OREANDA-NEWS. Taiwanese banks' offshore exposures are likely to continue growing as a percentage of assets over the medium term, facilitated by the easing of overseas investment limits in January. Regional expansion will enable faster growth and potential diversification benefits, while it could add to banks' risk profiles - especially if they are focused on emerging markets, says Fitch Ratings. Risk profiles will rise if profitability and stronger loss-absorption buffers are not commensurate with the higher credit risks and operational challenges that may come with heightened foreign exposure.

The passage of amendments to banking laws by Taiwan's legislature, as proposed by the Financial Supervisory Commission (FSC), has raised Taiwanese banks' overseas investments to 40% of net worth. The limit had previously been 40% of paid-in capital. This will make available around TWD400bn-500bn (USD13.3bn-16.7bn) in capital throughout the banking sector for offshore acquisitions.

Not unexpectedly, the regulatory changes indicate that the authorities are prepared to adopt a more accommodative position when it comes to offshore investment rather than stifle the banks' growth, since domestic prospects are more muted. However, the rule changes also point to efforts to diversify regional exposure and reduce concentration risk in China.

The larger banks are in a better position, and more likely to take advantage of the easing regulations and pursue overseas expansion. The additional investment capacity provided for by the change, will affect large banks' Fitch Core Capital (FCC) ratio by around 100bp-300bp - the FCC for large banks is currently around 9%-10%. As such, the rating impact from an overseas acquisition could be meaningful - depending on how the transaction is funded.

Taiwanese banks have already been targeting the regional market, especially China, in recent years to boost growth. Offshore lending, primarily in China, has grown rapidly as a result, at a compound annual growth rate (CAGR) of 21% from 2010 through to 1H14. While the growth has been rapid, it has come off a low base, and so has not had a significant credit impact as yet. By comparison, domestic lending grew at a CAGR of just 4%.

Fitch forecasts loans in Taiwanese banks' offshore units to rise to 19% of total loans by end-2016, from 15% at end-1H14. Chinese loans alone should account for 12% of total lending by end-2016, equivalent to 110% of our FCC estimate for Taiwan banks, while we forecast total China exposure (including loans, interbank exposures and securities investments) to be 15% of total assets, equivalent to 230% of FCC.

Acquisitions have also picked up, with Taiwanese banks buying up small and mid-sized lenders in China, Cambodia, the Philippines and Indonesia in 2014.

Taiwanese banks' ratings could come under pressure - especially if they are not adequately mitigated through higher risk buffers - if and when emerging market exposures become more meaningful, together with the accompanying transparency and governance weaknesses in these markets. The banking system is already highly competitive, with thin profit margins. Furthermore, the banks are generally less capitalised (or more leveraged) than other internationally active banks in the region. This limits their relative capability to withstand potential economic or other credit-quality shocks.

There will also be operational challenges from expanding into the region. Management at Taiwanese banks have limited experience with cross-border acquisitions or an established track record in sustaining a profitable offshore franchise. The banks' largest overseas subsidiaries, primarily in the US, the Philippines and Vietnam, have either posted losses or only modest profitability for the past five years. These subsidiaries have so far accounted for only a small proportion of total assets.