High interest rates cause rising risks for banks with large retail lending

High interest rates cause rising risks for banks with large retail lending

Banks have faced a tighter and more volatile operating environment, as elevated interest rates - driven by system-wide liquidity constraints and external pressures - weaken asset quality and profitability.

Mid-sized banks experienced the sharpest credit deterioration, with rising retail delinquencies and declining return on average assets. — VNA/VNS Photo

Persistently high interest rates and rising household debt are increasing risks for banks, particularly those with greater exposure to retail lending and weaker buffers against asset-quality stress, analysts have warned.

A new report by Vis Rating, an affiliate of Moody’s, said banks are operating in a tighter and more volatile environment as elevated interest rates, driven by system-wide liquidity constraints and external pressures, continue to weaken asset quality and profitability.

Mid-sized banks recorded the sharpest deterioration in credit quality, with rising retail delinquencies and declining return on average assets (ROAA) amid narrowing net interest margins (NIM) and higher credit costs.

By contrast, large and State-owned banks maintained broadly stable asset quality and earnings, supported by more diversified loan books, stronger customer franchises and resilient fee income.

The report said pressure on asset quality linked to retail lending is building at smaller banks as high interest rates and household debt continue to weigh on borrowers.

The sector’s problem loan ratio rose by 11 basis points quarter-on-quarter to 2.2 per cent in the first quarter of 2026, reflecting higher non-performing loan (NPL) formation.

“We expect NPL formation rate to increase in 2026, particularly among smaller banks with higher retail exposure, as elevated interest rates and rising household leverage continue to pressure repayment capacity,” the report states.

Profitability is also coming under strain as intensified competition for deposits pushes up funding costs, with small and mid-sized banks hit hardest.

Sector ROAA fell by 10 basis points quarter-on-quarter to 1.4 per cent in the first quarter, while NIM narrowed by an average of 11 basis points due to higher funding costs. The pressure was most severe among mid-sized and small banks with weaker deposit franchises.

Mid-sized banks also faced higher credit costs, softer fee income and the absence of one-off gains that had previously supported earnings.

Larger banks, however, maintained broadly stable profitability, supported by stronger NIMs, improved bancassurance income, lower credit costs and tighter cost controls.

"We expect continued NIM compression and rising credit costs to weigh on core profitability at small and mid-sized banks through 2026, given sustained funding competition and asset quality pressures," the report said.

The report added that ongoing capital raising efforts are strengthening banks’ ability to absorb losses, although capital trends are likely to diverge across different banking tiers.

Planned capital raising in 2026 is expected to strengthen buffers at smaller banks and support balance-sheet expansion at growth-oriented large banks.

In contrast, mid-sized banks could see capital ratios weaken because of lower internal capital generation and cash dividend payouts.

Funding conditions are expected to remain tight in the near term, with system deposit growth at just 0.6 per cent and nearly half of banks reporting deposit contractions across both large and smaller institutions.

The report said this reflected broad-based competition for deposits and greater reliance on short-term market funding.

While tighter liquidity regulations are structurally positive for credit quality, the report warned they are likely to intensify deposit competition, keep funding costs elevated and weigh on profitability in the near term, particularly for banks that depend more heavily on market funding. 

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