Tighter regulatory scrutiny drags down Chinese banks' profitability

Chinese banks must brace for net interest margin pressures and declining profitability in 2018.

Tight regulations on shadow and interbank activities in China are consuming more bank capital and create a drag on profitability, which contributes to Fitch Ratings maintaining a negative sector outlook, but should also improve transparency and help to contain financial risks. "We might consider revising the sector outlook if efforts aimed at promoting deleveraging are successful and sustained."

Here's more from Fitch:

Shadow and interbank activities will continue to face greater regulatory scrutiny in 2018, at least while the authorities remain comfortable with economic growth. Accordingly, funding conditions are likely to remain tight, pointing to continued margin pressure at smaller banks which rely more on non-deposit funding. The state banks are likely to play bigger roles in providing liquidity to smaller banks.

Credit growth is likely to decelerate next year, given the tighter regulatory stance. Nevertheless, a decline in system-wide leverage ratios is unlikely, as the drop in shadow lending will be partly offset by stronger on-balance sheet lending.

In fact, we expect Fitch-adjusted total social financing (FATSF) to rise from 260% of GDP at end-2016 to around 268% by end-2017 and 274% by end-2018. Moreover, it is uncertain whether the authorities' commitment to addressing financial-sector risks would be sustained if there was a danger of missing economic growth targets.

The migration of credit back on to banks' balance sheets should improve transparency, but will also accelerate risk-weighted asset (RWA) growth. Margin pressures are also likely to weigh on net profit growth, which we expect to remain in the low single digits in 2018, even with little change in reported asset quality given continued debt write-offs and NPL disposals.

Low internal capital generation amid high RWA growth could push down capitalisation, particularly since public equity-raising remains challenging. Planned issuance of capital instruments and private share placements are only likely to support capital ratios at existing levels.

The impact of IFRS 9 adoption, effective January 2018 for major China banks that are listed in Hong Kong, could add to banks' provisioning pressures for 2018, especially on their non-loan exposure.

However, the absence of readily available market prices for many of the banks' entrusted investments - and their short duration - implies that the impact from marked-to-market adjustments may not be significant for most Fitch-rated Chinese commercial banks. We would expect more of an impact on earnings volatility at second-tier banks, given their larger exposure to entrusted investments.