China's new loan prime rate to further hurt banks' profitability

The decline in average loan yields will deepen as more loans are repriced.

China’s new loan prime rate (LPR), which has brought down lending costs, will further weaken banks’ profitability as more loans come to be repriced on lowered LPR, reports Moody’s Investors Service.

"We expect banks' lending income will weaken as more outstanding floating rate loans switch to being LPR-based and as the government grants loan-rate caps and regulatory forbearance on loan payments to support economic recovery," says Yan Li, a Moody's assistant vice president and analyst.

The LPR, which was reintroduced in August 2019, is now broadly used as the reference rate of Chinese bank loans. More than 90% of new floating interest rate loans already repriced as of end-2019.

The People's Bank of China (PBOC) is expected to continue using the LPR to drive down lending rates, according to Moody’s report.

“The central bank has mandated that banks use the LPR as the benchmark for all new floating interest rate loan contracts that commence after 1 January, and all outstanding loans must be repriced under the new benchmark by August,” the report read.

As a result, Moody’s Li now expects the decline in average loan yields will quicken as more loans are repriced under it, especially with the LPR having declined by 46 basis points (bp) between August 2019 and June 2020.

Profitability pressure will vary across banks, with small banks under more pressure in an interest-rate-sensitive market as they rely more on interest and investment income.

To make up for lost profit, banks may shift their risk appetite in terms of credit selection, which could challenge their loan underwriting and raise their asset risk, warned Li.

Some banks could also choose to change the tenor of their loan portfolios' composition to adjust the exposures to be repriced. This could add to their interest rate risk and asset-liability duration mismatch, which they may not be able to hedge effectively given China's underdeveloped derivatives market as well as the banks' limited experience using this.