Sector Review:

Taiwan Banks Face Another Year Of Tight Margins In 2014

Primary Credit Analyst: YuHan Lan, Taipei (8862) 8722-5810; yuhan.lan@taiwanratings.com.tw Secondary Contact: Andy Chang, CFA, FRM, Taipei (8862) 8722-5815; andy.chang@taiwanratings.com.tw

Table Of Contents
Banks' Honeymoon With Low Credit Costs Is Over Competition And Heightened USD Funding Costs Compress Loan Margins Further Revenue Diversification Will Only Be Modest In 2014 Industry Consolidation And Geographical Diversification Could Lift Margins Related Criteria And Research

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Sector Review:

Taiwan Banks Face Another Year Of Tight Margins In 2014

(Editor's Note: Taiwan Ratings Corp., a partner of Standard & Poor's Ratings Services, issues ratings accompanied by a "tw" prefix to denote Taiwan and the rating scale's focus on Taiwanese financial markets.) Taiwan banks are likely to experience continued headwind against their efforts to boost operating margins in 2014. Sustaining profitability may even prove difficult for banks with limited revenue diversity and rising credit costs. The favorable conditions supporting the sector's higher return on average assets (ROAA) over the past two years have ended, and banks' average profitability remains one of the lowest among developed markets in the Asia-Pacific. Taiwan Ratings Corp. believes the local banking sector is unlikely to improve its profitability over the next year, due to rising credit costs, pressured interest margins, and slow growth in fee revenue. Taiwan banks will find it challenging to break free from their operating constraints any time soon. The industry's structural weaknesses and low revenue diversity are likely to curb major improvement in profitability for at least two to three years. At the same time, we expect banks' efforts to expand geographically and the Taiwan government's strategy for industry consolidation will take time to materialize. Overview The recent rock bottom level of credit costs is unsustainable in 2014 and additional revenue diversification will be modest at best. The sector's net interest margin is unlikely to rebound in the next year. Industry consolidation and geographical diversification could help, but will take time.

Banks' Honeymoon With Low Credit Costs Is Over

We expect banks' credit cost to rise this year due to the still fragile global economy. Exceptionally low credit costs were arguably one of the main reasons supporting the sector's profitability over the past two years. We estimate that banks' credit costs (the ratio of provisions to average assets) in 2014 will be closer to the sector's long-term average credit losses of 40-60 base points (bps). This compares to below 20bps in 2012 and 2013 (see chart 1). In addition, we expect the sector's bad debt recovery to decline in 2014 compared to the high rates in 2012 and 2013, because banks have already recovered the bulk of bad loans from the credit downturn in 2005-2009. Moreover, increasingly stringent reserve requirements from Taiwan's Financial Supervisory Commission (FSC) will lead banks to set aside higher loan loss reserves and push up their credit provisions over the next one to two years.

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Sector Review: Taiwan Banks Face Another Year Of Tight Margins In 2014

Chart 1

In our view, the susceptibility of Taiwan's trade-oriented economy to global economic uncertainty will push up banks' domestic credit losses over the next 12 months. At the same time, we expect the asset quality of banks' overseas loan exposures to deteriorate, especially those related to China. After two years of expansion, banks' China-based portfolios are beginning to season. More importantly, Chinese corporations are feeling pressure from the nation's slowing economic growth, while at the same time they face escalating borrowing costs under the China government's policy to tighten market liquidity. However, we expect potential credit losses from China to be manageable because banks' exposure in China is still a relatively small single-digit portion of their overall loan book. In addition, Taiwan banks are unlikely to aggressively expand such exposure in 2014 because the island's regulator has set limits on China lending that many banks are now approaching.

Competition And Heightened USD Funding Costs Compress Loan Margins

Bank interest margins are likely to remain among the lowest for Asia-Pacific peer banks in 2014. We believe the sector will find it hard to improve interest spreads in the next one to two years because of long-standing and intense domestic competition as well as limited overseas diversification. This is despite our belief that the domestic interest rate will rise gradually over the same period, which could benefit banks' lending spread to a small degree.

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Sector Review: Taiwan Banks Face Another Year Of Tight Margins In 2014

The island's banks have increasingly turned to overseas sources to reduce the impact of strong domestic competition on operating margins. As a result, foreign loans have been the main growth driver over the past two years. Foreign currency loans grew 17%, while domestic loans grew just 3% in the period 2012 to 2013 (see chart 2). This has increased the net interest margin of some banks by a slight degree compared to the industry average, particularly among banks with foreign loan exposures exceeding 30% of their total lending book. However, the sector as a whole has seen limited improvement in core earning capacity over the past two years. This is because banks' average overseas exposure remains an insignificant portion of their total lending portfolio, while domestic loans still carry low margins. As of the end of 2013, overseas exposure contributed only 16% of the sector's total assets, compared to 30% for Hong Kong banks and over 40% for Singapore banks.
Chart 2

We also believe that rising USD funding costs could rein in banks' foreign currency lending appetite in 2014, as banks acknowledge the difficulty to raise their net interest margin over the same period. Tight liquidity and financial reform in Mainland China have boosted demand for foreign currency loans from Taiwanese corporates operating in China, and pushed up Taiwan banks' USD funding costs. Consequently, Taiwan's interbank USD lending rate has remained close to a recent two-year high since late 2013 (see chart 3). We expect many Taiwan banks to see their foreign currency loan spreads squeezed as interbank USD borrowing becomes more expensive. This will have a lesser effect

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Sector Review: Taiwan Banks Face Another Year Of Tight Margins In 2014

on banks with ample foreign currency funding or strong pricing power to transfer the higher funding costs to borrowers.
Chart 3

Further Revenue Diversification Will Only Be Modest In 2014

We expect banks' fee income growth to be no more than moderate over the next year. Many local banks had good growth in fee income from bancassurance business in 2013, which mainly came from the stop-sale effect of short-tenor endowment insurance. Conversely, banks' sales of deposit-like insurance have slowed down in the first quarter of 2014, under stringent limitations by Taiwan's regulator. Therefore, we expect fee income from bancassurance to remain flat or decline slightly in 2014. This is because banks must now focus on selling protection-type insurance policies, which will be relatively challenging under the prevailing low interest rate environment in Taiwan.

Industry Consolidation And Geographical Diversification Could Lift Margins

We believe the efforts of Taiwan's government to promote industry consolidation and geographical expansion will help to improve banks' profitability, but this could take three to five years at least. Since the start of 2014, the FSC has

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Sector Review: Taiwan Banks Face Another Year Of Tight Margins In 2014

become more proactive in initiating consolidation within the banking sector. However, we believe meaningful consolidation will require several years, because Taiwan's banking sector remains relatively fragmented with the largest three banks by assets representing less than 30% of system assets. Many Taiwan banks have also expanded into Southeast Asia in recent years in addition to their expansion strategy in China by pursuing acquisitions or establishing overseas branches. In time, improved geographical diversification will allow banks to operate in areas offering higher margins. However, we believe that operating in Southeast Asian countries exposes Taiwan's banks to higher economic and credit risks than operating simply on domestic turf. As a result, we believe overseas diversification in the medium and long term will only bear fruit for those banks with strong underwriting controls and deep local knowledge.

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

Related Research
Taiwan's Banking Sector Maintains A Stable Credit Outlook in 2014, Amid Steadying Economic Growth, Feb. 13, 2014 China Banking Outlook 2014: A Turbulent Flight Ahead, Feb. 12, 2014 Banking Industry Country Risk Assessment: Taiwan, Oct. 28, 2013 Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.

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