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The uncertain operating environment in China is increasing the risk profile of Hong Kong banks and eventually raising the prospect of negative rating action, says Fitch Ratings.

Fitch estimates gross mainland exposure could rise to about 35% of Hong Kong banking assets by 2012, from 24% at end-June 2011 and 10% at end-2008.

To date, mainland credit exposures of Hong Kong banks have often been short-term, trade-related and collateralised. However, the operating environment is weaker, and corporate governance and transparency issues are more prevalent in the mainland.

"Hong Kong's banks will likely cede some of their historical strengths of robust capitalisation and low risk appetite if rapid growth in the mainland causes them to lower their underwriting standards," says Sabine Bauer, director in Fitch's financial institutions team. "Fitch is seeing signs of the increasing influence of Chinese banking parents on Hong Kong subsidiaries, which could negatively influence efficiency or even reverse progress in key areas including risk management."

The report notes that the Hong Kong banking sector still maintains adequate liquidity, and the agency is not expecting near-term systemic liquidity pressures. However, Hong Kong banks' liquidity could tighten suddenly, as the banking sector is sensitive to investor confidence in the China growth story, global risk aversion, and tight liquidity in the advanced economies. Banks in Hong Kong benefit from substantial foreign-currency funding from foreign banks, although this has proven volatile in the past.

Fitch sees the larger Hong Kong banks, and those which belong to international/Chinese banking groups, as best positioned to maintain or expand their market share, as competition will remain fierce in servicing the larger companies with stronger credit profiles.

The limited competitiveness and scale of the smaller Hong Kong banks may tempt them to expand into riskier segments. In addition, those banks which have experienced rapid growth over the last two years, and those most exposed to the mainland may find it most challenging to maintain solid asset quality in a weaker environment.

The outlooks on the long-term issuer default ratings (IDRs) of all Fitch-rated Hong Kong banks currently are stable.

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