Chinese banks at risk of being collateral victims of economic stimulus policies

Economic stimulus policies announced by China’s government this week could end up unintentionally hurting the country’s banks, which now face the prospect of reduced margins and deteriorating mortgage quality, analysts say. Despite the intentions to boost the economy, the fallout on the banking system could complicate the financial outlook in the coming months.

Net interest margins, a crucial indicator of bank profitability, could be reduced by up to a fifth of a percentage point. This translates into a decline of 20 basis points, according to an estimate by S&P Global Ratings. This adjustment could have a significant impact on return on assets, which is expected to fall by 14 basis points, leading banks to need to reduce deposit rates by a quarter of a point to neutralize this effect. However, this strategy would be difficult to implement, especially for those banks that have weaker deposit bases and lower regulatory buffers. This is the warning issued by the rating firm’s analysts after the new stimulus measures were announced.

The net interest margin is the difference between what banks pay their depositors and what they earn by making loans. This margin is a key source of income for financial institutions and a barometer of their financial health. But since the recent intervention by the People’s Bank of China, which ordered banks to reduce mortgage rates on existing loans by half a percentage point without changing deposit rates, this margin has become even narrower.

Fitch Ratings, another major credit rating firm, shared its analysis on the effect of policies on Chinese banking institutions. According to Vivian Xue, head of financial institutions in Asia-Pacific at the firm, banks’ net interest margins are expected to remain under pressure during the second half of the year, possibly extending into 2025. This pressure comes mainly from the mortgage rate cuts already implemented and government directives to reduce borrowing costs, measures aimed at supporting the economy amid a slowdown.

Xue also noted that while these measures negatively impact margins, some of this impact could be offset by a future reduction in reserve requirements and deposit rates. The latter suggests that the People’s Bank of China could further ease its monetary policy to ease the strain on banks, allowing them to operate with higher levels of liquidity and lower funding costs. However, the effectiveness of these potential offsetting measures remains to be seen, especially if the economy fails to recover as quickly as expected.

In an environment where banks are already facing challenges related to bad debts and asset quality, the recent measures add an additional layer of complexity. Mortgage rates, which have been an important pillar of banks’ profits, are now at the centre of a difficult dynamic. Cutting mortgage rates not only reduces interest income from loans already granted, but could also influence borrowers’ risk perception, at a time when some segments of the housing market are showing signs of fragility.

Indeed, the property market in China has been under intense pressure in recent years, with defaults rising and demand slowing in several key cities. This has led to rising debt levels and a decline in homeowners’ ability to repay, threatening to lead to a surge in non-performing loans in banks’ portfolios.

The combination of lower interest margins, a possible decline in the quality of mortgage loans and the need to comply with financial regulations makes the immediate future for Chinese banks uncertain. Although authorities are taking steps to stabilise the economy, banks are caught in a delicate balance. On the one hand, they must support economic recovery by providing cheaper loans; on the other, they need to protect their own profitability and financial stability in an increasingly challenging environment.

Stimulus policies that focus on making loans more accessible to businesses and consumers may have a positive impact on the overall economy, but at the expense of bank profitability. This reality could lead to increased competition among banks to attract and retain deposits, which could further erode profit margins. Moreover, banks with weaker deposit bases will be the most vulnerable in this environment.

As the year progresses, attention will focus on how Chinese banks manage these challenges, adjusting to an evolving regulatory and economic environment. The decisions they make in the coming months will be crucial not only to their own survival, but also to the success of the Chinese government’s broader economic policies. Meanwhile, the banking sector faces a complex landscape, with risks that could manifest themselves in the long term if the economic recovery does not take hold quickly.