The ebb of liquidity while deleveraging to reduce Chinese banks’ profitability

This is the second report of the China Banking Series 2021.

Although the profitability of Chinese banks crumbled amid the pandemic with larger-than-average provisioning, the impact was cushioned by asset growth. But the market should never take the accommodative monetary policy stance for granted. Since May 2020, the People's Bank of China (PBoC) has become cautious in money supply, which is relevant beyond the banking sector and can influence corporates and economic growth. In the second note of NATIXIS China Banking Series 2021, we analyze the performance of Chinese banks from the liquidity perceptive and the impact of the ongoing interest rate reform.

The changes in macro drivers are going to impact the banks’ profitability through asset growth and net interest margin (lending rates and cost of liabilities). Chinese banks have seen resilient net interest income growth since 2019, which contrasts sharply with non-interest income. The main reason is the credit expansion, especially after the pandemic. But the tide has turned with liquidity condition changing from injection to gradual withdrawal. With slower loan growth in 2021, the window for banks to grow profits through asset expansion is now half-closed. Banks’ asset growth has already returned to the pre-pandemic speed.

Even though Chinese banks managed to maintain net interest income growth, defying gravity during the pandemic, the sharp drop in the return on assets (ROA) indicates that the good news only comes from balance sheet expansion. The pressure on net interest margin only worsened as the PBoC cut rates to support the economy and the lower funding costs of banks cannot fully cushion the decline in lending rates.

Part of this support comes from the regulatory decision on 21st June to change the calculation of the deposit rate ceiling from multiplying to adding basis points to the benchmark rate. The original mechanism had previously fueled competition with high interest rates between banks to lure deposits for balance sheet expansion, but it was hard to keep such behavior in the current environment as banks are experiencing tougher conditions as liquidity ebbs. Beyond the reduced profitability, the gap in funding costs between short and long tenors may fuel risks related to the maturity mismatch and arbitrage opportunities. While the reform can offer certain timely help for banks, it should not be viewed as a rate cut as it is more of a structural policy change.

Going forward, the renewed deleveraging campaign will limit banks’ asset growth in the future. Although the deposit rate reform may give a helping hand on the cost of liabilities, it is unlikely to see significant pickup in lending rates. This means that the net interest margin may still be squeezed compared to the good old days. All in all, in the regulatory push of deleveraging, banks are likely to face higher pressure of “interest concession”, even though it may happen at a gradual pace.

Full report available for NATIXIS clients.