Citigroup's research indicates Hong Kong's banking sector maintains capital adequacy ratios at unprecedented levels, enhancing visibility for shareholder returns. The institution upgraded Hang Seng Bank (00011.HK) from "Neutral" to "Buy" while reaffirming its "Buy" rating for BOC Hong Kong (02388.HK), with Bank of East Asia (00023.HK) retaining a "Neutral" stance.

Hong Kong bank stocks have surged 37% year-to-date, outperforming the Hang Seng Index, driven particularly by BOC Hong Kong's robust gains amid strong southbound capital inflows targeting high-dividend stocks. Although recent declines in the Hong Kong Interbank Offered Rate (HIBOR) may pressure net interest margins, Citigroup anticipates sector profitability will recover as HIBOR normalizes by Q4 2025.

Medium-term challenges from potential Federal Reserve rate cuts appear manageable, given that most Hong Kong mortgages remain protected by prime rate ceilings, with market expectations pointing toward a terminal federal funds rate around 3%. While commercial real estate risks persist short-term, consensus forecasts already factor in elevated credit costs.

HIBOR pressures stem from the Hong Kong Monetary Authority's interventions when USD/HKD hit the strong-side convertibility guarantee in early May, causing one-month HIBOR to plunge 186 basis points quarter-on-quarter in Q2. Current one-month HIBOR near 1% could weigh on banks' Q2-Q3 net interest margins. However, as USD/HKD weakens toward the convertibility band's lower limit, HKMA's currency interventions should narrow the Hong Kong-U.S. rate gap. Citigroup's rate strategists project HIBOR rebounding to 2%-3%, supporting net interest margin recovery by Q4 2025.

Three key factors drove Hang Seng Bank's upgrade: 1) Market consensus sufficiently prices in ~50bps average credit costs for 2025-2027; 2) Its 21% CET1 ratio (Q1 2025) offers superior capital return visibility, supporting ~6% dividend yield through FY2025-2027 plus HK$3 billion share buybacks in FY2026-2027; 3) Citigroup's 2026-2027 revenue forecasts exceed consensus by 4%, primarily from resilient net interest income. Consequently, Hang Seng's target price rises from HK$105 to HK$135.

BOC Hong Kong retains its "Buy" rating with target price lifted from HK$33.9 to HK$40.8, reflecting steady revenue prospects, stable asset quality, and ongoing valuation re-rating potential fueled by southbound capital's lower return thresholds. Bank of East Asia's target increases marginally from HK$11 to HK$11.6.