Asia's Banking Systems Still At Risk

CIAO DATE: 2/00

Asia’s Banking Systems Still At Risk

Conference on Crisis & Credit: Restructuring Asia’s Financial Sector Asia Society
October 1, 1999, New York

Speeches and Transcripts: 1999

I want to thank the Asia Society for the opportunity to represent Moody’s at such a prestigious gathering.

I plan to speak for a few minutes about our assessment of Japanese banks and then say a few words about our views on the rest of Asia. In order to reconcile my comments with those expressed by others here today—as well as our own published ratings—I feel I should briefly explain our rating system.

At Moody’s, we provide two major types of ratings for banks: financial strength ratings—which provide an opinion about the intrinsic stand-alone credit worthiness of a bank; and expected loss ratings such as deposit and debt ratings.

Financial strength ratings are not unlike so-called CAMEL ratings that examiners and supervisors in the US compile for regulated banks, except that we use an A through E scale, where A signifies an extremely sound bank and E signifies an insolvent bank. On this basis, the average FSR for Japanese banks is a borderline E+/D, well below the global average of C.

This low average financial strength rating is supported by our view that:

Asset quality remains poor among Japanese banks, although disclosure of problem loans is improving. We suspect that, even after the large charge-offs taken in recent years for bubble-related loans, substantial sub-standard credits still remain on their balance sheets. Moreover, reserve coverage remains low for Class 2 assets. The interconnectedness among lenders and borrowers in Japan prevents banks from drastically reducing their exposure to weak, large borrowers, as this may cause hardship for other banks.
Earnings are too low to compensate for the high credit costs we expect to occur. While there has been some loan growth as a result of the state capital injection, overall loan demand is weak due to the slow economy and interest rates remain very low. Combined, these factors have put enormous pressure on net interest margins. Banks do seem to be trying to cut costs in earnest, but this will likely have only modest effects.
Capital levels, while meeting regulatory minimums on paper, are in reality quite low. And weak earnings will not add to capital in the near term. Reported capital levels at large Japanese banks include a number of non-economic features.

Turning now to Moody’s deposit and debt ratings, as I noted before, they are opinions about the expected loss of the rated instrument, not about the underlying financial strength. For example, the average deposit rating at Japanese banks hovers in the Baa1 range: a low investment grade rating. That is, despite their weak financial fundamentals, we expect that regulators will not allow a Japanese bank to default on its deposits, at least until March, 31 2001. On the other hand, we are less certain as to how bondholders, particularly subordinated debt holders might fare in a bank resolution before or after that date.

There have been many regulatory and structural developments over the past two years that support these ratings.

First, is the trend towards consolidation, such as the announced merger of Fuji Bank, DKB and IBJ—the ratings of which we have placed on review for upgrade. Going forward, we can envision four or five large City Banks dominating the Japanese financial landscape, each “Too Big To Fail.” On the other hand, we feel that the current emphasis on mergers, joint ventures and alliances is somewhat misplaced and that these will not, in and of themselves, solve the fundamental problems of large banks.

Second, is the de facto nationalization of the Japanese banking system through the large injections of state capital. We expect further government capital to be forthcoming for both large and small banks. We have also seen the establishment of certain receiver banks to minimize systemic turmoil and the subsequent failure of borrowers.

Third, is the slow privatization of banks placed in receivership, such as the announced sale of LTCB to Ripplewood. Beyond the symbolic nature of the sale, being the first so far, we have to wait and see if this wholesale bank can regain its franchise value.

We also welcome the move towards consolidated reporting of financial condition for large banks, as this adds to transparency and reduces accounting forbearance. That CPA’s opinions have gained new weight also bodes well for these issues.

We applaud the direction taken by Japanese regulators to lead banks to dispose of past mistakes, as this will ultimately strengthen the entire banking system. Our focus will increasingly shift from asset quality problems to profitability and franchise value. Consequently, our outlook for Japanese banks is generally stable, with the likelihood of upgrades still somewhat limited.

The Japanese economy is mired in a protracted slow-growth phase. This has placed a burden on the asset quality and profitability of Japanese banks. And there is still too much uncertainty surrounding the probable treatment of depositors or general creditors after March 2001 to warrant rapid upgrades in ratings. The rating implications of any further restructuring will depend on the ability of the “new” entity to create shareholder value through large and stable earnings.

Banking sectors in the rest of Asia are generally quite weak as well, with the exceptions being Hong Kong and Singapore. While these two nation-states did suffer somewhat during the Asian crisis, their strong regulatory systems and high capital levels prevented serious deterioration.

But the banking problems throughout South East Asia are only symptoms of a greater disease, and that is overextended, noncompetitive borrowers. Borrowers who are in many cases engaged in non-economic practices such as excessive real estate development or speculation in both real estate and equity markets.

Here’s a brief summary of each system:

Korea is still facing one of the most challenging periods in its economic life. The troubles at the large chaebols have put banks in a very difficult position. Deleveraging the Korean corporate sector shifts the pain to the large banks, who must accept debt-for equity swaps, maturity extensions or outright forgiveness of loans. There will likely be further restructuring of the Korean banking system in the near future, with an additional government injection of capital and further consolidation.

In China, serious reform of the Chinese banking system has finally begun, but this will be a long, drawn out process. The slowing economy and the deteriorating condition of the state sector has strained the banking system. But we do not expect a systemic financial crisis in the near- to medium-term, given the government’s priority to maintain stability and the insulation provided by a non-convertible currency.

To their credit, Taiwanese authorities moved swiftly to bolster the economy and stock market during the Asian financial crisis, and further reforms of the supervisory system are planned. But the incentives for fundamental reform have been hurt by the high degree of interference in the economy. The system also suffers from excessive speculative activity in the stock market.

The Philippines’ prior experience with economic crises left them with a much smaller “bubble” in economy and a strong base from which to handle the recent financial crisis. A “bottom-line” focus has led to strong profitability at banks and proposed new regulations will likely increase disclosure, the power of regulators and allow for more foreign ownership. Yet regulatory enforcement in the past has been hindered by limited resources.

While the focus in Thailand has moved away from the immediate insolvency of the banking system, the country faces a large overhang of restructured loans. The resolution of these loans will place a burden on taxpayers and will likely constitute a drain on the future profitability of the banking system.

Malaysia has an intrinsically stronger corporate sector, but government interference is high. On their own, bankers there are quite capable of operating in a prudent manner, but the government’s social agenda often includes the private agenda of well-placed individuals. Bank consolidation is proceeding quickly and, while we think this will be positive in the long run, the temptation for government meddling is still high.

Finally, Indonesia is facing the brunt of the Asian crisis and is undergoing a fundamental restructuring of the financial system with assistance from IMF and the World Bank. Massive bank consolidation—one-third of 238 banks existing pre-crisis have been closed or merged; in many cases bank management has been ousted and the banks closed for not meeting “fit and proper” tests. Yet there have been repeated delays and reversals in the reform program. Corporate debt restructuring has been slow and often “controversial” and IBRA may not meet its asset sales targets. Enthusiasm for reform has waned and resolution costs may rise further.

In summary, the overall outlook for Southeast Asia banks has now stabilized. We do not anticipate further downward rating revisions and feel that rating upgrades may occur over the longer-term horizon. Thank you.