Conundrum facing China’s top 50 banks

Qiang Liao, senior director in Standard & Poor's financial institutions ratings team, discusses the credit outlook for China's top 50 banks by asset size.

With China's economic growth slowing and some industry sectors encountering oversupply issues, the risks appear to be rising for the country's banks. Qiang Liao, senior director in Standard & Poor's financial institutions ratings team, discusses the credit outlook for China's top 50 banks by asset size, and explains why some banks are better positioned than others to weather the slowdown.

How are China's top banks exposed to the country's economic slowdown?

The top 50 banks delivered strong financial performances in 2012 amid rapid asset expansion, largely stable net interest margins, and benign credit provision costs. However, rapid on- and off-balance-sheet asset and credit expansion (see chart) is likely to weigh on banks' capitalisation, risk positions, and liquidity profiles, particularly as China's economy slows and policy uncertainty increases. In our view, the top 50 banks' profitability is set to slump over the next few years, albeit from a strong starting point. Rising credit costs, compressing interest margins, and growing pressures on noninterest incomes are likely to constitute a triple-whammy hit on earnings.

 

Which banks are most vulnerable?

The difference in the pace of the top banks' credit and asset expansion has far-reaching credit implications, in our opinion. The mega banks have managed to enhance their capitalisation and preserve their funding and liquidity strength through modest credit growth and retained profits, which could place them on a stronger footing to withstand China's economic downturn. On the contrary, the majority of smaller players are likely to experience a further weakening of capitalisation. Some may even see significantly deteriorated funding and liquidity profiles due to their unabated credit binge. Should these aggressive players be either overly leveraged or lack sophisticated risk management, we think they are highly likely to be caught off guard when market conditions change drastically. An example of such dislocations was China's interbank market liquidity crunch in late June.

What risks do you see to bank profitability?

Risks to bank profitability mainly hinge on the banks' loan performances. In our view, the massive infrastructure and manufacturing capacity built up over the years through bank lending could cause trouble for unprepared banking creditors if economic growth decelerates sharply. Secondly, fierce competition for deposits has been pushing up the banks' funding costs. Should China's policymakers decide to remove the deposit rate ceiling, particularly for short-term saving accounts, this could have a much greater impact on the banks' profitability. Thirdly, revaluation losses could affect the financial performances of China’s top banks in the next one-to-two years.

What are the prospects for bank capitalisation?

Most banks on our top-50 list saw some deterioration in their capitalisation in 2012, as measured by our risk-adjusted capital ratio before diversification and concentration adjustments. Unabated asset growth, together with earnings pressure, could further undermine these banks' capitalisation in the absence of capital injections. Based on our projections, 16 top banks' risk-adjusted capital ratios would be below 5% by end-2014, a level that would suggest a "weak" capitalisation under our criteria. By comparison, there were 11 banks with risk-adjusted capital ratios below 5% as of end-2012 and just six banks a year earlier. Although we expect to see a clear downward trend in ratios for the majority of the remaining banks, we believe they will likely maintain a ratio in the 5%-7% range, which we asses as "moderate" capitalization. The deterioration in many top banks' capitalisation could be more severe, however, if we take into consideration the impact from these lenders' wealth-management business.

How do you assess contagion risks within the Chinese banking sector?

In our view, there are growing contagion risks stemming from expanding interbank businesses. Some national banks and a growing number of small regional banks have aggressively grown their interbank borrowing to maximize profits. This has not only stretched their own capitalisation and liquidity management, it has also left a much greater number of even smaller banks being exposed to significant counterparty risks. Should these small banks at the centre of interbank financing be badly affected by severe credit losses and ensuing depositor runs, we would expect noticeable repercussions for a wider segment of the banking sector.

How could information risk affect China's banks?

Despite significant improvement in disclosure standards, we think information risk remains an issue in the Chinese banking sector, particularly for some national banks and many regional banks. While the adoption of China GAAP 2006 represented a leap forward, accounting standards are not always consistently applied and can still be subject to arbitrary interpretations, making peer comparisons difficult for certain items. For example, we believe many banks have disguised their sizable corporate credit exposure as investments in wealth-management products or other receivables. This heightens risks for asset quality as well as liquidity management if economic conditions deteriorate significantly.

Will there be consolidation within the banking sector?

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 shock for small banks could occur--despite the banks' seemingly comfortable liquidity ratios. 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.

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