New Chinese LDR rules could potentially boost bank asset quality risk

Bank credit profiles could be hurt.

The 30 June decision by the China Banking Regulatory Commission (CBRC) to amend the calculation of bank loan/deposit ratios (LDRs) is part of an ongoing targeted easing of liquidity conditions. Spurring growth of lending to small/micro enterprises (MSEs) has the potential to hurt bank credit profiles over the medium term.

According to a release by Fitch Ratings, the LDR change targets MSEs and the agricultural sector while continuing to restrict the growth of total credit, as with an earlier selective reduction in reserve requirement ratios.

The article also noted that the policy decision reflects the ongoing challenge of regulators as they seek to rebalance the economy away from capital investment and reduce the role of the shadow banking sector while avoiding a sharp economic slowdown.

Further, the release said that the new calculation excludes foreign-currency loans and deposits while also relaxing some of the qualifications for both the numerator and denominator of the ratio.

Six types of loans targeting the agricultural and the MSE sector will be removed from the numerator, and negotiable certificates of deposits (NCDs) and deposits from an overseas parent bank will be allowed as part of the denominator.

The action may result in lower reported LDRs for some banks, Fitch Ratings said, but will not alter liquidity positions in the near term, nor is it certain that it will give a meaningful boost to growth in loans to borrowers most in need.

Here's more from Fitch Ratings:

As a standalone change, the decision should not have a significant impact on the asset-risk profiles of the banks in Fitch's portfolio.

That said, this is part of a wider policy trend toward re-orienting bank lending toward MSEs. In addition to changes to LDRs and RRRs which ease MSE credit, regulators have also lowered the risk weightings applied to MSE loans used in calculating capital ratios.

Forthcoming interest-rate liberalisation will also incentivise banks to increase exposure to higher-yielding sectors, which is likely to include MSEs.

MSEs tend to be more vulnerable during economic downturns, and more sensitive to economic cycles.

So this could have a negative impact on the credit profile of the banking sector over the medium term, by further enabling increased credit for a sector which is generally associated with higher credit risk.

There are also risks should loans to MSEs be re-routed into property or other speculative investments such as shadow banking products, which would undermine the government's objectives to reduce funding to these areas.