China’s smaller banks could face greater earnings volatility

The latest earnings releases reinforce Fitch Ratings’ view that China’s large state-owned banks have more reserves than smaller banks to withstand the modest deterioration in asset quality that we expect to see over the next two coming years. The performance of smaller banks, on the other hand, could be more volatile due to their higher risk exposure and lower loss absorption buffers.

The loan loss provision ratio for the Chinese banking sector was 204% at the end of June, compared to 197% at the end of 2021, which leaves some room to cushion the increase in asset quality risk in the portfolio of outstanding loans. In particular, the non-performing loan (NPL) ratio reported by our rated banks for the real estate development sector continued to increase, based on available information, reaching 3.4% at the end of June, compared to 2.7 % at the end of 2021 and 1.8% at the end of June. end of 2020.

However, the NPL ratio for their total loan portfolio remained generally stable, helped by continued NPL resolutions and modest direct exposure to real estate development. Direct mortgage exposure represented around 5% of total loans on average for our rated banks at the end of 1H22, as most banks were disciplined in underwriting mortgages. Exposure to our rated mid-sized banks ranges from 5% to 9%. However, lagged recognition of asset impairments could underestimate reported NPLs.

The reported NPL ratio for residential mortgages remained modest at 0.34%, compared to 0.29% at the end of 2021. Most of our rated banks are likely to see a limited impact on their mortgage NPLs affected by the mortgage boycott movement, as only a negligible proportion of their balance sheets was tied to those loans, according to their disclosures. The government’s recent policy intervention, including a 200 billion yuan fund funded by strategic banks to improve financing for troubled projects, will also help contain a further deterioration in mortgage quality.

However, failure to restore buyer confidence, resulting in prolonged stress in the housing market beyond 2023, could test the resilience of the banking system. On the other hand, an aggressive easing of underwriting standards or a resumption of lending to struggling developers could weigh on our assessment of the operating environment for Chinese banks.

All of our rated banks comply with regulatory capital requirements, including the latest additional capital thresholds for systemically important banks which will come into effect on 1 January 2023. However, some mid-tier banks only have a thin cushion above their minimum Common Equity Tier 1 capital requirements, which we believe could limit their loan growth and profitability over the next year.

The banking sector’s net profit rose 7% year-on-year in 1H22, according to the latest release from the China Banking and Insurance Regulatory Commission. This partly reflects the December 2021 and April 2022 reductions in reserve requirement ratios which helped reduce funding costs and mitigate the decline in asset yields amid a lower loan prime rate and weak effective demand for loans.

We expect the sector’s net profit growth to slow to single digits in 2022, from 13% in 2021, as lower interest rates and weak loan demand weigh on credit lines and income. Further weakening in sector profitability relative to our expectations could limit banks’ internal capital generation and their ability to support NPL writedowns as they seek to address risks in the real estate sector.

Effective loan demand, particularly in the retail segment, is expected to remain sluggish amid sluggish consumer sentiment and a challenging near-term economic growth outlook. Still, funding for green projects, micro and small enterprises and infrastructure activities will be among the few drivers as the central government steps up its efforts to extend financial support to these areas. We expect them to support modest growth in total banking sector loans for the whole of 2022.
Source: Fitch Ratings

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