Chinese banks will report much higher non-performing loans as the effect of more stringent loan classification requirements introduced by China's central bank kick in.
Recent media reports suggest regulators will further improve bad loan recognition by doing away with the ‘overdue but not impaired’ category for loans overdue 90 days.
"Going forward these exposures are likely to be required to be treated as non-performing loans (NPLs) rather than special mention loans," says UBS analyst Jason Bedford.
As China continues to curb financial risks, Beijing has asked all commercial banks to reclassify such loans by the end of June.
A recent report by Bedford predicts that the new rules on NPL recognition could see these loans jump 14 per cent in 2018 pushing the system-wide NPL ratio to just below 2 per cent.
“However, 95 per cent of the impact will fall squarely on the joint stock banks and the city commercial and rural commercial banks which would see N grow 27 per cent and 33 per cent, respectively," he said.
“Indeed, we think the very purpose of these new rules is to bring the smaller banks in line.”
However, while Bedford claims NPLs will rise, he points out that the removal of discretion on whether or not to impair a loan overdue more than 90 days doesn't actually increase the amount of impaired assets in the system perse.
“What it does do is formalise impairment recognition of loans that were de facto non-performing."
In his view, this is less of a new regulatory change than a reversion to historical best practice, as prior to 2011 corporate loans overdue more than 90 days were always treated as non-performing.
Moreover, he argued, banks still have discretion regarding the level of impairment to apply to a loan based on the underlying collateral and hence can set lower specific provisions against an NPL.
"The good news is that NPL recognition has actually been improving since 2016 and the outstanding amount of loans booked as 'overdue but not impaired' has actually been shrinking," he added.
He also said the change in classification has a limited impact on China's major lenders whose loan impairment standards were largely in line with best practice already.
Bedford’s analysis of 222 banks suggests that while asset quality issues are moderating, this new standard will result in a significant provisioning shortfall of RMB250 billion across the sector.
Many of the 51 banks that will fall below the minimum 150 per cent non-performing loan provisioning ratio post this rule will see their core tier one capital significantly depleted to make up that difference.
"Given the lower ROEs and limited organic capital generation of most of these banks, we expect this may lead to an increase in recapitalisation needs."
That said, the new provisioning standards announced in March 2018, which allow loan provisioning levels to be reduced upon meeting certain criteria, may offer some relief.
The analyst believes this relief will be limited at best and disproportionately benefit stronger balance sheet lenders.
"Many of the smaller banks, particularly among regional lenders, are unlikely to meet the criteria to take advantage of these new rules."