Hong Kong banks face another testing year, with few lending opportunities, margins that will remain under pressure and a sluggish recovery in the economy. As the old year fades into the distance, the effects of this year's tough operating environment are already on display, with mortgage lenders trying to sell their portfolios and small banks in search of buyers. The Hong Kong-arm of the world's largest bank - Citigroup - has said it is thinking of quitting the local home-loan market, which analysts see as becoming increasingly less profitable due to the razor-thin margins banks are earning. International Bank of Asia's major shareholders, meanwhile, said they wanted to quit their investment in the local banking industry. While the bank insists its shareholders' decision to sell was to re-allocate assets to other - hopefully more profitable - areas, market watchers generally agree that their sale is driven by a lacklustre future in the SAR's banking market. According to a report by accounting firm Deloitte Touche Tohmatsu, not only did the amount of bad and doubtful debts recorded for 2001 rise 24 per cent over a selection of 23 banks, but bad debts continued to rise well into 2002. During the first half of 2002, the Deloitte report showed, bad and doubtful debts for a selection of 15 banks surveyed rose 34 per cent to HK$4.8 billion from HK$3.6 billion for the first half of 2001. Profit margins on home loans - which typically make up a third of all bank lendings - continue to be squeezed as the two-year war for mortgage dollars wages on. According to the Hong Kong Monetary Authority, lending margins have only very recently seen a slight sign of relief. For October, 41.3 per cent of new home loans approved were made at 2.5 per cent below the prime lending rate, compared with 43.2 per cent the month before. However, the amount of loans made at prime minus 2 per cent or more remains steady at 89.6 per cent. The margin crunch has especially hurt the SAR's smaller lenders, who lack large reserves of customer deposits and have to raise funds for mortgage loans on the money market. The Hong Kong interbank offering rate (Hibor) as the year-end approached stood at just over 1.5 per cent. This means those charging the typical 2.5 to 3 per cent interest rates on home loans - since the present prime lending rate is at 5 per cent - only earn a thin gross margin of 0.9 to 1.4 per cent. Consumer credit cards, which some banks have relied on as a source of profit last year, have also been hit hard by high unemployment and soaring personal bankruptcies. The Hong Kong Monetary Authority said last month that charge-off ratios hit 14.5 per cent in the third quarter, compared to 13.6 per cent for the quarter ended June last year. Analysts expect Hong Kong banks to face a tough environment this year. 'We are extremely negative on the banking sector in Hong Kong,' says HSBC Securities analyst Anna Borzi, citing crunches in revenues and net interest margin crunch, as well as rising non-performing loans. While credit-card charge-offs should level off, she expects non-performing loans to come under pressure in the new year. Phillip Securities research director Louis Wong is also not optimistic on Hong Kong's banking environment in the near future. 'I am not too upbeat about the earnings outlook of the banking sector, especially for the first half. I think they will still be plagued by negative factors such as rising unemployment and personal bankruptcies,' he says. 'Loan demand [for mortgages] won't see a strong recovery, and because of competition, banks may need to continue to offer attractive interest rates to borrowers ... I think it may not heat up further but I don't see much improvement in the short term. I don't think banks will see a great possibility in enhancing their [interest] profit margins. Banks will still need to rely on other income - for example, fee income from brokerages, and insurance commission - to offset the lowering interest margins.' Perhaps hinting that more of the SAR's smaller banks will go the way of IBA's recent announcement, a Standard & Poor's report says the drive to achieve economies of scale will become more important and may trigger mergers. 'Given these changes and increasingly demanding operating conditions, banks with small market positions and limited revenue diversity may be forced to consolidate in the medium term.' However, Bank of China International analyst Anthony Lok says this year ought to prove a slightly less harsh environment for SAR banks, if only because things can hardly become any worse. He expects credit card charge-offs to fall because people are only going to be able to go bankrupt once.