Smaller Chinese banks face higher funding costs than their larger peers and are grappling with tighter rules on shadow banking, but a stabilizing Chinese economy in the second half of the year is expected to relieve the pressure, analysts said.

"Small- and medium-sized Chinese banks are facing some pressure after recent financial regulations targeted shadow banking businesses, which contributed quite a lot to these banks' profits," Xia Le, chief Asia economist at BBVA Research in Hong Kong, told S&P Global Market Intelligence.

Among recent regulatory effects, China's banks have been banned since Sept. 1 from issuing negotiable certificates of deposit, or NCDs, with tenors of more than a year. Regulators had become concerned after various lenders used the instruments to raise funds to buy wealth management products and NCDs issued by other banks. Additionally, the country's banking regulator has warned of risks emerging from the interbank business and required banks to report the underlying assets and liabilities of their wealth management products in a bid to rein risks in the shadow banking sector.

With these regulatory curbs, the bottom lines of a number of banks will take a hit in the near term, Xia said.

And while China's four biggest banks — Industrial & Commercial Bank of China Ltd., China Construction Bank Corp., Agricultural Bank of China Ltd. and Bank of China Ltd. — which have sizable deposit-taking branch networks and strong relationships with corporate customers, other lenders in China cannot boast the same, "so they have to borrow more funds from the market and expose themselves to high borrowing costs and interest rate fluctuations," said Ken Shih, a DBS analyst based in Hong Kong.

Bank of Communications Co. Ltd., China's fifth-largest bank by assets, is familiar with these challenges. Moody's Investors Service on Sept. 7 downgraded the ratings of the lender to A3 from A2, with a stable outlook, citing the lender's weaker funding profile, and thus profit prospects, compared with other state-owned banks.

"The average cost for its interest-bearing liabilities increased by 10 basis points year over year in the first half of 2017, while that of other state-owned banks decreased," the rating agency said, while adding: "The bank's annualized return on assets was 0.91% in the first half of 2017, down 9 basis points year over year."

Bank of Communications reported a second-quarter net interest margin of 1.49%, down 35 basis points from the year-ago quarter, according to S&P Global Market Intelligence data. Medium-sized China Merchants Bank Co. Ltd. and China Minsheng Banking Corp. Ltd. saw declines of 9 basis points and 45 basis points, respectively. Such sharp margin declines reflect the pressure of rising borrowing costs, Shih said.

At ICBC, Agricultural Bank of China and Bank of China, net interest margins rose year over year for the second quarter, while China Construction Bank reported a 7-basis-point decline.

However, analysts believe the stabilizing domestic economy in the second half of the year will help the smaller banks reduce bad loans levels, and allow them to book lower loan provisions in order to boost profitability.

"The recent economic rebound will improve Chinese banks' asset quality and they will be less worried about bad loans," Xia said.

Shih agreed, noting a general rise in corporate profitability in the first half, which should improve their ability to keep up with loan payments, he said.

Most of Moody's rated Chinese banks carry a stable outlook, said David Yin, a Hong Kong-based senior analyst at Moody's. An exception is China Everbright Bank Co. Ltd., which has carried a negative outlook from Moody's since March 2016 following a downgrade of the sovereign's outlook to negative from stable.

Moody's cut its ratings on Agricultural Bank of China as well as Agricultural Development Bank of China, China Development Bank Corp. and Export-Import Bank of China in May following a similar action on China's sovereign ratings to A1 from Aa3. Fitch Ratings and S&P Global Ratings have not changed their ratings on the sovereign following the action by Moody's.

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