While China's banks continue on their growth path, they must adapt to new banking rules and a more challenging economy. Kimberley Long reports on how the banks are navigating these headwinds.

The hold China's banks maintain on the global banking sector is clear from the Top 1000 World Banks ranking, as Industrial and Commercial Bank of China (ICBC), China Construction Bank, Agricultural Bank of China and Bank of China keep their top four places for another year. While the size and scale of these banks is undisputed, it is the number of Chinese banks climbing up the ranking that will set the tone in the years to come.

China Merchants Bank holds 11th place for another year, while Postal Savings Bank has climbed one place to 12th. And just below, Industrial Bank, Shanghai Pudong Development Bank and China Citic Bank take 17th, 18th and 19th places, respectively. Chinese banks now occupy half of the top 20 banks ranking.

Although the strong dollar has had an impact on the banks in the ranking, it has not been enough to dent the success of China's financial institutions. And as the country emerged from the Covid-19 pandemic lockdowns, the banking sector was looking forward to a boost in business and profitability.

Violet Chung, senior partner at McKinsey in Greater China, says the banking sector has almost fully resumed normal operations, with the pressures on contracting demand, supply shocks and weakening expectations alleviated.

As of the end of the first quarter of 2023, the total assets of financial institutions in the banking sector reached Rmb397.3tn ($55.5tn), an 11% year-on-year increase, according to the China Banking and Insurance Regulatory Commission (CBIRC). At the end of March 2023, commercial banks reported net profits of Rmb667.9bn, a 1.3% year-on-year increase.

Monetary credit levels grew in the first quarter of 2023, as new loans amounted to Rmb10.6tn, an increase of Rmb2.27tn on the first quarter of 2022. At the end of March 2023, renminbi loans had increased by 11.8%, broad money supply increased by 12.7% and social financing — the total received by the real economy — increased by 10% compared with March 2022.

Meanwhile, loans to the manufacturing sector also grew year-on-year to the end of March 2023, with small and micro-sized loans increasing 26%, and medium-to-long-term loans increasing 41.2%.

Xu Li, chairman of Shanghai Rural Commercial Bank (SHRCB), says government policies promote pursuing high-quality development, along with boosting market expectations and confidence.

"SHRCB has established a series of working plans aiming at bolstering confidence, expanding demands, stabilising growth and promoting development," Mr Xu says. "With these plans, we strengthen the support for the real economy, private enterprises, small and micro enterprises, foreign trade enterprises and innovative enterprises to help shock the market back to life with the power of finance."

With increased customer demands, the bank has redoubled its focus on understanding customer needs and increasing resources to strengthen its product support.

"In view of the post-Covid era, when society is restoring confidence, SHRCB has undertaken in-depth research in aspects such as capital market and wealth management needs to generate unity in creating value for both customers and the bank," Mr Xu adds.

Banking pain points

Not everyone holds the view that the banking industry has returned to full health. Rather, there is the view that the sector is simply back to the position it occupied before the pandemic.

Nicholas Zhu, vice-president and senior credit officer at Moody's Investors Service, says: "The reopening has had a positive impact on the economy and the demand for bank loans, but this is mainly driven by the cyclical rebound, rather than a structural recovery. The economy is looking for new engines of growth and until they are found, we see it as a source of structural uncertainty."

While China looks for this new sense of equilibrium, there is a risk that uncertainty will impact financial sentiment. "As the economy moves to a new growth paradigm it is likely non-performing loans (NPLs) will form, which is why we have a negative outlook on asset quality for bank lending," Mr Zhu notes, adding that this is "a key driver for our current negative outlook on the Chinese banking sector".

In a March 2023 note, Moody's stated the adjustment following reopening will weigh on asset quality and profitability for 12 to 18 months, and that banks will dispose of bad debt in order to maintain the 1.63% NPL ratio.

Still, there is optimism. A spokesperson for Ping An Bank says: "Since the fourth quarter of last year, a series of changes in the market and policy situation, particularly the easing of the epidemic, have gradually created a resonant improvement in our businesses. Although we are well aware that the rebound will not happen overnight and that ups and downs and delays can happen, since the upward trend has formed we will definitely ride the tide."

While there has been a boost to banking, there remains caution among consumers. It had been forecast that there would be a rebound in consumer spending when Covid restrictions were eased. And while the 18.4% year-on-year growth recorded by the National Bureau of Statistics in April 2023 is sizeable, it fell short of the 21% forecast.

Ming Tan, director at S&P Global Ratings, says this is a drag on growth: "There has been an increase in economic activities, which will have a good impact on the banks' asset quality as there will be fewer requests for loan moratoriums. There is less pressure on the banks to make provisions. Sentiment takes time to improve, so it will not be an immediate return to positivity — especially for households. Only when job safety and incomes start to rise will we see a greater impact on confidence."

Sectoral divisions

While the Top 1000 World Banks results are testament to the strength of China's largest banks, there is a mixed picture at the country level, given its thousands of smaller local and regional banks.

Jinny Yan, managing director and chief China economist at ICBC Standard Bank, says: "The larger banks have a significant role in driving China's recovery, with deposit rates across many retail banks being lowered to 0.2% in June 2023, from 0.25%. This reflects the central bank's conviction to keep benchmark interest rates low while encouraging retail lenders to keep deposit and in-turn lending rates at the absolute minimum, even if that means lower profitability."

The deposit rate cut to 0.2% is now at the lowest level since 1996. The biggest lenders are offering 2.45% and 2.5% on three- and five-year deposits, representing a decline of 15 basis points.

There are risk elements for the smaller banks, especially if they are located in the poorer regions of the country. "We saw two small institutions enter bankruptcy proceedings in Liaoning province in 2022," Mr Tan says. "Institutions with weak government shareholders are more vulnerable."

He believes there are further risk factors that are being monitored. "China has more than 4000 banks, and as the economy develops there will be consolidation and credit divergence. The People's Bank of China (PBoC) has rated 366 of them — accounting for 1.55% of assets of the 4026 graded institutions — in the red zone and the problems may take time to surface. The government has taken measures to reduce stress. If they are large enough to impact stability, the government will step in as it is highly supportive of the banking system."

Local governments are permitted to issue special bonds to support small and medium-sized banks to enable them to expand their capital. During the first half of 2022, a quota of Rmb103bn in special bond issuances were granted to Liaoning, Gansu and Henan provinces, and the city of Dalian.

Yu Lingqu, vice-director of the department of financial development, state-owned assets and state-owned enterprise research at think tank China Development Institute, believes it is possible that this will be extended due to concerns raised by the US and European bank collapses seen in early 2023.

Mr Yu says: "The US and EU banks' collapse raised the alarm for containing financial risks for small and medium-sized banks. We need to supervise their activities and prevent financial risks. These banks support the local governments and local industries, for example iron and coal producers. These clients will take up the majority of their funding. This could be a source of financial risk in China."

Bank isolation

While the collapses of Silicon Valley Bank and Credit Suisse had little direct impact on the Chinese banking sector, with overseas assets standing at around only 3% across the Chinese banking sector, there is a heightened awareness of the risks of international exposure and contagion.

At digital bank WeBank, for example, there is limited exposure to market and liquidity risk, with only 0.5% of the bank's assets being financial investments in 2022. By comparison, 86% of assets were liquid assets including cash and short-term loans. "On the liability side, WeBank is less prone to overrun risk caused by industry-level events or concentrated withdrawals from specific customer groups because WeBank's deposit ticket size is generally small and diversified, with 99.9% of depositors fully covered by deposit insurance for deposits up to Rmb500,000," says Nanqing Li, president of WeBank.

Chan Kung, founder of China-based think tank Anbound, also believes any potential impact would be limited. "Chinese banks are relatively independent of banks in the US and Europe, so the wave of bank failures has little impact on the Chinese banking sector. However, there may be potential troubles or losses for a portion of private deposits in the Chinese banking system that are held offshore, possibly in Caribbean offshore banks, as these funds are not covered by US deposit insurance."

Still, the events have caused some shock, and it is expected there will be a tightening of measures by the regulatory authorities to strengthen their management of international banking risk exposure.

Grace Wu, head of Greater China bank ratings at Fitch Ratings, says: "Mainland authorities are more likely to provide pre-emptive support in preventing systemic stress, as they have done in the past. Regulatory tightening since 2017 has also reduced system contagion risk in our view, in terms of improved regulation over wealth management activities and reducing excessive investments at smaller Chinese banks.

"Fitch has warned about liquidity risks associated with wealth management products in the past, and we view the tightening measures in China over the past few years to have helped address some of these systemic risks. Concentration remains a risk for smaller Chinese banks and could continue to weigh on their performance, as the pace of recovery in regional economies could vary."

One fall-out from these events may be that banks take a more cautious approach to how they operate overseas. "There may be less external debt issuance, but this is more led by interest rates globally," Mr Tan says. "Issuing debt in China is cheaper than in overseas markets. The stress in the US and Europe adds to overseas uncertainty, which may lead to more domestic debt issuance. Domestic liquidity is strong and the PBoC has been very supportive."

Ms Yan believes the outcome will be a greater urgency in scenario planning and stress testing of banks. "Financial sector stresses trigger heightened volatility in global fixed income and foreign exchange markets. As the renminbi becomes more widely adopted as an international reserve currency, it is less likely to be insulated from global market volatility. Chinese corporates and banks therefore have a greater appetite and need to hedge currency and interest rate exposure across all assets."

Regulation

With these challenges in the international and the domestic markets, in March 2023, the banking regulators announced plans to overhaul the regulatory system. China's banking agencies will be consolidated into one, the National Administration of Financial Regulation (NAFR), which sits directly beneath the State Council. Rather than jurisdiction being split between the CBIRC, the PBoC and the China Securities Regulatory Commission, the NAFR will have full oversight of bank operations, except for the securities sector. The regulator will cover all forms of banking and financing, whether traditional or digital.

WeBank's Mr Li says the move has centralised regulatory functions and unified standards, while the "frequent introduction of new regulatory policies reflects more detailed and stricter requirements for financial institutions".

This came with the introduction of new regulation on the scope of risk asset classification, as the definition was expanded beyond just loans to all assets and credit — on and off the balance sheet. Capital management measures, to be introduced from January 1, 2024, will build a capital regulatory system for commercial banks to improve regulation, manage risk and align to international standards.

The banks state that the overall impact on them is not significant, with the spokesperson for Ping An Bank explaining that the risk asset classification draft called for input in 2019, with the bank incorporating most of the requirements outlined into its own guidelines by 2021. They add that the capital management measures will also have little impact on operations.

"The new plan sets out differentiated regulations for banks of different sizes and risk exposures, aiming to help banks bolster their capital and risk management," the spokesperson notes. "The impact on Ping An Bank is, statistically speaking, overall stable."

Ping An Bank also believes changes to risk-weighted assets is generally in its favour, being beneficial to banks with a high proportion of retail assets. "One of the significant benefits is a reduction in the weighting of qualified credit card traders. In the past, our weighting was 75%, but now it has reduced to 40%. The credit card has become our trump [card], so this is greatly favourable for our bank," the spokesperson adds.

While the banks are playing down the impact of these changes, ICBC Standard Bank's Ms Yan believes this represents significant progress for the banking sector. "One may look back in history at this period of time as a pivotal point for China's economic and financial transformation. Dual circulation means that Chinese banks are looking to carve out their own paths as China becomes the largest economy in the world. A test of success will be how these banks adapt to not only the dynamic global regulatory environment in order to satisfy its corporate and institutional clients overseas, but also deliver economic growth domestically while nurturing a digital economy to lift China's productivity," Ms Yan says.

Banks need to learn to be nimble in response to changes in regulation, whether they are domestic or overseas. "There is a recognition not only that the domestic regulatory landscape is changing, but the banks with global reach, and those aspiring for it, need to be responsive to changes in regulation across all jurisdictions," Ms Yan adds.

Digital in focus

The expansion of China's fintech space has also been a catalyst for regulatory change. As the fintechs dominate the digital payments space, they are exploring new channels of growth.

WeBank's Weilidai loan product, for example, has provided micro loans to more than 60 million users, while WeBank's overall user base has reached 360 million individual customers. The bank also offers the Weiyedai working capital product for small and medium-sized enterprises, and the WeBank Wealth+ wealth management product.

The developments are in response to the Plan for the Overall Layout of Building a Digital China issued by the Central Committee of the Communist Party of China and the State Council.

WeBank president Mr Li says the bank is looking at how to utilise technologies such as artificial intelligence big data models. "In the future, we believe that financial institutions need to grasp the opportunities brought by the new generation of intelligence to further enhance financial technology capabilities and facilitate the intelligence upgrade of technology and business."

While the digital providers have started to explore sectors such as wealth management, the banks retain the stronghold on areas such as corporate and wholesale payments. On the retail side, Mr Zhu believes there will be an evolution into more sophisticated transactions and complex models rather than the types of revolutionary apps that had previously emerged.

The banks have continued to innovate, with ICBC, Agricultural Bank of China, Bank of China and China Construction Bank, China Merchants Bank and Ping An Bank all having established their own fintech companies.

Mr Yu says: "Each bank has as many as 10,000 engineers developing products and services. Innovation in the digital banking space in China will be led by the major banks."

However, Mr Tan notes the challenges faced by the smaller banks, which have fewer resources for recruitment and building competitive digital systems.

Yet, the significance of the banks to the whole sector is undiminished. "The other side of the equation is the corporate side, which still relies on these banks to settle payments. When you look at the PBoC financial stability report, you see the number of third-party payments have increased but the value of the transactions is still less than 10% [of the total]. Although they are very convenient for retail customers, the amount per transaction is small," he says.

Despite challenges, the progress of the Chinese banking sector will continue unabated, according to Mr Chan. "My belief is that the Chinese banking sector will secure a prominent position, if not a dominant role, in the realm of digital banks and digital payments. Why? The reason is that the Chinese government plays a vital role and has effectively driven the restructuring of those technological fields, which enables the Chinese banking sector to roll out digital technology at a lower cost."

Media link: https://www.thebanker.com/China-s-banks-forced-to-learn-new-operational-rules-1688716621