Chinese Banks Face A Triple-Whammy Hit To Profitability

The author is Standard & Poor’s Ratings

As China’s economic growth decelerates and some industry sectors face growing oversupply issues, the risks from China’s recent credit boom appear to be rising to the surface for the country’s banks.

In our view, the top 50 Chinese banks’ profitability is set to decline over the next few years, though from a strong starting point. Rising credit costs, compressing interest margins, and growing pressures on non-interest incomes are likely to constitute a triple-whammy hit to bank earnings.

In particular, we think it is highly likely that the banks could incur substantially higher credit losses in the coming years. If the government pushes more vigorously for consolidation of industries afflicted by oversupply, this could lead to unexpected substantial rises in the banks’ credit losses, despite China’s still comparatively strong economic growth.

In addition, we believe that liquidity management among China’s top banks is becoming increasingly strained. Should those regional banks that have relied heavily on interbank financing suffer severe credit losses and potential depositor runs, we would expect there to be wider negative repercussions for the banking sector as a whole.

Besides Chinese banks’ rapid asset expansion over the past few years, another striking phenomenon has been the continued slide of the top banks’ combined market share in the whole banking sector.

In aggregate, the top banks’ total assets grew by 17.1% from end-2011 to RMB112.61 trillion ($17.92 trillion) at the end of 2012. But the top banks accounted for 84.3% of total assets in the banking system as of end-2012, compared with 84.9% a year earlier.

We believe mega banks are better positioned than most of their smaller peers given their relatively diversified credit portfolio, proportionally higher exposure to the highly rated sovereign, substantially stronger fee-based businesses, and superior funding base. Likewise, in our opinion, many leading national banks have a better chance to maintain their track record of below-average credit losses, thanks to their selective underwriting standards and significant diversification in their credit portfolio.

The financial impact from financial dis-intermediation and deposit competition is likely to remain modest and manageable for the largest banks. But for many national and regional banks with narrow funding bases that are skewed toward corporate deposits and wholesale interbank finance, the impact to their interest spreads could be significant, in our view.

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 under-performing 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.

In our view, small banks will try hard to avoid such a fate through consolidation in coming years. 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 present credit downturn. Massive market-driven consolidation may be on the cards for many players as credit quality becomes dramatically polarized.

(This article has been edited for clarity)

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