NATIXIS China Banking Monitor 2020 - Catch-22 for Chinese Banks: How to support growth and keep financial soundness simultaneously?

• From the forceful deleveraging and the clampdown on shadow banking to the risks of the US-China relationship and the Covid-19 pandemic, China’s banking sector has faced multiple shocks in the last few years. For banks, the current situation could give both benefits and drawbacks.
• On the tailwinds, the intermediation of monetary and fiscal stimuli has resulted in the comeback of fast asset growth, which should put a floor to decreasing profitability. A certain degree of regulatory easing also helps banks to withstand the consequences of structural deceleration and poorer asset quality. On the headwinds, lower interest rates are pushing the net interest margin (NIM) down, even more so as banks are forced to lower lending rates. Therefore, profitability will be lifted by asset growth but pressured by ever decreasing interest rates.
• Even without the sudden halt in growth due to the Covid-19, the slowdown of the economy in 2019 has already started to show its scars in asset quality. Although the coronavirus will lead to higher credit risk, the faster loan growth is going to mask the deterioration of asset quality. The stressed loan ratio is likely to remain stable with minor increase. But it still means banks will need to sacrifice profits in writing off loans, of which their charge-off rate is already higher than global peers.
• While liquidity was a big challenge in the past, it turned out to be less of a problem thanks to monetary easing. The direct beneficiaries are smaller banks with enough liquidity to even become lenders in the interbank market. But the new spotlight is on structured deposits. As the People's Bank of China (PBoC) limits banks’ exposure through window guidance, some small banks may feel liquidity stress.
• The key challenge is on financial stability in the future, which hinges on the solvency ratios. For several small banks, the relatively poor capital ratios could become problematic notwithstanding the issuance of perpetual bonds to add AT1 capital since early 2019. The cushion for small banks between capital and regulatory requirement continues to narrow, meaning more consolidation is expected. However, local governments are now allowed to use bond proceeds to refurbish banks’ capital, which gives higher government influence on Chinese banks.
• All in all, China’s banking sector seems to face a Catch-22 situation with vital responsibilities but contradictory goals, i.e. bank-supported economic growth and financial soundness. Some signs of trade-off also start to emerge with the intervention of 9 financial institutions recently. The insulation of financial risks from “non-standard assets” will continue through wealth management subsidiaries with asset securitization to facilitate the sharing of risks across sectors. Regulatory harmonization will stay with an expanded macro prudential assessment. As such, the need to restore the clean-up will only be more apparent down the road.

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