Asian banks: Opportunities and challenges for the decade ahead

In the wake of broad global regulatory initiatives including Basel III, the roll-out of Dodd-Frank, the European Market Infrastructure Regulation ("EMIR") and other regulatory guidelines, a variety of issues are currently impacting the Asia-Pacific ("APAC") financial services sector.

Specifically, domestic financial institutions in the region have a unique opportunity to fill the void being left by large, international banks most seriously impacted by many of the aforementioned global regulatory efforts. Many of these universal banks have been compelled to begin the process of assessing the profitability across their business lines and, in many cases, have already retrenched from more capital-intensive businesses.

That said, while a number of Asian banks largely meet Basel III capital guidelines, the risk-weightings on certain bank activities still pose a challenge for local financial institutions that also face the tough task of supporting the continued, rapid economic expansion throughout the region.

Together, broad macroeconomic developments have reinforced the effects of global regulatory trends. First, the exceptional level of worldwide economic stimulus has created an environment of generationally low volatility and interest rates.

Second, numerous global regulatory efforts aimed at improving the soundness of the banking system has led to sharp reductions in balance sheet risk, trading book inventories and market-making among the largest universal banks.

Additionally, bank profitability has been affected by many of these new rules, which have constrained the means by which banks have typically enhanced revenues through reductions in proprietary trading, and the imposition of higher capital requirements.

As an example, many European banks have reduced their exposure to and presence in the APAC region to focus on their core domestic markets.

These changes have led to a reduction in capital markets activity, trade and infrastructure lending, while in APAC regional banks, Chinese financial institutions and some Japanese and Australian banks have stepped into the breach.

As a result, Asian banks have increased focus on active liquidity management through the optimisation of balance sheet, financing and investment collateral.

The challenges faced by financial institutions have been increased by the introduction of Dodd-Frank and EMIR over-the-counter ("OTC") derivative guidelines, which require in the U.S., Europe and parts of Asia that the bulk of OTC products be centrally cleared and traded on electronic exchange-like platforms.

Regulated banks are likely to take on more traditional activities in less risky assets and businesses, committing less balance sheet capital and acting more on an agency basis (versus taking a principal role in the transaction). Unlike their U.S. and European universal bank counterparts, Asian banks are primarily retail deposit-based and more focused on the traditional bank businesses of consumer lending to households and companies.

While Asian banks have already stepped up in areas where others have retrenched, a key challenge for local financial institutions is the implementation of Basel III requirements, specifically those which focus on the conservative risk-weightings which impact bank loan activities in Asia, such as trade finance, small and medium-enterprise (SME) lending and infrastructure finance.

The more stringent Basel III capital and net stable funding ratio (NSFR) requirements for highly liquid assets could trigger unintended consequences that penalise bank lending in these areas. These loans remain the key credit and economic growth drivers for most Asian nations (particularly in emerging Asia); all are critical to the overall economic development and growth of the APAC region.

Asian regulators will clearly need to strike an appropriate balance between reduction of risk and the availability of credit finance to meet the long-term funding needs of the region.

In spite of concerns about U.S. monetary policy tightening and some slowdown in China for the balance of the year, the IMF's recent "World Economic Outlook," found that GDP growth in the APAC region is still forecast to reach 5.5% in 2014, accelerating slightly to 5.6% in 2015 (driven primarily by emerging Asia).

In fact, Asia’s emerging markets are expected to increase from 30% of world GDP (measured at purchasing power parity) to 41% in 2023. Major concerns are, of course, a sharper-than-anticipated downturn in China's real estate sector and less-effective-than-envisioned 'Abenomics' in Japan, which could also adversely affect regional growth prospects.

Broadly, however, as Asia continues to outperform the world in economic growth, the strength of the local banking sector and its ability to adapt to economic conditions should foreshadow the strength for the broader APAC financial community in the decades to come.