Tightening market liquidity and regulatory oversights may force small banks in China to merge for survival in 2020, analysts said.

The financial health of small, less-capitalized banks has worried investors since the government-led seizure of city commercial bank Baoshang Bank Co. Ltd. in May 2019. It was followed by state-backed bailouts of Bank of Jinzhou Co. Ltd. in July, HENGFENG BANK CO. Ltd. in August and Harbin Bank Co. Ltd. in November. Yingkou Costal Bank Co. Ltd. was also reportedly struggling to meet withdrawal demands in November.

The People's Bank of China on Nov. 25, 2019, identified 586 "high risk" banks and financial companies, many of which are small rural commercial banks. The central bank said they needed structural changes, although the sector's risks were still manageable. The PBOC did not name the banks.

The Chinese authorities are reportedly considering a package of measures to address risks at small banks, which may include encouraging problematic banks to merger or restructure, according to a Bloomberg report in November 2019.

"It will be a harsh winter for city commercial banks [following the liquidity problems faced by Baoshang Bank and other small lenders]," said Zhang Jiqiang, an analyst with Huatai Securities.

Zhang said pressure on small banks to survive will continue to increase amid stricter banking regulations and growing competition from larger banks as well as internet-based finance companies. Tight market liquidity, slowing economic growth and elevated corporate defaults leave those banks even more vulnerable in tough times.

Increasing pressure to survive

Smaller banks in China have limited depositor bases, and often turn to the interbank market or larger lenders for short-term funding to meet their lending needs. As the confidence in the sector is shaken, smaller lenders are facing fewer willing lenders and higher funding costs despite Beijing's continued efforts to increase market liquidity. Meanwhile, the Chinese authorities have tightened their scrutiny of smaller banks in a bid to prevent or preempt more fallout.

"Large banks may be encouraged to take over smaller, troubled banks, or participate in strategic restructuring, whereas small regional banks in neighboring areas are also likely to merge in pursuit of synergy effect," Zhang said.

Iris Pang, Greater China Economist at ING Bank, also expected more mergers among small banks next year. It is largely also because the government might want to avoid the repeat of market repercussion following its unexpected takeover of Baoshang Bank.

Pang added that the regulators took a softer stance in handling Bank of Jinzhou case where subsidiaries of state-owned Industrial & Commercial Bank of China Ltd. and China Cinda Asset Management Co. Ltd. agreed to rescue the struggling lender by acquiring a stake in it.

Wu Fan, vice president of Bank of Guizhou Co. Ltd — a Chinese city commercial bank that raised HK$5.46 billion from a Hong Kong IPO in December 2019 — believes that the confidence shock from the Baoshang Bank case is already under control, and that small banks' credit risk is manageable for regulators.

Meanwhile, Wu stressed that the bank will be "very careful" with potential risk of financial contagion and has stepped up risk management measures. Bank of Guizhou disclosed in its IPO prospectus that it has written down 147.8 million yuan for its deposits totaling 1.45 billion yuan in Baoshang Bank.

Liao Zhiming, an analyst at Tianfeng Securities, believes that improvement in corporate governance plays a key role in preventing financial risk, as some risks come from loopholes in banks' operation or information disclosure rules.

The quality of corporate governance will improve alongside with fundraising activities such as IPO, equity financing or debt financing, as such deals will encourage better information disclosure, according to Liao.

On the local government level, authorities have been encouraging regional banks to accelerate IPO plans or introduce strategic investors, as lenders would be able to replenish capital and improve capital adequacy ratios through such plans, according to Zhang.

As of Jan. 1, US$1 was equivalent to 6.96 Chinese yuan.