Hong Kong banks' exposure to China in focus as BEA kicks off earnings season

* BEA H1 net profit hits record HK$3.58 bln vs HK$3.38 bln yr ago

* BEA says asset quality to remain under pressure in H2

* HK banks have increased their mainland exposure in recent yrs (Adds details from press briefing)

By Saikat Chatterjee

HONG KONG, Aug 1 (Reuters) - The first of Hong Kong's banks kicked off earnings on Friday with the biggest family-run lender posting a record interim profit after giving more loans to mainland borrowers, renewing investor focus on credit lines to China and the risks they pose.

Bank of East Asia, which reported a 6 percent increase in first-half net profit to HK$3.58 billion ($462 million), said it would take steps to mitigate credit risks in China where it expected asset quality to remain under pressure in the second half of the year.

The growing exposure of Hong Kong banks to the mainland in recent years has grabbed headlines about their ability to scrutinise credit risks against the backdrop of a slowing Chinese economy. Rating agencies and supranational bodies such as the International Monetary Fund have openly voiced concern.

Long praised by investors for their sound risk management, Hong Kong's mid-sized banks are increasingly becoming more exposed to any blowup in default risk as they hunt for new opportunities in the mainland amid sluggish growth at home.

"Hong Kong banks' exposure to China has been rising for a while, and we would be cautious of any sharp rise in exposure because they may not have the requisite expertise to analyse the underlying credit risks on the ground," said Frank Tian, portfolio manager and part of a team that manages $25 billion in equities at Aberdeen Asset Management (Other OTC: ABDNF - news) .

Data from the Hong Kong Monetary Authority (HKMA), the city's de-facto central bank, shows a sharp rise in cross-border business. By the end of 2013, the exposure of Hong Kong banks to corporate borrowers constitutes a fifth of their total assets compared with around 5 percent in 2007.

While the HKMA has repeatedly said a significant share of the non-bank mainland exposure is backed by guarantees and is symbolic of a strong financial centre, the fact remains the ability of a Dah Sing Bank or a Wing Hang Bank (HKSE: 0302-OL.HK - news) to absorb big losses is far less than their foreign counterparts such as Standard Chartered (HKSE: 2888.HK - news) or HSBC .

For example, Bank of East Asia, a medium-sized city lender, would require only roughly 15 percent of its net loan book going sour to wipe out its entire equity base, according to its 2013 annual earnings.

CHINA EXPOSURE

Bank of East Asia said loans to customers in mainland China edged up 9.5 percent to HK$207 billion at the end of June from end-December. Those loans comprised roughly half of its total loan book.

Bad debts as a percentage of total loans rose to 0.44 percent in the first half from 0.39 percent at the end of 2013.

"A tipping point may be reached if the yuan depreciates very sharply or if loan books are expanded aggressively," said Aberdeen's Tian.

Under an extreme scenario presented by the IMF in May, if the default rate in the mainland banking system's interbank obligations hits 80 percent, the losses would wipe out all the capital in the city's banking system. System-wide, non-performing loans as a percentage of their total loan book remains below 1 percent so far.

Bank of East Asia said at an earnings briefing on Friday it expects to see more stress in China's property sector due to maturing products from trust companies, which pool money from rich people and companies to make high-interest loans and are part of the China's vast and opaque shadow banking system.

Shares (Frankfurt: DI6.F - news) of the bank closed 0.6 percent lower on Friday, in line with a 0.9 percent drop for the benchmark Hang Seng Index .

UNDER PRESSURE

To be sure, the city's lenders are among the best capitalised in the world with average capital adequacy ratios of more than 15 percent and system wide NPLs at 0.04 percent.

Even in its China business, much of the credit risk in the mainland is towards state-owned enterprises and to finance non-mainland companies' operations within China. Trade finance thanks to the growing internationalisation of the yuan has also grown.

"This means high default rates are unlikely," said William Fong, investment director of Asian equities at Barings Asset Management in Hong Kong which manages $2.8 billion of assets.

Notwithstanding their growing China exposure, Hong Kong banks command some of the highest price-to-book ratios within the region due to their sound risk management techniques which saw them escape the 2008 financial crisis unscathed.

That said, investors are wary that banks which have expanded their footprint aggressively in China - whether for trade finance or corporate lending - may be most at risk at a time when other foreign banks have pulled back.

While this is an opportunity for the banks and their corporate customers, it also entails risks, with future credit performance likely to be different from past experience, Moody's strategists wrote in a March report. ($1 = 7.7498 Hong Kong Dollars) (Reporting by Saikat Chatterjee; Editing by Anne Marie Roantree and Ryan Woo)