Hong Kong's banking system weighed down by steep borrowing costs, deteriorating loans

Non-interest income growth will be sluggish.

Hong Kong's banks will face deteriorating operating conditions over the next 12-18 months on back of higher borrowing costs and the steady increase in non-performing loans, according to a report by Moody's.

The report noted that banks will see a gradual rise in borrowing costs because the territory's currency is pegged to the USD. The impact of the higher costs will be magnified by current high private sector leverage.

As for asset quality and capital, Moody's stated that problem loans will increase from current low levels because the combined effects of a slower Hong Kong economy and likely higher interest rates will add pressure on loan delinquencies.

In terms of profitability, the banks will be pressured by lower interest income and higher credit costs. In addition, the banks will see lower non-interest income in 2016, driven mainly by lower brokerage fees, as domestic stock market activities retreat from their peak in mid-2015.

"We expect a more challenging operating environment for Hong Kong banks in the coming 12-18 months, because of the weak growth in global demand, and also because the banks' borrowing costs are higher, owing to further monetary tightening in the US," said Sherry Zhang, a Moody's Analyst.

"This situation will pressure the system's asset quality and profits, and test its resilience, given the territory's elevated property prices and the banks' growing linkages with Mainland China," Zhang added.