Other challenges are the potential slowdown in US consumption and bird flu, he said in a teleconference Wednesday to discuss prospects for Asian banks.

Against the backdrop of a largely firm regional economy, stable and increasingly diverse earnings and better risk controls, the outlook for Asian banks "remains stable with a positive bias going into 2006," said Chew, although he said improvements will be slower this year than in 2005.

"The low-hanging fruits in the non-performing asset pools have been picked and any further reduction in NPA would come from the resolution of the relatively intractable assets," said credit analyst Ritesh Maheshwari in a press release accompanying the rating firm’s "Asia-Pacific Banking Outlook 2006."

Profitability of the region’s banks is expected to remain stable with an increasing share of non-interest income likely to help them weather any future economic slowdown, which many expect from 2007.

Net interest margins are shrinking, but this was not a real issue against the backdrop of solid overall earnings, Chew said.

The earnings profile of banks in Asia has also improved with most now having a more diversified earnings base, he said.

Meanwhile, merger-and-acquisition activity is expected to gather steam as countries realize that a smaller number of banks can be more efficient than a larger number, but the speed of consolidation will vary from country to country.

Although risk management has improved, S&P said it was also "in various stages of evolution" across the region and forecast that banks — particularly those in India, Indonesia, Thailand and the Philippines — will step up the pace.

Although the broad outlook for the sector is stable, different countries face different challenges.

Maheshwari said the level of non-performing loans in Malaysia remains "sticky," with the country’s banks having been slower to reduce them than in some other countries in the region.

"More resolution of this is needed," he said, but saying it was too soon to comment on whether new rules to allow non performing loans to third parties would succeed.

Recent monetary tightening in Malaysia has yet to impact loan growth but Maheshwari said that if there are more rate hikes this year, it could have a moderating effect, particularly on the consumer finance side. Rate hikes in Malaysia, as elsewhere in the region, would affect individual consumers rather than corporates which will likely continue to be keen to borrow for expansion or capital spending.

Next door, Indonesian banks have benefited from a greater number of foreign partners and capitalization — though higher than regional peers — is adequate given the higher country risk.

Loan quality is at its best since the crisis and is improving. However, S&P said the low level of intermediation is a challenge given relatively low loan-to-deposit ratios. It noted higher interest rates could also translate into incremental credit risk for the sector.

Singapore enjoys a very stable and sound regulatory environment but its banks face a "mature and saturated home market" which is likely to mean further regional investment by the city-state’s three domestic banks, said Maheshwari.

In Taiwan, consolidation is expected to continue at a slow pace. One issue for the sector in the short term could be the consumer-credit bubble. While this could hurt banks’ bottom lines for a year or two, it will not likely cause much damage to balance sheets, said S&P.

Taiwan would not suffer from a reprise of the consumer-credit fallout in South Korea several years ago largely because in Taiwan, lending is spread out among many banks and is across a wider variety of products.

China, the only country in the region to have a positive outlook on its banking system, has seen dramatic improvements but will have to work hard in the future to build on recent improvements in the sector, S&P said.