Chinese banks cut bad loans

While Chinese banks have improved the quality of their loan books, risks associated with high debt leverage and further credit losses have yet to reached a turning point, according to the earnings reports for the 2016 second half.

"Lackluster 2016 results for Chinese banks reinforce our negative view on the sector, and our expectations that credit quality across the banking sector will continue to diverge," said S&P Global Ratings credit analyst, Frank Wu.

Total net profit growth for the eight biggest Chinese lenders was anemic at 2.1 per cent in 2016, which Wu claimed was because of narrower net interest margins and higher credit costs. In the second half, however, margins stabilised somewhat. Headline earnings might have come in even lower were it not for a release in countercyclical loss reserves aimed at smoothing profits.

"Over time, such practices could erode reserves and subject banks to significant earnings swings due to potential jumps in non-performing loans,” Wu noted.

That said, pockets of improvements in banks' credit metrics were apparent during the second half of 2016 with six banks reporting a fall in non-performing loans.

However, as Wu sees it, these figures distorted the true pace of asset deterioration because many banks increased their bad debt write-offs and disposals over the period to clean up their balance sheets.

“The decline in part reflects more aggressive non-performing loan cleanups and the use of instruments including securitization and debt-for-equity swaps to remove problem loans from balance sheets."

Lower provisioning 

In 2016, five banks reported lower credit costs, as measured by loan provisions as a percentage of the average outstanding loan book for the period.

“But although lower provisioning helps smooth profits in challenging years, this practice can come at the expense of running down loss reserves, gradually weakening buffers to absorb future loan losses," said Wu.

While the coverage ratios of China Construction Bank and Bank of Communications remain very close to the regulatory minimal of 150 per cent, Industrial and Commercial Bank of China's coverage ratio fell to 137 per cent at year’s end.

New bad loan formation rates retreated slightly but remained high during the year reflecting defaults by corporate borrowers.

“We attribute most new problem loans to credit stress spreading from a few segments that private companies typically dominate, such as wholesale and retail trade, export-oriented industries, shipbuilding and coal mining."

Still, the analyst acknowledged the improvement in debt-servicing on the back of a recovery in corporate profits in 2016.

China's top four banks - ICBC, CCB, Agricultural Bank of China and Bank of China - have the strongest deposit funding bases and are better positioned against tightening domestic market liquidity and regulatory crackdowns on "shadow banking" and trading activities in the interbank market.

“However, other mid-sized national players are more vulnerable to monetary and regulatory tightening because they have become increasingly reliant on wholesale fundingto support growth strategies and maximize profits.”

Thus, Wu is expecting the credit profiles of the big banks and some mid-sized players to polarize as China's economic growth slows.

“These smaller lenders may see their metrics erode at a faster pace because of more focused SME lending, higher reliance on wholesale funding and weaker capitalization to buffer against future losses," he said.

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