Outlook for China's banking system improves for the first time since 2015

Moody's has revised its outlook for to stable from negative.

"The revision reflects our expectations that nonperforming loan formation rates will be relatively stable at current levels," says Yulia Wan, a Moody's Assistant Vice President and Analyst.

Moody's points out that by comparison, the banks' asset quality had deteriorated more rapidly during 2015 and also in the first half of 2016.

"The stable outlook is also based on our assessment that the government's adoption of more coordinated policy measures to curb shadow banking will help mitigate asset risks for banks, and address some key imbalances in the financial system," adds Wan.

Here's more from Moody's:

The stable outlook is based on Moody's assessment of five drivers: Operating Environment (stable); Asset Quality and Capital (stable/stable); Funding and Liquidity (deteriorating); Profitability and Efficiency (deteriorating); and Systemic Support (stable).

On the operating environment, Moody's says that conditions are stabilizing, helped by government policies to support growth and reduce systemic financial risks.

In particular, growth will come from policies to encourage investment in specific sectors such as infrastructure and the construction of self-occupied residential properties. And, the banks will benefit from the Chinese regulators' stronger efforts to address two long-running financial risks: the accumulation of financial leverage among corporates, and the strong growth in shadow banking.

Moody's report also says that asset risks will moderate over the next 12-18 months, while capitalization will stay stable. Specifically, overall delinquency rates will stabilize as corporate profit continues to recover, helped by stable and solid economic growth, steady commodity prices and a slower increase in corporate leverage.

As for funding and liquidity, small and medium-sized banks that have increased their reliance on short-term, confidence-sensitive funds to support illiquid assets in recent years will continue to face tight liquidity conditions.

On profitability and efficiency, Moody's report says that the banks' profit growth will be constrained by continued pressure on net interest margins (NIMs) and slower growth in fee income.

In particular, pressure on NIMs will continue, as funding costs increase in a tighter liquidity environment. Growth in net fees and commissions income will also slow because stricter regulations on shadow banking will reduce growth in income from fees for wealth management, consultancy and custodian services.

Moody's expects the Chinese government will remain a key shareholder of major banks and continue to be committed to providing strong support for the banks in times of stress. Moody's view takes into account the banks' size and systemic importance, and the government's policy priority of maintaining systemic stability and public confidence in the banking system.

However, government support for smaller banks will likely become more selective, following the introduction of deposit insurance scheme in May 2015.

The change in Moody's outlook for Chinese banks follows Moody's individual rating actions on medium-sized Chinese banks in October 2016 and big five banks in May 2017. As part of the rating actions, Moody's changed most of the banks' ratings outlooks to stable from negative. Banks with stable outlooks now account for a combined 89% of total assets held by Moody's-rated banks in China.