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Smaller Chinese banks face rising default risk despite recovering economy

Mid-sized and small Chinese banks set aside more cash as loan loss provisions than they earned as net profit in the first half of 2020, highlighting a rising default risk for locally focused and less-capitalized lenders despite a recovering economy, analysts say.

For the six months ended June 30, the combined loan impairment losses of 20 mid-sized and small Chinese commercial banks listed in Hong Kong totaled 67.82 billion yuan, 42% more than their combined net profit of 47.74 billion yuan, according to calculations by S&P Global Market Intelligence. In the same period last year, these lenders set aside 58.41 billion yuan as buffer against expected loan losses, 19% more than their combined earnings of 49.26 billion yuan.

"Some of the smaller banks will definitely still face worsening [nonperforming loan] pressure," said Michael Chang, director, HK and China Financials, Equity Research at CGS-CIMB Securities. "That is why this segment is a big focus [for] regulators."

While banks of all sizes in China have increased lending over the past year to help revive the slowing economy, locally focused commercial and rural banks that serve mainly small businesses and farmers have been hit harder by defaults than their larger national counterparts, whose customers are mostly major corporations and state-owned enterprises. The economy recovered from a 6.8% on-year contraction in the first quarter to a 3.2% on-year growth in the second, though latest indicators such as the manufacturing PMI suggest that the pent-up demand may have lost some steam and point to more tepid growth ahead.

According to the China Banking and Insurance Regulatory Commission, the asset quality of rural commercial banks is the worst among all bank types. In the second quarter, their average nonperforming loan ratio was 4.22%, up from 4.09% in the first quarter. Meanwhile, the average NPL ratio of city commercial banks improved to 2.30% from 2.45% during the same period, and that of large-scale national commercial banks slipped to 1.45% from 1.39%.

Rural commercial banks are the biggest source of the so-called inclusive loans, which are less than 10 million yuan per credit line and target small businesses with relatively weaker credit profiles. In the second quarter, rural commercial banks extended 4.866 trillion yuan of such loans, or 35% of the nation's total and up 7% from the first quarter, according to the CBIRC. Meanwhile, city commercial banks extended 2.010 trillion yuan of such loans in the second quarter, or 14.6% of the nation's total and up 9% from the prior quarter.

Capital risk

Relatively low level of capital is an added risk for some mid-sized and small banks when more loans are now deemed risky, said Bruce Pang, head of Macro and Strategy Research at China Renaissance.

The capital adequacy ratios of city and rural commercial banks are the lowest among all bank types in China. According to the CBIRC, the average capital adequacy ratio of city commercial banks fell to 12.56% in the second quarter from 12.65% in the prior quarter, while that of rural commercial banks dropped to 12.23% from 12.81%.

There have been several bank failures in China since May 2019 but Beijing either seized the management of the lender or launched state-backed bailouts to prevent them from collapsing. This was seen to have helped prevent financial contagion from spreading to other parts of the banking system.

"Bank bailouts over the last year and a half have given us some confidence that the central bank or the Ministry of Finance would step in to prevent financial system instability," Chang said.

China's central bank has also introduced measures such as boosting the relending and rediscount quotas as well as slashing the required reserve ratios of small and midsize banks to recapitalize the lenders.

In addition, on July 1, China's State Council said it would allow provincial governments to use some of their proceeds from special local government bonds to recapitalize small and midsize banks. Caixin reported in mid-July that 18 regions have earmarked 200 billion yuan for this initiative, about 5% of the total special-purpose bond quota of 3.75 trillion yuan for this year.

"Smaller banks' urgent need for capital may be easing, as authorities are stepping up efforts to inject funds and recapitalize them," Pang said.

As of Aug. 31, US$1 was equivalent to 6.85 Chinese yuan.