Credit Risk Management Of Commercial Real Estate Exposures
The Hong Kong Monetary Authority (HKMA) published today the classified loan ratio of the banking sector at the end of the second quarter. The ratio was 1.97%, broadly comparable to 1.98% at the end of March. As I have discussed on different celebrations, the classified loan ratio continues to deal with upward pressure, primarily driven by commercial property (CRE) loans. Pressures in global CRE (including retail residential or commercial properties and offices) originating from the increase of e-commerce and remote operate in recent years are also evident in Hong Kong. A boost in workplace conclusions has actually also caused continuing modifications in the costs and leas of CRE in Hong Kong throughout the first half of 2025. Moreover, the high rates of interest environment over the past few years has actually worsened the debt-servicing concern of commercial residential or commercial property designers and investors, drawing market attention and raising concerns on the capability of banks to efficiently manage the appropriate danger direct exposures and monetary stability danger. I hope to clarify these inquiries here.
Standing together with enterprises
CRE rates and leas are currently under pressure from various elements, consisting of rates of interest and market supply and demand characteristics, which have actually caused a decline in the worth of loan collateral. Borrowers are naturally worried regarding whether banks will demand immediate payment. To address this, the HKMA and the banking sector have actually repeatedly emphasised that while the fall in local residential or commercial property costs and leas in the last few years have actually led to a downward modification to the independent residential or commercial property valuations, banks consider a host of aspects when evaluating credit line, including the borrower's credit demand, overall financial position and repayment ability. Banks will not adjust a merely due to a change in the value of the residential or commercial property security.
There have actually also been misconceptions that landlords might refuse to adjust leas in action to market conditions or even leave residential or commercial properties vacant out of concern over banks demanding loan payments. However, this does not line up with banks' real practices, and is likewise not logical from a risk management angle. In reality, banks have actually earlier made it clear that they would not require instant payment exclusively due to a decline in rental earnings. This pragmatic and flexible approach shows banks' willingness to stand together with business, in addition to their position and dedication to ride out hard times with the community.
If a debtor in short-term financial difficulty breaches the regards to the loan covenant, will it lead to the bank requiring immediate payment? The answer is not always so. In practice, banks will first negotiate with the debtor, for instance, by changing the payment strategy such as the loan tenor. Banks will take appropriate credit actions just as a last option to protect the strength of their operations and the interest of depositors.
Protecting banking stability and depositor interests
The public may therefore wonder if banks' assistance for enterprises will come at the expense of banking stability and depositor interests. There is no requirement to fret as the HKMA has actually been closely keeping an eye on the total healthy advancement of Hong Kong's banking sector. Our company believe that the credit danger related to CRE loans is manageable. A significant portion of Hong Kong banks' direct exposures connecting to regional residential or commercial property advancement and financial investment loans are to the big players with relatively good financial health. For exposures to small and medium-sized regional residential or commercial property designers and investors, including some with weaker financials or higher tailoring, banks have currently taken credit risk reducing procedures early on, and many of these loans are protected. Besides, there is no concentration danger at individual customer level.
A recent media report highlighted the risks related to CRE loans, with a particular concentrate on the accounting of banks' "anticipated credit losses". In reality, this is simply a computation based on modelling for accounting purposes. Loans classified as "anticipated credit losses" do not always represent uncollectable bills, and therefore can not be utilized as a basis for a comprehensive assessment of banks' possession quality.
Similarly, some other commentaries have actually focused solely on banks' classified loan ratios, which provides a somewhat limited perspective. Hong Kong has actually gone into a credit downcycle over the last few years, having actually been affected by aspects like macroeconomic change and rates of interest level. This has actually naturally caused a boost in the classified loan ratio of the banking sector. While the classified loan ratio has slowly gone back to the long-lasting average of around 2%, from 0.89% at the end of 2021, the ratio remains far listed below the 7.43% seen in 1999 after the Asian Financial Crisis.
To acquire an extensive understanding of credit quality, one can think about the following extensively and long-used indications:
- The first basic sign is the capital adequacy ratio: The healthy development of the banking sector involves building up capital throughout the expansion phase of the credit cycle, such that when the credit cycle adjusts and we see credit costs go up and a wear and tear in asset quality, banks would have adequate 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 global minimum requirement of 8%. - The 2nd crucial sign is the provision coverage ratio: When assessing non-performing loans, the sixty-four-thousand-dollar question is whether the appropriate losses will affect a bank's core foundation. The provision coverage ratio is used to assess if the provisions for non-performing loans suffice. If a bank adopts prudent threat management and its provision coverage ratio stays 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 effectively reflected in the bank's arrangements. For the Hong Kong banking sector, provisions are enough, with the arrangement protection ratio (after deducting the worth of security) standing at about 145% at the end of March 2025. - The 3rd indicator is certainly monetary strength: Despite the greater public attention on non-performing loans, one essential criterion when evaluating a bank's stability is whether the bank can preserve good monetary strength and its revenue design can be sustained after subtracting credit expenses. In this regard, Hong Kong's banking system taped profit development in the last 3 consecutive years even after considering the expenditures for anticipated credit losses. The total 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 monetary strength.
These three key signs show that Hong Kong's banking system is well-capitalised and has adequate provisions and great monetary strength to stand up to market volatilities. In the face of a still-challenging macroeconomic environment, the credit risks dealt with by the banking sector have actually increased recently, yet the profit designs of banks have not been affected. I would also like to take this opportunity to clarify the earlier "bad bank" rumour. The establishment of a "bad bank" is an amazing step which would only be considered when banks have extremely serious balance sheet problems. This is totally inconsistent with the present situation of banks in Hong Kong, which are running in a sound way with strong monetary strength.
Hong Kong's banking sector has securely sailed through the 1998 Asian Financial Crisis, the 2008 Great Financial Crisis, the few years following the Covid-19 pandemic in addition to the 2023 banking turmoil in the US and Europe, demonstrating its strength and strength. Although the worldwide economic outlook goes through numerous uncertainties and many industries have been significantly impacted, the banking sector has remained supportive to consumers in troubles and has been riding out obstacles with them, one crisis after another. This is a testament to both the ability and commitment of the banks to weather tough times with the neighborhood. The HKMA, together with the banking sector, will continue to do their utmost to support the advancement, upgrade and transformation of the genuine economy.