Increasing nonperforming loans, rise of Internet finance among major challenges forsector this year

The nation pursued financial reforms in an orderly manner in 2014 by introducing measures oninterest rate liberalization, expanding the scale of direct financing and accelerating the two wayopening-up of its capital market.

With the deepening of financial reforms and continued slowdown of economic growth, Chinesebanks will face increasing pressure from bad loans, narrowing of net interest margins andfinancial disintermediation this year.

To handle these challenges, banks must restructure their asset portfolios, focus on financialinnovation and strive to operate across multiple markets, said bankers and researchers.

Here are the major challenges facing the Chinese banking industry and possible solutions:

Bad loans

Chinese banks will face greater pressure from bad assets this year. Economists said thatnonperforming loans may rise further and the exposure to bad debts may accelerate this year.

NPLs and the overall NPL ratio of commercial banks increased continuously starting in the firstquarter of 2012. As of Sept 30, 2014, NPLs amounted to 766.9 billion yuan ($124 billion),compared with 563.6 billion yuan a year earlier. During the same period, the NPL ratio increasedfrom 0.97 percent to 1.16 percent, according to the China Banking Regulatory Commission.

Wen Bin, principal researcher at China Minsheng Banking Corp Ltd, said that economic growthhas continued to slow since the beginning of 2014. As China has not yet found a new growthdriver, traditional industries are facing elevated pressure of structural readjustment, and smallerbusinesses in related sectors are facing the threat of being acquired.

If the economy does not stabilize this year, the credit risk of some industries and companies willrise during their process of transformation.

"Although nonperforming loans and the NPL ratio are expected to rise in 2015, the overall riskcan be controlled as long as China's economy does not suffer a hard landing this year and theloan-loss provisions remain at a high level, which was 247 percent as of the end of September2014, "Wen said.

Cao Yuanzheng, chief economist at Bank of China Ltd, said that banks can handle debt risksbecause they had set aside more than 2.5 percent of their total lending book to cover potentialbad loans.

"The average NPL ratio for banks nationwide was 1.08 percent at the end of June and webelieve the probability of the ratio hitting 2.5percent is extremely low," Cao said.

Responding to the changes in macroeconomic and financial conditions, domestic banks workedharder to manage their asset quality and accelerated their resolution of bad loans.

Zhang Jinliang, executive vice-president of Bank of China Ltd, told a news conference in Augustthat the bank had strengthened its supervision and management of key regions, areas andcustomers to reduce financial risks as early as possible.

Commercial banks also strengthened the collection and resolution of nonperforming assets andimproved their NPA cash recoveries. They actively resolved NPAs by various means such asbulk transfers and write-offs.

In the first half of 2014, Bank of China resolved NPAs worth 27 billion yuan. The Agricultural Bankof China Ltd wrote off 6.9 billion yuan of bad debts and transferred 8.3 billion yuan of them.

Interest rate liberalization

Interest rate liberalization caused banks' net interest margins to contract and thus put banks tothe test in terms of their direction of development and competitiveness.

Bank of Communications CoLtd's net interest margin dropped 15 basis points from a yearearlier to 2.21 percent in the first three quarters of 2014.During the same period, ChinaMerchants Bank Co Ltd's net interest margin fell 36 bps to 2.30 percent.

"Such changes will have a big impact on bank profitability. Most banks' profit growth will drop tosingle-digit levels in 2015, while the majority of listed joint-equity banks still had double-digitgrowth from January to September last year," said Wen of China Minsheng Bank.

To make sure that the scale of lending and returns on loans remain at an adequate level, bankswill inevitably adjust their customer structure by increasing the number of small and medium-sizedclients, he said.

Previously, banks focused on large companies, but now they are being forced by interest rateliberalization to increase their lending to small companies, which had to borrow from privatesources at high interest rates when they could not obtain bank loans.

The pressure of reduced earnings also forces banks to increase revenues from intermediarybusinesses such as financial derivative transactions. Intermediary businesses have huge growthpotential and challenge each bank's risk management capability, especially in terms of talentreserves, Wen said.

The non-interest income of China Minsheng Banking Corp Ltd grew 28 percent year-on-year inthe first three quarters of 2014. It accounted for 32.5 percent of the bank's operating revenues, up3.01 percentage points from the previous year.

In the meantime, China Merchants Bank's income from fees and commissions rose nearly 58percent, accounting for 27.4 percent of its operating income.

Banks are building a platform across diversified financial sectors including the securities,insurance and trust sectors. In the future, banks may cooperate with licensed non-bank financialinstitutions and regulators are expected to allow capable banks to develop mixed operations,Wen said.

Financial disintermediation

Financial disintermediation will accelerate this year, as more policy changes may arise in the fields of Internet finance and private banks. It will take more lending business away from banks and stimulate banks to make innovations

A huge amount of capital has moved from banks to the capital market, turning from debt capital to equity capital, said WuQing, deputy director of banking research at the Development Research Center of the State Council.

"That is in line with the orientation of our country's financial policy. We hope that our financial system will have a transition from the bank-led model to a market-driven one," Wu said.

From January to November 2014, the bond market grew 20.5 percent year-on-year, with bond issues of 10.2 trillion yuan, said the People's Bank of China in an announcement published on its website.

Different types of online financial businesses also expanded rapidly over the past year.

As of the end of November, the number of peer-to-peer lending companies stood at 1,540, with out-standing loans hitting 89.64 billion yuan, up 20 percent month-on-month. Such outstanding loans probably reached 100 billion yuan by the end of 2014, according to data from wangdaizhijia.com, a Web portal that tracks the industry.

The popularity of crowd funding and online payments is also on the rise. As of Nov 30, China had 122 crowd funding platforms. The 15 leading project-oriented platforms raised 56.65 million yuan for 347 projects in November.

During the first 11 months of last year, the growth of yuan deposits slowed down. Central bank statistics showed that yuan deposits increased by 8.76 trillion yuan year-on-year, lower than the growth of 11.41 trillion yuan a year earlier.

Lian Ping, chief economist at Shanghai-based Bank of Communications Co Ltd, said financial disinter mediation will lead to slower growth of deposits and the loss of high-quality clients.

"Banks should make full use of their comprehensive advantages to provide a package offinancial services, so the clients' money will stay with the banks. They should also apply Internettechnologies, business philosophies and processes more often to traditional banking servicesand develop Internet finance led by banks," Lian said.

Many banks are setting up their own Internet finance companies or cooperating with othercompanies that specialize in this field.

Baoshang Bank Ltd, a joint-equity commercial bank best known for its micro-business financeservice, launched an online wealth management platform called Xiaoma Bank in June, offeringdebt products and money-market funds.

Instead of assessing a client's risk profile at a bank outlet, Xiaoma Bank offers online risktolerance assessments to its clients and recommends different portfolios of financial products todifferent clients according to their characteristics.

Industrial Bank Co Ltd, a listed bank based in East China's Fujian province, launched a directbank in March, offering securities investment funds, money market funds, bank acceptancepledge financing and wealth management products online.

As of the end of November, its customers had exceeded 500,000 and assets reached more than50 billion yuan.

Yang Zhong, general manager of the electronic banking department at Industrial Bank, said: "Whether or not a bank could ride the wave of Internet development and push forward reforms ina timely manner in terms of standardized financial products and services will decide whether itwill succeed amid fierce competition."