How will China's latest policy developments affect bank operations?

For the next 12-18 months, at least.

While Moody's Investors Service expects that the overall credit profile of Chinese banks will be largely stable over the next 12-18 months, the recent policy developments in China will have a profound impact on driving Chinese banks' operating, financial and support parameters over a horizon that would start as early as, but will clearly go beyond, the coming 12-18 months.

According to a release from Moody's Investors Service, its stable outlook reflects its assessment that, on balance, the developments in monetary policy, financial supervision and market reform will help stabilize banks' operating environment, their liquidity and their capital.

"But [these] could also pressure their profitability, asset quality and support assumptions, over the next 12-18 months," says Christine Kuo, a Moody's Vice President and Senior Credit Officer.

Moody's analysis is contained in its report titled "Banking System Outlook: China," and is authored by Kuo.

The report -- whose outlook expresses Moody's expectation of how bank creditworthiness will evolve in this system over the next 12-18 months -- looks at China's banking system in terms of five factors: Operating environment (which is classified as "deteriorating"); asset quality and capital ("deteriorating"); funding and liquidity ("improving"); profitability and efficiency ("stable"); and systemic support ("stable").

On the banks' operating environment, Moody's baseline scenario assumes that China's real GDP growth will slow to just below 7% in 2015, and fall slightly lower than the 2015 figure in 2016.

The recent shifts towards more accommodative monetary and credit policies will help arrest the decelerating trend in the credit cycle and maintain broad credit growth in the range of 15%-20%. Bank credit will grow in the range of 10%-15%.

Nonetheless, overall financial leverage — as measured by total credit to nominal GDP — will likely exceed 200% in 2015; indicating a rising level of repayment risk for the system.

Here's more from Moody's Investors Service:

On asset quality in particular, Moody's report says the banks' asset quality metrics will likely continue deteriorating, in line with China's slower economic growth rate.

Problem loans will continue to originate from mostly private sector borrowers in cyclical industries such as manufacturing and trading, as well as from medium-sized and small borrowers.

In addition, problem loans from the real estate sector may start to rise from a low base if the downturn in the property market continues. The other sectors could be negatively affected too, through supply chain
linkages.

Moody's report points out that while the government's latest measures on local government financing vehicles (LGFVs) and state-owned enterprises (SOEs) will address some of the structural issues and risks banks face in
financing these borrowers, the impact of such measures on bank asset quality will not be material during the next 12-18 months. Although SOE and LGFV defaults on bank loans have been far less than those for privately owned companies, default probability for smaller and less strategically important SOEs and LGFVs appear to be rising.

On the banks' capital positions, Moody's report says banks could face a slower pace of internal capital generation on lower lending profitability and higher credit costs, but most banks will likely be able to maintain their capital ratios by managing credit growth. Some players will also likely raise common equity and other Basel III-compliant capital over the next 12-18 months; thereby helping to stabilize the industry's capital position.

Moody's report also says that the banks' funding and liquidity positions should improve, given the central bank's more accommodative stance on liquidity provision when compared with the stance it adopted in 2013
-2014. Further moves by the authorities to liberalize interest rates will also provide the banks with more flexibility to improve their pricing of liabilities to stabilize their funding base.

However, the banks' profitability levels will come under pressure because of narrowing net interest margins from the interest rate cut and deregulation, and low growth in fee incomes as a result of the tighter supervision of their wealth management business and the regulatory limits on fee charges for bank services.

On systemic support, the form of government ownership in banks could become more decentralized and effected through multiple SOEs or private companies in various industries. We see this development as a potential drivers for the government to gradually curtail its direct and overt commitment on support. However, Moody's believes the government will likely remain a major shareholder in large banks and systemic support for them will remain strong and intact, reflecting their systemic importance.

Continued market reform -- including the introduction of more components, such as deposit insurance, to facilitate orderly bank exits -- could pave the way for a more nuanced and differentiating support regime for other banks, but Moody's does not expect any meaningful reduction in systemicsupport to other banks over the horizon of this outlook.