you look at the distribution of net level of general government debt to GDP, then Asia is pretty much in line with the rest of the world. (Although Japan and Sri Lanka represent the two most highly leveraged governments among rated sovereigns—the two left-most yellow bars in the chart below).

Chart 4b

In short, Asia-Pacific debt increased a lot but that doesn't mean that government debt is excessive.

In terms of what this means for their ability to support banks: they remain strong, despite the higher debt burdens they shoulder. Most sovereigns in the region are investment-grade (see table 1 in Appendix). That means they have the ability to support their banking systems--which are closely correlated to their creditworthiness.

Writer: Cathy Holcombe

Appendix

Table 1

Table 2

Table 3

Related Research

• How The Property Downturn Is Hitting Asia-Pacific Banks, Aug. 31, 2023
• Asia-Pacific Financial Institutions Monitor 3Q 2023: Bank Credit Losses To Hit US$485 Billion In 2023, Aug. 10, 2023
• SLIDES: Asia-Pacific Banking Country Snapshots: Pain Within Expectation, Aug. 9, 2023
• Global Bank Exposures To Commercial Property Are Top Of Worry List For Investors, Webcast Polls Show, Aug. 3, 2023
• Global Banks Country-By-Country Midyear Outlook 2023, July 20, 2023
• Global Banks Midyear Outlook 2023 | Resilience Will Be Tested, July 20, 2023
• Interactive Dashboard--Global Banks Midyear Outlook 2023: Resilience Will Be Tested, July 20, 2023
• Global Banks: Our Credit Loss Forecasts, July 13, 2023
• Asia-Pacific Sovereign Rating Trends Midyear 2023: Sturdier Times, July 6, 2023
• EMEA Financial Institutions Monitor 2Q2023: Steering Through Volatility, May 24, 2023