Chinese banks to continue to struggle with declining profitability this year

Blame it on the tight market liquidity.

Chinese banks will struggle to avoid further declines in profitability this year if tight market liquidity aimed at slowing further build-up in leverage remains in effect, as it is likely to increase funding costs, Fitch Ratings says. There is limited scope to pass higher funding costs to borrowers because corporate leverage and associated interest burdens are already high.

Here's more from Fitch Ratings:

Net interest margin contraction and large loan provisions led to declines in all Fitch-rated Chinese banks' ROA and ROE in 2016, which we expected. This year, higher interbank interest rates will mostly affect the smaller banks, which tend to be more reliant on wholesale funding facilities, and most vulnerable to liquidity squeezes.

We expect smaller banks' margins will erode further in 2017 but larger banks, typically net providers of market liquidity, may see margins stabilise or slightly increase.

Recent reported asset quality metrics were largely flat quarter-on-quarter, but this does not indicate a stabilisation in asset performance, in our view. We believe it has been driven by costly debt resolution measures such as the disposal of non-performing loans and debt-to-equity swaps, as well as delays in the classification of weakened borrowers.

Most banks lowered their provision coverage last year to avoid declines in reported net profits. However, there is little room to relax coverage further this year as coverage ratios have typically fallen close to the sector's 150% regulatory minimum. Notably, Industrial and Commercial Bank of China's (ICBC) coverage ratio fell to 137% at end-2016, down from 156% at end-2015, while it reported just a 0.5% increase in net profit.

We note the delay in designating domestic systemically important banks (D-SIBs) in China provides temporary relief for those which otherwise were supposed to comply with a minimum loan loss reserve of 2.5% by end-2016. Among the state banks, ICBC, China Construction Bank and Bank of Communications did not meet this requirement at end-2016.

Loan-to-deposit ratios are stable for the largest banks but notably higher for some mid-tier banks, reflecting their aggressive loan growth - a trend that is likely to continue. This is negative for their standalone credit profile. Mid-tier banks have also continued aggressive growth in entrusted investments, which are often quasi-loan substitutes with lower risk weights, and effectively help banks to bypass lending restrictions and capital constraints to pursue growth while profitability and capital are under pressure.

Exposure to wealth management products (WMPs) is stable for state banks but still growing for mid-tier banks, and we expect this growth to continue in 2017 despite new Macro Prudential Assessment (MPA) rules incorporating off-balance sheet WMPs into the credit calculation for regulatory purposes. Most banks do not expect the new MPA framework to alter their business strategies and some are even planning to increase their focus on off-balance-sheet credit given the higher yields it offers.

Risk-weighted assets relative to total assets declined for most banks in 2016, as mortgages (which have a 50% risk weight) and entrusted investments were the main drivers of on-balance-sheet growth. We expect mortgage loans will remain the key loan growth driver in 2017, but the growing presence of non-loan and off-balance-sheet credit will continue to add risks.

Overall we believe banks are targeting a similar pace of credit growth in 2017, in line with our base-case scenario where credit continues to outpace GDP growth over the medium term. We view such rapid growth and rising system leverage as unsustainable. It weighs negatively on the sector's operating environment and is a key rating constraint for Chinese banks' viability ratings.