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S&P: Smaller Chinese banks may lack sufficient capital buffers if default rises

Smaller banks in China may not have sufficient buffers against bad debt if lingering economic uncertainties push more lower-risk borrowers into default, according to analysts at S&P Global (China) Ratings.

The Chinese accounting standards require banks to set aside loan loss provisions only for nonperforming loans that are 90 days past due. However, well-collateralized loans that show signs of borrowers' financial troubles are classified as "special-mention loans," which are considered less risky and not required to be provisioned.

As China's economic growth continues slowing and global trade frictions linger, "there is a higher chance of special-mention loans becoming nonperforming loans," said Li Zheng, a financial institution analyst at S&P Global (China) Ratings, during an Oct. 24 webcast focusing on Chinese banks' credit quality.

The country's city and rural commercial banks, many of which have lower reserve coverage of troubled loans than larger national lenders, are likely hit harder if their total overdue loans rise, Li said.

"Loan loss provisions among some of China's city and rural commercial banks are not enough to cover total overdue loans," said Li.

Li did not name the potentially affected banks, but said that the nonperforming loan ratios among smaller Chinese banks are likely to increase also because they continue to improve their nonperforming loan classification practices.

Meanwhile, for state-owned banks and most joint-stock banks, their loan loss reserve coverage, which comprises a bank's pretax profit and loan-loss provisions, are generally higher, Li added.

The increasing pressure to maintain sufficient reserve coverage could also force smaller banks to set aside more earnings as reserve, according to Wang Yifu, a senior analyst with S&P Global (China) Ratings.

It will likely hurt smaller banks' profitability going forward, and widen the gap of credit costs between large and small banks, Wang said during the same webcast.

The city and commercial banks are also facing more challenging liquidity and funding environment "in the foreseeable future," as investors become more cautious about small banks' credit risk after the Baoshang Bank Co. Ltd. case, according to Wang. Earlier this year, Baoshang Bank was taken over by the central government due to rising liquidity and credit risks.