The Vietnamese banking system could face a capital shortfall of almost US$20 billion (9% of GDP) to meet Basel II implementation, scheduled for January 1, 2020, and to increase allowance coverage to a level that reflects underlying asset-quality problems, says Fitch Ratings.

Banks are likely to step up capital issuance over the next 18 months, which could improve the credit profiles of rated banks if it results in a meaningful and sustained increase in capitalisation. However, a lack of depth in domestic capital markets may create challenges, particularly as some banks are close to or at the limit for foreign ownership.

Basel II implementation is likely to require Fitch-rated banks to raise USD4.1 billion in capital, assuming they target a minimum 8% Tier-1 capital ratio and continue to rapidly grow their balance sheets. This estimate is based on our assessment that Basel II will increase average risk-weighted assets by 42%, taking into account the impact of higher standardised credit risk weights and capital charges for operational and market risks. The total capital shortfall of Fitch-rated banks could increase to US$6.5 billion if they were to also raise their allowance coverage to 5.0% of gross loans and Vietnam Asset Management Company (VAMC) special bonds, from 2.3% at end-2017. This would be more commensurate with a normalised through-the-cycle problem-loan ratio and address the system-wide under-reporting of non-performing loans.

The capital needs of the whole banking system could be as much as three times larger than that of Fitch-rated banks, which accounted for 40% of total system assets at end-2017 and were better capitalised than the rest of the system. State-owned banks are likely to require the majority of this capital, in light of their lower capital bases and weaker profitability compared with private banks.

The large size of the Vietnamese banking system relative to its still-developing capital market limits banks' ability to raise capital domestically. Total system assets were more than 200% of GDP at end-2017, while the total market capitalisation of the Ho Chi Minh Stock Exchange index was about 45% of GDP.

Free-float adjusted market capitalisation was considerably lower, at 15% of GDP. This leaves banks reliant on foreign investors as a source of Tier-1 capital, making the 30% ceiling on foreign ownership a challenge, especially for banks near or at the limit - most notably, Vietinbank and ACB.

The ability to issue share dividends will reduce the capital burden for some, though not significantly. Banks may issue Tier-2 capital in the form of subordinated debt as a short-term measure to meet regulatory minimum capital requirements. However, the amount of subordinated debt recognised as Tier-2 is capped at 50% of Tier-1 capital.

Large Vietnamese banks raised around US$1.7 billion in equity capital in 2015-2017, largely through share dividends and issuances. Banks plan to raise a further USD2.0 billion in 2018, largely driven by capital raising efforts of private banks, such as Techcombank and VPBank, most of which is still to be completed.

Fitch Ratings noted that the agency has captured the banking system's long-standing structural weaknesses of thin capital buffers, under-reporting of non-performing loans and weak profitability in our assessment of Vietnam banks' Viability Ratings, which are some of the lowest in the Asia-Pacific markets that we cover.