The Banker magazine’s recent annual survey suggests Chinese banks accounted for about a third of global banking profits last year, up from just 4 percent in 2007. According to it, Chinese banks are gaining as European banks struggle.
Three large Chinese banks were at the top of the profit table. At the top, for the second year in a row, was Industrial & Commercial Bank of China (ICBC), which earned $43.2 billion before taxes. China Construction Bank (CCB) came in second place with profits of $34.8 billion and Bank of China (BOC) was third with earnings of $26.8 billion. JP Morgan, which was in fourth place, earned $26.7 billion and HSBC, the most profitable European bank, earned $21.9 billion.
Just five years ago, European banks had accounted for 46 percent of banking profits. But that dropped to 6 percent last year while Chinese banks accounted for 29.3 percent, the magazine reported.
But even as they grow rapidly, China’s banks are facing challenging times ahead. Second-tier lenders, in particular, may be facing a liquidity squeeze as the practice of extending loan repayments remains common while off-balance-sheet lending grows and customers find places other than their bank accounts to put their large pool of savings.
Second-tier banks in China are in a “deteriorating asset quality environment,” said Charlene Chu, a senior director at Fitch Ratings, during the rating firm’s Global Banking Conference in June. Although the situation has not reached a critical stage, specific banks and the banking sector will have to quickly develop the skills to navigate an increasingly challenging environment.
Modern banking is only about 10 to 15 years old in China, said Chu, so awareness of the challenges ahead and in-house experience to deal with them varies widely between institutions.
China’s big four State-owned banks — ICBC, CCB, BOC and Agricultural Bank of China — are well equipped to ride out any storms and will get government support, if needed. But second-tier banks may be in a different position. There are also a lot more second-tier banks. The largest and more stable include Bank of Communications, China Citic Bank, China Everbright Bank, China Minsheng Bank, China Merchants Bank and others.
Typically, second-tier banks were seen as having a lower ratio of non-performing loans and some, which received investment from foreign institutions, rapidly stepped up their operations. HSBC, for example, invested in Bank of Communications. Nevertheless, these banks may not be prepared for the challenges ahead, challenges that arise out of an increasingly sophisticated financial environment.
Adding to the difficulties, the People’s Bank of China lowered benchmark interest rates in early June, the first cut to benchmark rates since 2008. Although this may provide banks with more flexibility when setting their own rates, the move is generally a negative one for Chinese banks which “will be incentivized to increase the weight of higher-yielding loans that carry more risks”, according to Tom Byrne, senior vice president — regional credit officer at ratings agency Moody’s.
Nevertheless, the move may be a first step in reforms to China’s financial system.
Liberalizing what banks can charge for loans should, in the long run, help Chinese banks. In the short term, however, lower interest rates could exacerbate the liquidity crunch that they face.
For many years China’s banks were a picture of stability, said Chu. Customers who had almost nowhere else to put their money made deposits and banks loaned out the funds. Banks had stable funding and a nearly captive deposit base until the mid-2000s. Bad loans were not really an issue because banks could carry the loans indefinitely as long as they had that constant source of funding.
But over the past decade China’s banking system has changed tremendously.
“China’s economy has become immensely more complex in the past three decades of rapid, double-digit growth,” said Byrne.
There are multiple reasons for the complexity. Economic growth has translated into greater savings and customers who demand greater yields on their deposits and investments. At the same time, as China started opening the sector, more investment products became available. So individual customers found new places to put their money into other than bank accounts.
However, corporate deposits have stopped growing as Chinese enterprises keep more foreign profits abroad to fund international expansion plans or set up their own independent financial institutions to manage their money.
The slowdown in deposit growth over the last few years coincided with a credit boom, partly driven by the global financial crisis that forced China to set up a large stimulus package that relied on considerable bank lending.
The result of fewer deposits and the expansion of lending could lead to a serious shortfall in liquid assets that could make it difficult for Chinese banks to meet their obligations. Second-tier banks that once held excess cash may now be scrambling to meet all their obligations. And less cash means less capacity to lend, which translates into less credit available for customers and ultimately, a credit crunch.
Smaller banks, said Chu, are in a tight spot. In contrast, the larger banks still have the same amount of credit capacity as before.
These shifts may be the result of three key developments in China’s financial services sector, said Chu.
The first is a proliferation of wealth management products, which now account for more than half of all deposit growth in the country. These products give savers higher returns than deposit accounts. While this is good for customers, it also means that banks have to deal with higher costs of capital. Indeed, deposit rates have increased by about 3 percent.
These products also result in greater systemic risk. By and large, banks have moved these wealth management products off their balance sheets but they have very little capital left over to cover the shortage of funds.
As deposit rates have increased, banks have been going after borrowers willing to pay more for funds, such as small and medium enterprises that are inherently riskier borrowers than governments or large corporations.
A second development is a significant slowdown in the inflow of funds, particularly from loan repayments, said Chu.
Forbearance of loan repayments is very common in China but it means it takes a long time for banks to replenish their capital bases and they have less money to lend. Second-tier banks need about 60 percent of their loans repaid on time and in full, so slower repayments crimp bank lending.
Chu anticipated that second-tier banks would need about 4 trillion yuan ($629 billion) in liquidity this year to keep up with so much forbearance and so many credit extensions.
The third development is growth in off-balance-sheet lending, which is nearly as large as bank lending and may take place outside the traditional banking system. This type of lending can create difficulties for regulators.
The People’s Bank of China, which has used banking policy as a key tool to control bank credit, now has less control and since non-bank activity is often less transparent and subject to weaker disclosure, Chu said oversight may be insufficient.
Chu said she is looking for signals whether banks are getting close to breaking point.
The non-performing loan ratio is not all that informative given the amount of off-balance-sheet lending and regularly extended loans. Looking at bank liquidity may be a better way to gauge the health of China’s banks. If banks are facing liquidity stress because loans are not getting repaid, there may be higher inter-bank borrowing.
The rate cut in June gives banks more flexibility in setting both the rates they pay on deposits and the rates they charge on loans. According to Byrne, loans are unlikely to get any cheaper for any but the safest and largest customers — in particular the largest State-owned enterprises. Nevertheless, banks face another squeeze in the short term.
Lu Ting, chief China economist at Bank of America Merrill Lynch, believes the rate cut introduced in the first week of June is ultimately good for both banks and the economy. In a note to customers, he said that “in China the issue is about banks making too much money instead of being about non-performing loans”.
“We summarize our views in two sentences. What’s bad for banks is good for the Chinese economy in the near term. And what’s good for the economy is good for banks in the long term,” said Lu. “We will likely see a couple of rate cuts down the road, depending on China’s macro data and global economic situation.”
As China’s banks take an increasingly large share of global profits, smaller lenders in the country’s rapidly developing financial industry could be facing a liquidity squeeze.