Credit Risk Management Of Commercial Real Estate Exposures
The Hong Kong Monetary Authority (HKMA) released today the classified loan ratio of the banking sector at the end of the 2nd quarter. The ratio was 1.97%, broadly similar to 1.98% at the end of March. As I have pointed out on various celebrations, the classified loan ratio continues to face upward pressure, mostly driven by commercial property (CRE) loans. Pressures in international CRE (including retail residential or commercial properties and workplaces) coming from the increase of e-commerce and remote operate in current years are also evident in Hong Kong. An increase in workplace conclusions has actually likewise resulted in continuing adjustments in the costs and leas of CRE in Hong Kong during the first half of 2025. Moreover, the high rates of interest environment over the past couple of years has actually worsened the debt-servicing concern of business residential or commercial property designers and investors, drawing market attention and raising questions on the ability of banks to successfully handle the pertinent risk exposures and financial stability threat. I want to clarify these questions here.
Standing together with enterprises
CRE rates and leas are currently under pressure from various factors, consisting of rate of interest and market supply and demand dynamics, which have actually led to a decrease in the value of loan security. Borrowers are naturally stressed regarding whether banks will demand instant payment. To resolve this, the HKMA and the banking sector have actually repeatedly emphasised that while the fall in regional residential or commercial property prices and leas over the last few years have actually resulted in a downward modification to the independent residential or commercial property appraisals, banks think about a host of aspects when reviewing credit limits, consisting of the borrower's credit need, general financial position and payment ability. Banks will not adjust a credit limit merely due to a change in the value of the residential or commercial property security.
There have likewise been misunderstandings that landlords may refuse to adjust leas in reaction to market conditions and even leave residential or commercial properties vacant out of concern over banks requiring loan payments. However, this does not align with banks' actual practices, and is likewise not sensible from a danger management angle. In truth, banks have previously made it clear that they would not demand instant repayment exclusively due to a decrease in rental income. This and flexible method demonstrates banks' determination to stand together with business, in addition to their position and dedication to ride out tough times with the community.
If a borrower in short-lived monetary problem breaches the regards to the loan covenant, will it cause the bank requiring immediate payment? The response is not necessarily so. In practice, banks will initially negotiate with the debtor, for example, by changing the repayment plan such as the loan tenor. Banks will take suitable credit actions just as a last resort to protect the soundness of their operations and the interest of depositors.
Protecting banking stability and depositor interests
The general public might thus question if banks' assistance for enterprises will come at the cost of banking stability and depositor interests. There is no requirement to fret as the HKMA has actually been carefully keeping track of the general healthy advancement of Hong Kong's banking sector. We believe that the credit threat related to CRE loans is manageable. A substantial part of Hong Kong banks' exposures relating to local residential or commercial property development and financial investment loans are to the large gamers with fairly good financial health. For exposures to little and medium-sized regional residential or commercial property developers and financiers, consisting of some with weaker financials or higher gearing, banks have actually currently taken credit risk reducing measures early on, and the majority of these loans are secured. Besides, there is no concentration risk at specific customer level.
A recent media report highlighted the dangers connected with CRE loans, with a particular concentrate on the accounting of banks' "anticipated credit losses". In fact, this is simply an estimation based upon modelling for accounting purposes. Loans classified as "anticipated credit losses" do not always represent bad financial obligations, and therefore can not be used as a basis for a comprehensive assessment of banks' asset quality.
Similarly, some other commentaries have focused solely on banks' classified loan ratios, which provides a somewhat limited perspective. Hong Kong has actually entered a credit downcycle recently, having been impacted by elements like macroeconomic change and interest rate level. This has naturally caused an increase in the classified loan ratio of the banking sector. While the classified loan ratio has gradually returned to the long-lasting average of around 2%, from 0.89% at the end of 2021, the ratio remains far below the 7.43% seen in 1999 after the Asian Financial Crisis.
To get a thorough understanding of credit quality, one can think about the following widely and long-used indications:
- The first basic sign is the capital adequacy ratio: The healthy development of the banking sector involves developing capital during the expansion stage of the credit cycle, such that when the credit cycle changes and we see credit expenses go up and a deterioration in possession quality, banks would have sufficient capital to soak up the credit expenses. Banks in Hong Kong have sufficient capital - the Total Capital Ratio for the banking sector stood at 24.2% at the end of March 2025, well above the worldwide minimum requirement of 8%.
- The second crucial indicator is the arrangement protection ratio: When assessing non-performing loans, the important question is whether the appropriate losses will impact a bank's core foundation. The arrangement coverage ratio is used to determine if the provisions for non-performing loans are enough. If a bank embraces prudent risk management and its provision coverage ratio remains above 100% after subtracting the value of collateral from the non-performing loans, it implies that the possible losses from non-performing loans have actually been sufficiently shown in the bank's arrangements. For the Hong Kong banking sector, arrangements are enough, with the arrangement protection ratio (after deducting the value of collateral) standing at about 145% at the end of March 2025.
- The 3rd sign is clearly financial strength: Despite the greater spotlight on non-performing loans, one important criterion when evaluating a bank's soundness is whether the bank can maintain great monetary strength and its revenue model can be sustained after deducting credit costs. In this regard, Hong Kong's banking system tape-recorded revenue growth in the last 3 consecutive years even after taking into consideration the expenses for anticipated credit losses. The general pre-tax operating earnings of retail banks increased by 8.4% year-on-year in 2024, and by 15.8% year-on-year in the first quarter of 2025, showing sound financial strength.
These three essential signs reveal that Hong Kong's banking system is well-capitalised and has adequate arrangements and excellent monetary strength to hold up against market volatilities. In the face of a still-challenging macroeconomic environment, the credit threats dealt with by the banking sector have actually increased over the last few years, yet the profit models of banks have actually not been impacted. I would also like to take this chance to clarify the earlier "bad bank" rumour. The facility of a "bad bank" is an extraordinary procedure which would just be thought about when banks have really major balance sheet problems. This is totally inconsistent with the existing circumstance of banks in Hong Kong, which are running in a sound manner with strong monetary strength.
Hong Kong's banking sector has securely sailed through the 1998 Asian Financial Crisis, the 2008 Great Financial Crisis, the couple of years following the Covid-19 pandemic along with the 2023 banking chaos in the US and Europe, demonstrating its strength and resilience. Although the worldwide economic outlook goes through numerous uncertainties and numerous markets have actually been badly impacted, the banking sector has actually stayed supportive to customers in difficulties and has actually been riding out challenges with them, one crisis after another. This is a testimony to both the ability and commitment of the banks to weather tough times with the community. The HKMA, together with the banking sector, will continue to do their utmost to support the development, upgrade and transformation of the genuine economy.