Sustained-but-subdued profits may drive banks to take on more risk to boost earnings.

Most APAC banking markets’ asset quality is sighted to further deteriorate in 2021, putting pressure on their profitability, reports Fitch Ratings.

In a media note, the credit agency said that they would likely reduce rating downgrade risks in their APAC-rated banks thanks to the expected economic recovery of many markets in the region. Recoveries are expected to stabilize in the second half of 2021. These, in turn, should improve banks’ profits.

Amongst developed markets, capital levels are most adequate in Australia, New Zealand, Hong Kong and South Korea. Singapore’s major banks have the least headroom. In emerging markets, challenges to maintaining capital levels comfortably above minimum regulatory requirements are greater in India, China, Vietnam, Sri Lanka and Mongolia

Despite the expected economic recoveries, APAC markets will still see elevated unemployment levels compared to those during pre-coronavirus, which will weigh on household delinquencies and credit costs. Risks will reportedly be greatest for borrowers in vulnerable sectors like tourism, retail or commercial property, as well as in SME borrowing.

Relief and forbearance measures implemented in response to the pandemic is also set to unwind by 2021—and unravel asset-quality deterioration across APAC in 2021. This trend may even extend into 2022 in some markets, notably India and Thailand.

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“This will manifest in loan reclassifications—including to impaired—and higher loan-loss provisions where banks have not pre-emptively provided for or written off these costs. Asset quality-related headwinds to profitability will be most apparent in the near term, with banking sectors in Thailand and India set to be among the more affected,” Fitch noted.

Fitch warned that asset quality or capital metrics will remain a problem in China, India, and Vietnam. Relief measures in these three markets have reduced transparency around asset quality, which was already opaque pre-pandemic in China, India and Vietnam.

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Furthermore, the region’s improving economic fundamentals may give banks confidence to boost lending, but it will not fully mitigate the structural challenges due to lower interest rates and acute competition.

Profits will be sustained but subdued, which may drive banks to take on more risk selectively in the longer term to boost earnings, the credit agency added. For example, banks may adapt looser underwriting standards, increase concentrations in higher-margin lending including unsecured loans, increase investments in higher-risk securities, and expand into faster-growing emerging markets.

On the other hand, many banks may also choose to adopt a more risk-averse approach in the near term if they remain uncertain about the economic outlook.

The rise of sustainability also threatens some markets’ business models, particularly Japan. Fitch has observed ongoing ESG-related adjusted across APAC banks that include greater investments in enhanced digital capabilities and the adoption of leaner and more flexible cost bases.

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The higher investment costs for these adjustments will add to near-term earnings headwinds for the larger banks, although they are better positioned than smaller rivals to weather the competitive threats over the longer term.