Sector Review:

How Rising Private Sector Credit Could Weaken Taiwan Banks' Capitalization And Credit Profiles
Primary Credit Analyst: Eva Chou, Taipei (8862) 8722-5822; eva.chou@taiwanratings.com.tw Secondary Contact: Andy Chang, CFA, FRM, Taipei (8862) 8722-5815; andy.chang@taiwanratings.com.tw

Table Of Contents
Taiwan Has Relatively High Private Sector Indebtedness Compared To Asia-Pacific Peers Strong Growth In Private Sector Credit Could Worsen Taiwan's Economic Imbalance Taiwan Banks' Capitalization Is Quite Sensitive To Rising Economic Risk BASEL III's Capital Requirement Could Help Moderate Banks' Loan Growth Related Criteria And Research

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Sector Review:

How Rising Private Sector Credit Could Weaken Taiwan Banks' Capitalization And Credit Profiles
A gradual rise in the U.S. and global trade volume is likely to support faster growth in Taiwan's export-dependent economy over the next 12 months. Standard & Poor's Ratings Services believes the island's brighter economic prospects for the year ahead could fuel a rise in domestic credit levels, because GDP growth has historically been linked with an expansion in bank lending. This could place significant or prolonged stress on banks' capitalization, but we expect the banking sector's stringent controls to largely offset this risk. Capitalization and credit profiles are sensitive to banks' lending levels and could come under pressure from strong and prolonged growth in private sector loan demand if not properly managed. A continuously strong rise in bank lending may suggest the emergence of an economic bubble and raise Taiwan's economic risk, according to our Banking Industry Country Risk Assessment (BICRA) analysis. This higher economic risk could in turn undermine our assessment on the banking sector's capitalization, and ultimately on bank credit ratings. However, the more stringent capital requirements under the BASEL III accord are likely to prevent strong loan growth. Under our base-case scenario, we expect loan levels to grow 3%-5% in 2014, which shouldn't pose significant risk to bank capitalization levels or our ratings on domestic banks. Overview Taiwan has a relative high level of private sector indebtedness as a result of ample market liquidity and prevailing low interest rates. Strong private sector credit growth could increase the banking sector's economic risk and undermine bank capitalization and our overall assessment of the sector's creditworthiness. More stringent capital requirements under Basel III should moderate banks' loan growth appetite.

Taiwan Has Relatively High Private Sector Indebtedness Compared To Asia-Pacific Peers
We expect private sector borrowing to rise further in 2014, supported by ample market liquidity and low interest rates. We also believe Taiwan's strong household financial position and market liquidity somewhat offset the risks posed by the island's relatively high private-sector indebtedness compared to its Asia-Pacific neighbors (see table). Taiwan's private sector leverage (defined as private sector credit as a percentage of GDP) increased to 153.2% in 2012, up from 149.7% in 2011. This was mostly due to banks' active overseas expansion in the pursuit of higher margins than those available in the intensely competitive home market. Moreover, Taiwan, unlike most countries in Southeast Asia, has not faced a rising household debt problem in recent years. This is mostly because corporate loans accounted for the majority of Taiwan's private sector credit growth in recent years. Our overall assessment for 'credit risk in the

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Sector Review: How Rising Private Sector Credit Could Weaken Taiwan Banks' Capitalization And Credit Profiles

economy' is 'intermediate risk' for Taiwan.

Table 1

A Regional Comparison Of Private Sector Credit-To-GDP Ratios

--Year ended Dec. 31-(%) Taiwan China Malaysia Singapore Japan 2008 144.7 103.1 97.6 99.8 105.9 2009 145.0 124.3 112.3 101.3 107.3 2010 142.5 129.5 111.4 100.0 104.7 2011 149.7 127.1 113.0 112.6 105.2 2012 153.2 132.2 119.8 117.0 106.6

Source: Standard & Poors Ratings Services Financial Institutions Ratings

Strong Growth In Private Sector Credit Could Worsen Taiwan's Economic Imbalance
In our view, the risk of an economic bubble in Taiwan could rise if the level of private-sector credit is allowed to grow much faster than the pace of overall economic expansion. The annual change in the ratio of private sector credit to GDP provides a good indicator of economic imbalance. In Taiwan, the ratio grew 3.5 percentage points in 2012 and 7.3 percentage points in 2011, partly as a result of domestic banks' aggressive loan expansion, including in overseas market. We estimate that our economic risk score for Taiwan could deteriorate to "4" from the current score of "3" if bank lending continuously outpaces growth in GDP. However, our base-case scenario for Taiwan's economic expansion assumes the ratio will increase only moderately in the coming two years, and benefit from an improved GDP outlook in 2014, as well as more cautious loan growth by banks under the implementation of the BASEL III accord. We expect the rise in Taiwan's real estate prices to continue to moderate over the next two years, which could also affect our assessment on economic imbalance. Our prediction of moderating price rises for commercial and residential property reflects the Taiwan government's proactive tightening measures on the real estate market, as well as our expectation of a gradual rise in interest rates under the US Federal Reserve's scaling down of quantitative easing measures. However, we do not expect a sharp property price correction in the coming two years because we believe any interest rate rise would be moderate and gradual according to the Taiwan central bank's track record.

Taiwan Banks' Capitalization Is Quite Sensitive To Rising Economic Risk

A rise in Taiwan's economic risk could increase banks' balance sheet risk given their large lending exposures in the local market. An increase in economic risk could also weaken banks' capitalization adjusted for risk. The risk-adjusted capital ratio incorporates banks' available core capital and their risk exposures by different risk categories that are weighted by the economic risk of the different countries in which the banks operate. Under our BICRA analysis and Bank Capital Methodology And Assumptions criteria, an increase in Taiwan's economic risk score to "4" from "3" could also increase the risk weighting for the Taiwan corporate and retail banking sectors'

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Sector Review: How Rising Private Sector Credit Could Weaken Taiwan Banks' Capitalization And Credit Profiles

loan exposures. For example, the risk weighting for corporate loans under economic risk group "3" is 100%, but this would increase to 116% if the economic risk group deteriorated to "4". Similarly, the risk weighting on prime residential mortgages would increase to 37% from 30% under the same economic risk scenario. As a result, Taiwan banks' capitalization would weaken on a risk-adjusted basis even though the nominal amount of assets and capital do not change. For example, a bank in Taiwan would have an "adequate" 7% RAC ratio according to our capital assessment under an economic risk score of "3", but the same bank's RAC ratio could drop to a "moderate" level of below 6.5% under a weaker economic risk score of "4". As a consequence, we may lower our rating on the bank by one notch excluding consideration for any possible group support or government support.

BASEL III's Capital Requirement Could Help Moderate Banks' Loan Growth
We believe the implementation of the BASEL III accord will lower banks' pursuit of high-risk assets and moderate their loan growth because of the accord's more stringent capital requirements. Under BASEL III, banks will need to limit growth on their loan portfolio or boost their capital level over the next few years through capital injection or good profit retention, which may prove difficult for Taiwan banks with mediocre profitability amid strong domestic competition and relatively low revenue diversity.

Related Criteria And Research

Related Criteria
Banks: Rating Methodology And Assumptions, Nov. 9, 2011 Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011 Bank Capital Methodology And Assumptions, Dec. 6, 2010

Related Research
Banking Industry Country Risk Assessment: Taiwan, Oct. 28, 2013

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