How bad will the rest of 2016 be for Chinese banks?

Fitch expects subdued earnings growth to persist.

Major Chinese banks' results for 2015, which are due to be released next week, should show continued subdued earnings growth amid margin compression and asset deterioration, says Fitch Ratings.

Fitch expects these trends to continue in 2016, underscoring our negative sector outlook. Chinese bank profits are likely to decline this year unless authorities relax the minimum NPL provisioning requirement of 150%.

Here's more from Fitch:

System-wide net profit for China's banking sector grew by only 2.4% in 2015 as net interest margins declined by around 12bp to 2.53%. A combination of interest-rate cuts and worsening asset quality will continue to have an impact on profitability in 2016. The quarterly run-rate in reported NPLs decelerated in 4Q15, while we believe this is due partly to more substantial NPL write-offs/disposals towards the end of the year as banks struggled to meet their provisioning requirements.

The provision coverage ratio at state banks and joint-stock banks had fallen to 172% and 181%, respectively, on average by end-2015. The need to maintain this ratio above 150% will restrain earnings growth in 2016 - unless this ratio is relaxed. The floor could also encourage further under-reporting of NPLs.

Reports from local media today suggest that the authorities are considering lowering the provisioning requirement to 130%-140% for selected banks. Fitch believes a relaxation would run counter to a need for conservative provisioning at a time when asset quality is deteriorating and the concerns around the true level of NPLs in the system.

That said, such changes in regulations in isolation should not have major rating implications as our analysis takes into account factors and performance trends beyond reported profitability figures.

The reduction in the interest burden for borrowers following successive rate cuts and other monetary loosening through 2015 should keep reported NPLs below 2% for most banks. The system-wide NPL ratio and "special-mention" loan ratio were 1.67% and 3.79%, respectively, at end-2015, up from 1.25% and 3.11% a year ago.

The trend in overdue loans may paint a more interesting picture, though, as Chinese banks tend to report very similar NPL ratios despite varying levels of overdue loans.

Furthermore, changes in investment income or revaluation reserves may also signal deterioration in the quality of non-loan credit, especially in mid-tier banks. This may take the form of investment receivables representing a growing share in the asset mix.

Loss-absorption trends could be a key rating driver for most banks while profitability and asset quality weaken and pressure on provisioning increases. Major Chinese banks were key issuers of Additional Tier 1 (AT1) instruments in 2015, owing to increased pressure to shore up capital due to balance-sheet growth and slowing profitability.

However, as long as assets continue to grow at a rapid pace and profitability remains subdued, there will be little underlying improvement in core capitalisation levels. Such capitalisation pressures continue to weigh on Fitch's assessment of Chinese banks' Viability Ratings, especially those of the mid-tier banks.

The expansion of non-interest income is likely to be a key earnings driver in 2015-2016, especially for mid-tier banks, driven by strong card and underwriting fees as well as the sale of wealth management products (WMPs). But Fitch views excessive reliance on WMPs as risky for banks, and a significant shift in the business towards this area could lead to increased credit and liquidity risks.