The banking sector remains well capitalised, highly liquid, and financially resilient with good asset quality. The recovery in the net interest margin during 2006 is likely to be important in underpinning future profitability, while high levels of liquidity and capital give banks a sound platform to continue to support economic growth. In addition, the benefits of the new Basel II capital adequacy regime should start to become apparent in 2007, particularly in the substantial up-grading of banks' risk management practices which the new framework involves.

Despite these many positives, there are, however, a number of risks that will require close monitoring. The ample liquidity conditions experienced in 2006 may not persist throughout 2007. While banks are sufficiently liquid to absorb the consequences of any large-scale outflow of funds, a change in the direction of capital flows will have implications for domestic interest rates and, consequently, for asset quality. Banks need to monitor their interest rate risks and to assess the impact of any sudden shift in domestic interest rates on their main borrowers and asset classes.

Ample liquidity has also encouraged intense competition in some markets, for example for residential mortgage loans. If current levels of liquidity persist, banks will need to remain vigilant that the resulting competition for lending does not drive margins below an adequate risk-adjusted return or that it does not lead to excessive relaxation of credit underwriting standards. If demand for IPO-related lending, which accounted for a substantial part of domestic loan growth in 2006, slackens in the year ahead, competition in other markets may become more intense.

Finally, banks are likely to continue to look for profit opportunities outside Hong Kong during 2007, including the Mainland. Such expansion partly reflects the commercial reality that Hong Kong is now a mature banking market and, as such, returns may be modest compared with those that can be made elsewhere. Nonetheless, cross-border expansion places a particularly high premium on banks’ ability to identify, manage and control the associated risks.