Cynthia Cohen Freue and Geeta Chugh of Standard & Poor's -

Asset quality deterioration, shortage of capital and slowing credit growth could undermine the BRICMT (Brazil, Russia, India, China, Mexico, and Turkey) banks' credit quality, especially amid economic slowdown following years of strong credit growth. In addition, we remain concerned about the rising household debt burden, given still low - although increasing - GDP per capita and cyclicality of these major emerging market economies.

Furthermore, the following country-specific factors are pressuring the banks' asset quality: increasing economic imbalances in Brazil due to a recently accelerating credit expansion by government-owned banks; rapid increase of high-risk unsecured lending in Russia; a highly leveraged corporate sector in India; lackluster export growth, debt-laden local governments, and many manufacturers suffering from oversupply in China; large homebuilders' woes and deteriorating consumer lending in Mexico; and rapid credit card debt and consumer lending in Turkey.

Despite our expectation of a slowing credit growth in BRICMT countries, the pace will still likely be higher than the global one for the next two years. We expect BRICMT banks' loan portfolios to grow on average 15%. As a result of this high growth and the expected implementation of new Basel III rules, BRICMT banks will require additional capital to support that growth. In particular, Russian, Brazilian, Indian, and Chinese banks, which currently have on average only moderate capitalization (based on our risk-adjusted capital measure). Mexican and Turkish banks are better positioned in this respect.

The expectation of the U.S. Federal Reserve's reversal of its loose monetary policy has hit most emerging markets, pushing financing costs higher and currencies lower, and reducing the pace of global and regional market issuance. In our view, the resulting global capital outflow will have varying effects on banks in the BRICMT nations. For instance, Turkish banks will be the most vulnerable, while some of the other banking sectors will be more resilient.

Still, our outlook on the large rated banks in Russia, China, and Turkey is stable, reflecting our expectation that these countries' banking sectors will experience only a moderate deterioration in asset quality and earnings amid slower economic growth. Our outlook on the major rated Indian and Brazilian banks is negative, which reflects the negative outlook on these two sovereigns. Conversely, our outlook on the largest rated Mexican banks is positive due to the positive outlook on the sovereign and our view that the banks' stand-alone credit profiles (SACP) are stronger than the current ratings on these entities.

Slowing Economies And Growing Household Debt Burden Take A Toll On Asset Quality

The BRICMT household debt burden to GDP rose faster than the GDP per capita, except for India, where consumer lending in India has been growing at a slower pace, as banks have been cautious due to prior large credit losses among unsecured consumer loans and as high real estate prices have led to a slower rise in residential mortgages volume.

Given the cyclical nature of these economies and their still low GDP per capita, we expect this trend to pressure the banks' asset quality performance.

Russia's GDP per capita has grown by 66% since 2009, China by 60%, and the rest of countries in the peer group experienced a growth in the 24%-34% range. GDP growth has led to higher employment and purchasing power and has allowed a greater share of population to access banking products, spurring lending activity. Although household debt to GDP among the BRICMT countries has grown sharply, it remains significantly below that of more advanced economies. China has the highest ratio out of the six countries (30.7%), Brazil the second (25.3%), and Turkey the third (20.5%). However, the BRICMT's GDP per capita is far below that of developed economies, limiting household debt burden capacity.

Economic imbalances in Brazil have increased due to a recently accelerating credit expansion as the government-owned banks boosted lending amid a slowly growing economy. Further lending would increase an already hefty debt burden on households, subjecting the financial system to incremental credit risk. Our base-case scenario assumes that state-owned banks will continue growing at double-digit rates during 2013 - 2014 but at a lower peace than in 2012.

The cyclical economy and poor credit quality of many private-sector borrowers in Russia expose banks to much higher losses during recessions than in developed economies. In addition, real disposable income growth in Russia lags behind credit growth. Moreover, strong lending growth in the past few years stemmed largely from the rapid increase of high-risk unsecured lending through consumer and cash loans and credit card debt, which together represented 64% of total retail loans at the end of 2012. Still, we expect credit losses for the next 12-24 months to remain well below the peak of 2009.

India's sluggish economy growth, rising interest rates, and the volatile currency are hurting the country's highly leveraged corporate sector. We expect continued weakness in infrastructure-related loans, metals and mining, and construction-related sectors. Consumer loans, on the other hand, have low nonperforming loan (NPLs) levels, reflecting low (and declining) household debt, steady unemployment rates, and rising wages, although amid high inflation. We expect the banking sector's NPL ratio to surge to 4.4% of total loans by March 31, 2015, from with 3.4% as of March 31, 2013, due to increased defaults among corporates, particularly small to midsize enterprises. In our view, stressed loans in India exceed 10%, as the reported NPLs exclude restructured loans.

We believe the Chinese banks' satisfactory asset quality ratios don't fully reveal vulnerability of their asset portfolio to a severe economic downturn. In our view, Chinese banks are significantly exposed to lackluster export growth, debt-laden local governments, and many manufacturers suffering from oversupply. However, in our view, a still robust economy, supportive credit conditions, and continued regulatory forbearance to local government financing platforms (LGFPs) will prevent a surge in NPLs.

We expect a slight deterioration in asset quality among Mexican banks as a result of large homebuilders' woes, increased growth and loan loss provisions in consumer lending activity, and the GDP growth slowing to 1.5%. We believe that strong growth in consumer lending could spike NPLs if the economic fundamentals or credit market conditions weaken. Nonetheless, we expect NPLs to remain at manageable levels and reserved at more than 100%.

We believe rapid loan growth in Turkey in recent years, notably in retail loans, pressures its economic imbalances.

Loans grew by 34% in 2010 and 30% in 2011 thanks to a surge in credit card debt and consumer lending amid strong domestic demand. The most recent system-wide data suggests a year-on-year lending growth of more than 20% for 2013. Inflation is still in high-single digit area, but the retail segment's credit growth is above those in many of Turkey's peers even on a real basis. Yet, if Turkey experiences another slowdown owing to a domestic or external shock, we believe that the extent of asset quality deterioration and banks' credit losses could be significantly above what they were in 2009.

Banks Need More Capital To Fund Still Strong Lending Growth And Basel III Rules

Banks in the BRICMT countries will require large amounts of capital to support the double-digit lending growth and comply in certain cases with the upcoming implementation of new Basel III rules.

According to our risk-adjusted capital (RAC) measure, the Russian, Brazilian, Indian, and Chinese banks' capital adequacy ratios have continued to drop, as lending growth has outpaced their earnings generation capacities. These banks' current RAC ratios are on average in the moderate range, according to our bank criteria (see "Banks: Rating Methodology And Assumptions," Nov. 9, 2011), we consider capital to be moderating when it ranges between 5% to changes to its Basel III implementation guidelines and schedule and will begin the rollout in October 2013. In our view, these new guidelines clarified the capitalization requirements and potential adjustments (deferred tax assets, subordinated and hybrid instruments, etc.). In addition, the changes allowed banks the flexibility to maintain their credit growth pace and to gradually comply with the new rules. Nevertheless, we view the rescheduling as somewhat negative, because we believe banks would benefit from more and higher-quality capital amid the rapid credit expansion in Brazil since 2006. In addition, in our view, the new schedule delays the prudential nature of the Basel III rules (creation of countercyclical and conservation capital buffers). Along with the changes to Basel III implementation, authorities also decided to make some changes to their credit risk capital charges for specific business lines (see "What Does The Rollout of Basel III's Capital Rules Hold For Latin American Banks?," Sept. 18, 2013).

The recently announced delay in implementing the tougher capital requirements for the Basel III rules mitigated immediate pressure on the Russian banking sector. We understand that Russia's central bank intends to start transitioning Russian banking sector in 2014 to meet the Basel III capital requirements. We note, however, that the implementation will be gradual, might be further delayed, or might take longer than currently envisaged the two-three year period. We expect that tighter capital requirements will encourage banks to secure additional capital to cope with their growth plans. Limited Tier 1 capital could force banks to resort to alternative sources of capital such as hybrid capital instruments; although we think that only the largest market players will be able to raise capital through hybrid capital sources. We expect long-term consequences of Basel III implementation in Russia to be credit positive, supporting more cautious credit growth strategies and more conservative capital policy. However, we expect the regulatory transition period to be challenging both for banks and for the banking regulator in Russia.

Indian banks began implementing the new Basel III capital requirements on April 1, 2013. The regulatory requirements in India are more stringent than the Basel Committee on Banking Supervision (BCBS) guidelines. Large Indian banks hold sufficient capital with reference to regulatory requirement, though in our opinion, adjusted for risk, this capital is moderate. We estimate Indian banks would require minimum additional capital of about INR691 billion for the next five years for growth and Basel III. This amount could rise to INR2.6 trillion, given the domestic banks' tendency to hold higher-than-minimum capital and the limited market for hybrid instruments in India. Top-tier Indian banks might manage the capital shortfall without cutting exposure to riskier assets. The capital requirement is higher for government-owned banks, which poses a challenge for a government that is already grappling with fiscal deficit. We believe top-tier Indian banks are well-placed to achieve Basel III targets, while potential difficulties among some smaller banks could lead to consolidation in the sector.

Major banks in China hold sufficient core capital, and the common equity tier 1 (CET1) ratios of all rated banks are between 9% and 10%, exceeding the regulatory requirement for 2019. In our view, major Chinese banks face two key issues in meeting future requirements: They need to maintain capital in line with high asset growth, and globally systemically important banks (G-SIBs) in China need to prepare for possible additional capital requirements. According to the BCBS, the Bank of China is one of G-SIBS, so it's required to hold a 1% additional capital requirement. BCBS intends to review the scope of G-SIBs and additional capital charges annually, so it may impose an additional capital charge of 1.0%-2.5% on other Chinese banks. Future capital ratios depend on growth of risk assets, future earnings, and credit costs. We estimate that major Chinese banks will need $84 billion to attain a 9.5% CET1 ratio in 2019, based on our assumptions that risk assets will grow by 15% annually, and their return on assets (ROA) will decline by one-third from current levels.

In January 2013, Mexico completed the implementation of the Basel III capital requirement. Comisión Nacional Bancaria y de Valores' March 2012 impact assessment resulted in an increase in the average Basel regulatory ratio to 15.72% from 15.45% for Mexican banks. The funding, liquidity, and leverage ratios assessment will be implemented up to 2018.

Turkey's regulatory preparations for the implementation of Basel III gained momentum in 2013. The regulator has requested opinion of the banks for its draft proposals, and it aims to finalize its rules in coming months. In July 2013, the regulator stated that bank will begin implementing the new rules on Jan. 1, 2014.

Outlooks On The Largest Rated Banks Mainly Reflect The Outlooks On The Sovereigns

Our outlook on the major rated Brazilian and Indian banks is negative, reflecting the negative outlook on the sovereigns. The three Brazilian banks included in this article have an SACP above the sovereign rating, reflecting their very strong business positions; however, their ratings are constrained by the sovereign ratings as we don't expect these banks to withstand a sovereign-related stress. The SACPs on a few large Indian banks are also above the sovereign ratings, though their ratings are also constrained by the sovereign rating for the same reason. If we lower the sovereign ratings, we could downgrade the banks.

Our outlook on the large rated banks in Russia, China, and Turkey is stable, reflecting our expectation that these countries' banking sectors will experience only a moderate deterioration in asset quality and earnings amid slower economic growth. Our expectations already factor in some level of volatility that is inherent to these emerging markets.

Our outlook on the largest rated Mexican banks is positive due to the positive outlook on the sovereign and our view that the banks' SACP are stronger than the current ratings on these entities. The SACPs are above the sovereign, mainly reflecting strengths of their business and capital positions.

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