Why a credit downturn would seriously test China’s banking sector

Following a review of China’s top 50 banks, Qiang Liao, director of financial institutions ratings at Standard & Poor’s, explains some of the key factors that will test the resilience of Chinese banks.

China’s banking industry is facing a serious test over the next few years: Corporate delinquency is rising, net interest margins are tightening, and liquidity management is becoming increasingly strained. What’s more, the scene is set for a credit downturn amid worries about a slowdown in the Chinese economy and export sector.

What’s dimming the profit outlook for Chinese banks?
A lending spree, low credit-provisioning costs, and explosive growth in fee income have lifted the earnings of China’s banking sector in the past few years. However, we believe the country’s banking sector will find it tougher to maintain adequate profits as the economy slows and credit losses spiral up. Indeed, the solid profitability of the top 50 banks could slump over the next few years.

In our view, moderating credit growth, increasing credit costs, and interest rate cuts are likely to strain earnings. The burden could become more acute if credit losses jump. Consecutive interest rate cuts could also significantly slash the banks’ net interest margins as China once again starts to deregulate interest rate processes.

Which banks will be most affected by weakening conditions?
We expect aggressive but unprepared players — particularly smaller banks without a competitive niche — to be hardest hit by the weakening conditions. This could significantly erode public confidence in small and underperforming lenders. Much depends on whether banking regulators maintain rigid adherence to liquidity requirements. If they do, we believe a liquidity trap for small banks could occur — despite the banks’ seemingly comfortable liquidity ratios.

What will contribute to rising credit risks?
We see a growing likelihood that the banks could incur substantially higher credit losses in the coming years, reflecting the banks’ unproved risk management amid strong credit growth, and for some regional banks their fairly high concentration of risks.

China’s huge stimulus package following the global financial crisis in 2008-2009 shackled the banks’ risk positions, as the banking sector served as the government’s chief instrument in this stimulus. While cheap loans associated with the lending spree have helped the banks contain their credit losses in the past few years, the damage to their balance sheets is about to surface. The trigger is coming from the slowdown in China’s economy since late 2011 and precarious global economic conditions.

Soaring profits have come at a cost as banks have built up massive latent credit risks. This calls into question the sustainability of their profitability and capitalisation in the long run. The protected interest spread under China’s regulated interest rates and unstoppable growth in loan volume served as the primary forces for lifting banks’ profits. But artificially low deposit rates have prevented the banks from fully nurturing a risk-pricing culture. The deposit rate ceiling makes low lending rates for corporate clients and infrastructure finance not only affordable for banks but also seemingly justifiable before such loans turn sour.

However, we continue to view the risk positions of the majority of the top 50 Chinese banks as moderate, due to the banks’ very low ratio of nonperforming loans (NPLs) and good track record in maintaining low credit loss experiences in the past five years.

Are funding and liquidity profiles a concern?
In our view, the funding and liquidity profiles of China’s top 50 banks appear adequate overall and remain solid by international standards. The top banks’ aggregate loan-to-deposit ratio increased to 66.7% at the end of 2011, from 63.6% in 2006. The rise was mainly due to subdued deposit growth relative to strong loan growth. We expect the top banks’ aggregate loan-to-deposit ratio to come closer to the regulatory ceiling of 75% in the next few years. This is because depositors tend to start to shift toward wealth management products when deposit rates trail behind inflation rates.

Nevertheless, sound funding profiles mask a challenging liquidity situation as regulatory policy remains tight and financial disintermediation unfolds. The constant strain on banks to satisfy their clients’ demand for credit and arguably outdated regulatory funding and liquidity requirements have driven many banks to hide their credit exposure through wealth management products or other shadow banking channels.

Finally, it’s not yet apparent if the top regional banks’ satisfactory funding and liquidity ratios could stand up under a distressed scenario of a run on deposits. While such a situation looks remote at present, it can’t be ruled out completely if the sector suffers a substantial spike in credit losses.

How have the banks’ market positions changed?
The profile of the top 50 Chinese banks has substantially altered over the past five years. While total assets have risen, the top 50 banks’ market share has dropped, reflecting faster growth at smaller banks than larger players against a backdrop of rapid expansion of balance sheets across the sector. In aggregate, the top banks had total assets of Chinese renminbi Rmb83.3 trillion ($13.2 trillion) at the end of 2011, representing a compound annual growth rate (CAGR) of 19.7% over the past five years. But the top banks accounted for 73.5% of total assets in the banking system last year, compared with 74.8% five years ago.

Total loans also rose at a CAGR of 18.9% from end-2006 to end-2011. However, this figure masked major growth in the banks’ off-balance-sheet credits, such as loan commitments, bankers’ acceptance (or time drafts), and letters of credit. Off-balance-sheet credits increased by a CAGR of 53.2% over the past five years, amounting to 37.5% of the banks’ total loans at the end of 2011.

Do you expect industry consolidation?
In our view, many larger and stronger banks will see a good opportunity to snap up smaller and weaker players to strengthen their market positions. We believe the top banks, particularly national banks and large regional banks, could spearhead massive market-driven consolidation, which proved to be hard to achieve in a buoyant market. The pace of consolidation will hinge on the severity of the sector’s credit downturn that’s unfurling.

A slowdown in China’s economic growth may be the catalyst for an industry shakeup. We expect the polarisation of business profiles and financial strength to continue to deepen. Owners of small and weaker banks are likely to seriously consider their options as once very profitable businesses become marginalised.

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