The implications are serious for the future earnings of banks like Dah Sing Bank and Public Financial Holdings, and for Greater China corporates seeking credit lines to keep operations running.
With Hong Kong's currency pegged to the US dollar, funding costs are expected to rise further as its main financial institutions keep a tighter grip on their money at a time when companies need it most.
The pullback in loans and deposits from French and other previously aggressive European lenders is the latest blow to the city, which is already facing pressure from expectations of a Chinese slowdown and a property correction.
"The overall downturn in Hong Kong is being exacerbated by the European banks deleveraging," said Paul Schulte, head of financial research and strategy at CCB International.
The worry among companies looking to borrow is that Hong Kong lenders, faced with rising loans and falling US dollar deposits, are no longer willing to assist corporates in need of new credit to keep business humming.
"In the US dollar market, we're already seeing pressure on the project financing front, whether it's for aircraft or ships or infrastructure," said Emmanuel Pitsilis, a director at McKinsey & Company.
Banks around the region are facing similar pressure, although Hong Kong stands out in particular because it lent generously to fast-growing Chinese companies looking to borrow in the past two years when China was tightening monetary policy.
Those factors pushed up loan to deposit ratios, as did soaring demand for Chinese yuan and a booming real estate sector paid for with cheap credit. LDR ratios, when they hit 100 percent, means a bank is lending as much as it's taking in. For small banks, the 100 mark can be a red flag because it means they have to raise funds through other ways such as debt issues to finance new loans.
Loan-to-deposit ratios for the Hong Kong dollar stood at 85 percent at the end of October, hovering around seven-year highs, according to data from the Hong Kong Monetary Authority.
Worst-hit by the impending crunch is likely to be the smaller and mid-sized Hong Kong banks such as Dah Sing Bank and Public Financial Holdings, whose margins have been under pressure the past few years.
For example, Public Financial's operating profit margin fell to 32 percent at end-June from 36 percent at the end of 2010. Other small and mid-sized banks are also facing the same problem.
"The smaller banks just need to gather more deposits right now," said Dominic Chan, a financials analyst with BNP Paribas in Hong Kong. "Loan growth will be restricted as long as they don't get new deposits, which will continue to hit margins."
Best-placed to pick up the slack left behind by any departing Europeans would be the two city's two biggest retail banks, HSBC and Standard Chartered, which have lower local currency LDRs as compared to their smaller rivals.
BNP Paribas' Chan estimates HSBC and StanChart's Hong Kong dollar loan-to-deposit ratio at below 60 percent. The two banks do not disclose their LDR numbers for Hong Kong.
"If anyone leaves, the local guys who can afford it will come in and pick up some of the slack," said Jim Antos, an analyst at Mizuho Securities in Hong Kong. "That's going to be good for the big guys to pick up market share."
On a more macro level, credit as a percentage of GDP in Hong Kong stood at 200 percent at the end of last year, according to World Bank figures, its highest in over a decade and surpassing levels seen just before the Asian financial crisis. By comparison, regional rival Singapore clocked in at 86 percent.
Singapore's banks now seem healthier than their smaller Hong Kong rivals. For example, Southeast Asia's largest lender, DBS, had a Singapore dollar loan-to-deposit ratio of about 62 percent, Barclays Capital estimates, almost 25 percentage points lower than the average Hong Kong number.
Other Singapore banks, such as UOB, also have similarly low local currency loan-to-deposit ratios, giving them the ability to ramp up their US dollar lending when others are pulling back. In both cities, European banks account for over 15 percent of syndicated loans available.
"What we're seeing right now is that Hong Kong banks are afraid of being part of a syndication," said Schulte at CCB International. "They don't want to be the ones left holding the bag."
This has set off alarm bells at Hong Kong's de facto central bank, the Hong Kong Monetary Authority. In November, it warned banks to set aside more in reserves to beef up what it called "countercyclical measures."
To appease the regulators, banks have pushed up deposit rates to attract fresh cash. HSBC, Hong Kong's largest retail bank, has begun offering rates of 1.9 percent for a two-month time deposit, almost 10 times that of the interbank lending rate of the same tenor.
The higher deposit rates have, in turn, pushed up mortgage rates and hit the other lifeline of Hong Kong's economy, the real estate sector.
If mortgage rates rise, first-time buyers may be priced out of the market, which would then have a ripple effect on the secondary real estate market, Barclays Capital said in a note last month.
"The cheap corporate credit enjoyed by Hong Kong developers is ending," the brokerage's analysts Andrew Lawrence and Tom Quarmby wrote. "Higher funding costs are clearly a negative for the property sector."
