Growing exposures to Mainland China and deteriorating credit conditions in the Mainland underpin Moody's Investors Service's continued negative outlook on Hong Kong's banking system over the next 12-18 months.
Other key risks include asset market imbalances in Hong Kong's economy, and the government's proposals on revised bank resolution regimes.
Moody's says that as interest rates start to rise in 2015, after a long period of extremely easy monetary conditions, the operating environment is likely to become more challenging for Hong Kong economy and banks.
In a newly released report, Moody's points out that the banks' Mainland exposures grew 14% in 2013, and accounted for 20% of their total assets at end-2013 versus 18% at end-2012.
The report notes that the key drivers behind the strong growth in the banks' Mainland exposures are Mainland and overseas corporates' expanding cross-border trade and investment activities.
Relatively low funding costs in Hong Kong compared to China, and credit demand diverted to Hong Kong from China due to tighter liquidity conditions in the Mainland are also key drivers.
Conservative credit standards
According to Moody's report, the banks have so far maintained conservative credit standards on their Mainland-related lending and report good asset quality metrics.
However, the rapid growth in their Mainland-related business and the transformation in their financial profile entail risks, as the banking system evolves as an important offshore financial conduit for Mainland China.
The strong growth in Mainland business will pressure some of the banks' liquidity profiles and capitalization levels.
Moody's report also points out that while property prices in Hong Kong have stabilized after more than doubling between 2009 and 2012, prices remain elevated relative to rent and continue to pose risks to the territory's economy and banks.
While Moody's assessment is that the banks can withstand the direct impact of a substantial fall in property prices, such a fall would have negative effects on the economy, which in turn could prove disruptive to the banks' credit profiles.
Moody's report says two groups of Hong Kong customers, namely unsecured consumer loan borrowers and small- and medium-size enterprise (SME) borrowers pose the highest credit risks for the banks.
Non-mortgage consumer lending, which is more sensitive to economic cycles than mortgages, grew 22% in 2013. Moody's report also says that the operating environment for Hong Kong SMEs with operations in southern China are unfavorable, as land and labor costs continue to rise.
Mid-sized banks are especially sensitive to the financial conditions of such borrowers.
Moody's report further points out that while latent risks remain in the operating environment, both the economy and the banks are entering this period from a position of strength.
For example, the banks reported good financial results in 2013, characterized by sound asset quality metrics, strong capitalization, and good profitability.
The bank's strong financial profiles explain why they continue to have high credit ratings.
Hong Kong banks have the second highest baseline credit assessments (only after Singapore) on a weighted average basis in Moody's rated universe.
On the planned adoption of the government resolution regimes, Moody's says this development is credit negative for bank creditors because they are less likely to benefit from public sector support and more likely to have losses imposed on them during times of stress.
Moody's rates 17 banks in Hong Kong, which together accounted for 71% of total domestic loans at end-2013.