Singapore’s financial system - from household balance sheets to corporate lending - remains in sound shape, but challenges lie ahead.

The assessment came from the Monetary Authority of Singapore (MAS), which released its annual report card on the sector yesterday. There were plenty of positives, but the regulator warned of considerable risks ahead, including sharply higher interest rates.

Loose monetary policies, most notably in the United States, have flooded the globe with cheap money in recent years. This has encouraged a build-up of debt among households and firms here, MAS said in its financial stability review.

A scaling back of stimulus could trigger an abrupt tightening of financial conditions, with a series of knock-on effects, starting with a potentially sharp rise in interest rates on debt across Asia.

As investor confidence dips, Asian currencies could depreciate, which would add to debt repayment costs for those who had borrowed in foreign currencies.

Banks may pull back on loans as defaults rise, leading to a vicious circle of declining asset quality, tightening credit and slowing growth.

In short, MAS said, "interest rates, and therefore debt-servicing burdens, could increase markedly and perhaps unexpectedly soon. In turn, growth shocks and financial market volatility could affect the property market and the banking system".

DBS economist Irvin Seah noted this grim scenario is not far- fetched. "The rhetoric in the MAS report sounds more cautious than usual, but in September, when there was merely talk of US stimulus tapering, that was enough to send so much volatility into financial markets."

While cooling measures have moderated property market sales and housing loan growth, developer bids for land parcels remain firm, MAS noted. The market "warrants continued caution and vigilance", it added.

CIMB economist Song Seng Wun said it will take a while more for interest rates to rise - the US must first show sustained jobs growth and European banks have to report fewer non-performing loans - but that it pays for regulators to be vigilant early.

MAS gave the assurance that Singapore's corporate and household balance sheets are healthy overall, and the local banking system has stayed resilient even under severe stress tests.

Even so, it added, the banking sector needs to guard against credit quality deterioration and liquidity risks, especially as they expand cross-border lending.

The gross flows of funds, both loans and deposits, since the 2008 financial crisis between Singapore and China has grown by 85 per cent, while that between Singapore and India has surged 129 per cent, MAS noted. China, which was previously a net lender to Singapore, is now a net borrower from Singapore.

"Cross-border banking activity may carry greater currency mismatch risk than intra-country lending... Sharp or prolonged depreciation of domestic currencies may weaken borrowers' capacities to repay such foreign currency- denominated loans," MAS said.

Local banks said they have measures in place to screen customers and maintain their credit portfolios. United Overseas Bank's head of investor relations and research, Mr Jimmy Koh, said the bank regularly conducts stress tests to assess the resilience of its portfolio.

At OCBC, although overseas lending as a percentage of total loans and advances has increased by more than 20 per cent in the past five years, domestic lending continues to account for the bulk of outstanding loans.