A combination of factors, including stable economic growth and structural improvements associated with preparing for the Basel II international capital framework, has left most Asian banks with stronger credit profiles, despite the challenges presented by rising interest rates and oil prices, according to ratings agency Standard & Poor's. Across the region, it says, the quality of bank assets has improved as strong profitability - and in the case of China, a helping hand from the central government - has allowed bad loans to be worked through or written off. And further progress on the credit front in the year ahead is to be expected, the agency added in its recently released Asia Pacific Banking Outlook 2006, albeit at a slower pace, since the easy 'first fruits' of banking reform have now been plucked. Bank management, meanwhile, now faces more intractable issues, including a widespread need to incorporate enterprise-wide risk management systems; to plug more or less seamlessly into Basel II; and to improve profitability through raising non-interest income. Progress on these fronts will deliver further positive results, but will take time to show up in balance sheets. Therefore, since present share prices and ratings fully discount the most likely course of credit events in the year ahead - there were 85 bank ratings' upgrades from S&P last year, up from just 38 in 2004, barring unexpected shocks to the system like an outbreak of bird flu, expect no developments on the credit front to dramatically alter valuations of stocks or bonds. Unsurprisingly, that message comes with a couple of caveats - one from analysts at Lehman, who agree that while not much more juice can be expected from S&P, Moody's could give paper issued by some lenders a boost by raising their credit ratings. In Hong Kong, a beneficiary of such a move, Lehman adds, could be Citic Ka Wah, although since Moody's has already announced that Citic it is under review for a possible upgrade, it is difficult to see a better credit rating having much impact when it comes. Pitfalls on this relatively safe, if not spectacular, road for banks in 2006, warns S&P, include uncertainty over interest rates and oil prices, bird flu, weakening United States consumer demand affecting Asian exports and bottlenecks in some parts of China's infrastructure, not to mention massive overcapacity in others, such as the mainland's vehicle industry. But for all that, expect last year's profit performances to be sustained this year, it says. Since the focus of the report is the outlook for credit ratings attached to bank paper, the key issue for bond holders is how well or badly banks have dealt with their non-performing loans. Well enough, says S&P (see charts 1 and 2), and the ratings agency's view is one that is endorsed by bank analysts. Yet more remains to be done. Inevitably the spotlight falls on China, where concerns remain that the clean-up of the banking system might include a fair share of mere window-dressing and that an explosive expansion in credit contains the seeds of another calamitous round of loan defaults. Present loan loss reserves reinforce the point that the mainland's banking system is in no shape to withstand a big new wave of bad loans (see Chart 3). Although its caution will come as no surprise, S&P emphasises that in Hong Kong, despite prospects of a trouble-free year ahead for the economy, small banks will have to continue wrestling with the consequences of being small fry in a mature and competitive marketplace. The stiff competition for business in such an over-banked market puts more pressure on small banks because of their reliance on relatively expensive time deposits. Another negative factor facing Hong Kong lenders, it adds, is their increasing exposure to the mainland. While cross-border links present new loan opportunities and mainland exposure is steadily accounting for an increasing portion of outstanding loans made by Hong Kong banks, this business comes with the associated risks of lending to China's corporate sector. Shareholders with Hong Kong bank stocks, in other words, might want to keep one eye on the lending environment in the local market, and the other on news from the mainland signalling any rise in corporate defaults.