Chinese banks to be hit by heightened profitability pressure as credit costs rise

That is despite slightly improved capitalization levels.

Moody's Investors Service says the full-year 2015 results of the listed Chinese banks that it rates show continued pressure on asset quality and profitability, despite slightly improved capitalization levels and ample funding and liquidity.

"The performance of headline asset quality metrics was mixed in the second half of 2015, but forward-looking asset indicators point to continued asset quality pressure over the next 12-18 months," says Yulia Wan, a Moody's Assistant Vice President and Analyst.

"We also expect increased profitability pressure in 2016, due to a continued rise in credit costs and ongoing asset and liability re-pricing, in turn reflecting not only falling domestic interest rates but also rising deposit competition in response to interest rate liberalization," adds Wan.

Moody's conclusions were contained in its just-released report on the 10 listed banks that it rates in China, titled "Chinese Banks: 2015 Results Show Continued Pressure on Asset Quality and Profitability".

Here's more from Moody's:

The 10 banks on average reported higher NPL ratios but lower formation rates of 90+ days delinquencies in the second half of 2015, although both remained above 2014 loans.

Special mention loans also increased by 20 basis points in 2H 2015 to 3.47% of total loans, indicating further asset quality pressure ahead.

Moody's further notes that banks with a focus on loans to small- and medium-sized borrowers have seen a faster rise in credit costs, because so far this credit cycle distress has been more severe among private sector companies that do not benefit from government support.

While Moody's expects SME loan books to remain pressured, it also expects to see a shift towards more distress in larger corporate loan books, especially for loans to non-strategic state-owned enterprises in overcapacity industries.

Most banks reported Common Equity Tier 1 (CET1) capital ratios for 2015 that were better or on par with those at end-2014. Moody's says this improvement was partly due to increased focus on managing risk-weighted assets. The big five banks and China Merchants Bank Co., Ltd. (Baa1 negative, baa3) also benefited from the implementation of internal ratings-based approach in capital calculation.

The big five banks remain highly liquid and less reliant on the interbank market for funding than their smaller counterparts, providing them with a buffer against potential tightening in system liquidity as capital flows become more volatile.

However, some joint-stock commercial banks that have a higher reliance on interbank funds and increasing investments in loans and receivable could see liquidity deteriorate, says Moody's.

These investments -- most of which are packaged by other banks, securities firms and trust companies -- are associated with poor liquidity, and their inclusion would have pushed several banks' adjusted loan-to-deposit ratios close to or in excess of 100%.

And while Moody's expects the central bank will inject liquidity into the market when necessary, it also expects to see more frequent episodes of tightening funding conditions due to volatility in capital flows and the banks' growing portfolio of illiquid investments.