Chinese banks:Banking sector quarterly –Financial deleveraging impact half-shown

Commercial banks 1Q17: a decline in PPOP offset by much lower credit costsThe CBRC released 1Q17 operating data for China’s all commercial banks, withquarterly net profit of Rmb493bn, up 4.6% yoy. The bottom line was mainlydriven by lower credit costs (89bps vs. 122bps in 1Q16) to offset a decline inPPoP by 1.4% yoy. In line with listed banks, the results highlighted the impactof financial leveraging, which has led to notable NIM contraction and slowerasset growth. Looking ahead, we expect financial deleveraging to continue,which would result in capital and asset quality pressure for smaller banks. Forthe entire sector, we remain Neutral, but we continue to prefer retail-orientatedbanks (Big Four/CMB).

    NIM compression on higher funding pressureNIM for the entire banking sector was down by 19bps qoq to 2.03%. Webelieve this was mainly driven by higher market rates, which pushed upfunding costs for smaller banks. Indeed, all smaller banks, including joint-stockand city/rural banks, saw their NIM dropping 37bps qoq to 2.01% in 1Q17 (Fig.

    4). In the near future, NIM pressure should persist given higher market rates.

    For instance, the issuance cost of interbank CD has hiked to 4.7% in May (Fig.

    5). In contrast, the Big Four banks recorded an NIM recovery of 2bps qoq.

    Who is lending? Smaller banks slowed down while the Big Four stepped upChina’s domestic banking assets amounted to Rmb232tr as of March 2017, up14.1% yoy. Total banking asset growth slowed from 16.5% yoy in 2016, whichwas mainly dragged down by slower growth of smaller banks. Total assets ofjoint-stock and city/rural banks (45% of total banking assets) slowed notably to16% yoy in 1Q17 from 19% in 2016 (Fig. 10). This is mainly because smallerbanks slowed shadow banking asset growth when facing tighter regulations(Fig. 11). In contrast, the Big Five banks (36% of total banking assets) aregrowing their asset base modestly faster at 10.6% yoy vs. 6% in 1H16.

    Notable drop in NPL formation; but shadow banking asset quality may weakenThe banking sector recorded a notable decline in NPL formation in 1Q17 to49bps of the average loan balance from 117bps in 1Q16 (Fig. 6), according toour estimate. However, it may be too early to visualize the peak of the creditcycle. We believe that China is transitioning between two credit cycles for theprivate sector and SOEs. The private sector credit cycle may have peaked out,but the SOE credit cycle has just started. While SOEs’ profits have recoveredrecently on price reflation, their debt servicing ability remained stretched. Inaddition, the tightening regulations are likely to lead to less funding availabilityfor shadow banking borrowers, which may weaken the asset quality of bankswith higher shadow banking exposure.

    Financial deleveraging is only halfwayWe expect the financial deleveraging to continue as the goal of bringing downfinancial leverage has not been achieved and the government’s tolerance levelhas not been hit. If measured by the credit-to-deposit ratio, financial leverageremained elevated at 114% vs. the 81% it should be in theory. Moreover, thegovernment tolerance level includes property market correction and bank runsin the wholesale funding market, which seems remote as of now. We continueto prefer deposit-funded banks with stronger capital i.e. CMB/ICBC/BOC/CCB(in pecking order), while remaining cautious on the rest.