Chinese Banks’ Profits Soar

But new regulations may crimp profit growth by year end by Leo Zhang

Although most top Chinese banks have reported staggering first-quarter earnings， the profit picture may not be so bright come year end with new regulations that would tighten capital requirements already in the pipeline， which will mean banks will have to alter their business models.

The new rules were announced in May by the China Banking Regulatory Commission just days after China’s top lenders reported January-March net profits that beat analysts’ estimates. Based on the Basel III global regulatory framework， the rules are part of ongoing efforts to curb risks in the financial system and stipulate that the minimum capital adequacy ratio for large-sized national lenders will be 11.5%， while it will be 10.5% for all other lenders. The Commission is also requiring banks to set aside a provisional amount equivalent to 2.5% of total loans as well as 150% of their bad loans and that the leverage ratio should be no lower than 4%.

Chinese banks have until January 2012 to adopt the new capital rules. Major lenders must meet the standards by the end of 2013 while smaller lenders will be given three more years to reach the goals.

“The new capital requirements are largely in line with market expectations， showing regulatory determination to rein in risks，” said Luo Weiming， a trader with Guosen Securities (國信證券). “They are tougher， but banks have enough time to prepare for them.”

The higher-than-expected profits posted by the Chinese banks for the first quarter are due in large part to interest rate hikes – China has raised interest rates four times since October of last year in an effort to tighten its monetary policy. The rate hikes boosted banks’ profits by increasing their interest margins. The average net interest margin at Chinese lenders in the first quarter hit 2.5%， about 10 basis points higher than a year before. Banks were also able to ask for higher margins from companies needing capital as curbs on loans made it difficult for businesses to get credit.

Industrial and Commercial Bank of China (中國工商銀行/ICBC)， the world’s largest bank by market value， said its net profit rose 29% from a year earlier to RMB 53.8 billion (USD 8.3 billion)， helping it retain the title of the globe’s most profitable lender. China Construction Bank (中國建設銀行/CCB)， the country’s No.2 lender， posted net profits of RMB 47.2 billion， a 34% rise. Net income at the Bank of China (中國銀行/BOC)， the nation’s third largest bank， jumped 28% to RMB 33.44 billion. Agricultural Bank of China (中國農業銀行)， the fourth-largest， posted first quarter net profits of RMB 34.07 billion profit in the first three months， an increase of 36%. Bank of Communications (交通銀行/BoCom)， the fifth-largest， said its net earnings rose 27% to RMB 13.3 billion.

Some analysts believe that the banks’ first quarter profits are an anomaly， and they expect the interest spread and profit margins to grow more slowly or even drop in the second half of this year as competition heats up and consumer prices slowly come down.

“Banks are expected to face tougher competition in luring deposits and that could partly offset any increase in the interest margin，” said Jin Lin， an analyst with Orient Securities (東方證券). “The net interest spread is largely in line with CPI growth， which may remain stable the rest of this year.”

Analysts expect that the new capital requirements will likely force Chinese banks to gradually boost their non-interest businesses as profits derived from credit growth may face downward pressure in the next few years. Currently， banks’ non-interest income comes mainly from settling and clearing， credit card and financing consulting services.

“Banks should further diversify by setting up or acquiring businesses including insurance， trust， financial leasing and securities investment，” say Li Feng and Li Shaojun， analysts with Minsheng Securities (民生證券)， in a note to clients. “They should also reduce risks in their loan business by extending more credit to industries that will receive government support， such as modern agriculture and energy supplies.”

Big banks such as ICBC and BOC have already tapped financial leasing businesses while smaller lenders have gradually shifted their lending focus to small- and medium-sized enterprises with growth potential. And in fact the banking regulator has already set different capital adequacy ratio targets for the country’s five biggest lenders based on their risk-control conditions and asset quality.

According to a Bloomberg News report， authorities have asked ICBC， CCB， BOC and BoCom to maintain a capital adequacy ratio of at least 11.8% in 2011， while AgBank should keep a ratio of 11.7%. ICBC’s capital adequacy ratio was 12.27% at the end of 2010. CCB’s ratio was 12.68%. The ratios were 12.58% for BOC， 11.59% for AgBank and 12.36% at BoCom， according to the lenders’ annual reports.

An earlier Reuters report， citing an internal document， disclosed that should extreme conditions arise the banking regulator is prepared to adjust the banks’ capital adequacy ratio to 14%.

“Setting different capital adequacy ratio targets will help lower volatility in the banking industry and ensure banks gain steady returns，” said Luo Yi， an analyst with China Merchants Securities (招商證券). “We expect the new rules to slow loan growth to an average 12 to 15% in the next couple of years.”