China's latest economic stimulus measures may come at a cost to the country's banking sector. Analysts warn that policies meant to boost the economy could squeeze banks' profit margins and degrade asset quality.

The People's Bank of China (PBOC) recently told banks to reduce mortgage rates by 0.5 percentage points on existing loans while keeping deposit rates unchanged.

This move, part of a broader stimulus package, is expected to put significant pressure on the net interest margins (NIM) of banks.

Put simply, NIM is the difference between what a bank earns from loans and what it pays for deposits. The bigger this difference, the more profit a bank makes.

S&P Global Ratings estimates that banks' NIMs could drop by 20 basis points.

That means the average deposit rate would need to fall by a quarter point to “neutralize the impact, which would be challenging for banks with weaker deposit base and regulatory buffers.”

Vivian Xue, director of Asia-Pacific financial institutions at Fitch Ratings, expects banks' NIM to be squeezed into the second half of 2024 and even in 2025.

State-controlled banks report lower margins

China's largest state-controlled banks are already feeling the pinch. Five out of six banks reported declines in their NIM in first-half results, except for the Agricultural Bank of China.

In addition to rate cuts, the government has reduced the down payment ratio for second homes from 25 per cent to 15 per cent, a drastic move to encourage buyers to return to the property market.

This could ease the mortgage burden for 150 million people, according to the PBOC. However, banks could be taking on more risk by lending more money relative to the value of the homes.

"Over the long run, we are mindful of the lower down payment ratios, especially on second homes in lower-tier cities, if the property prices do not stabilize," S&P analysts cautioned.

Change in reserve requirement ratio offsets losses

The picture, however, isn't entirely bleak.

The central bank's decision to cut the reserve requirement ratio by half a percentage point could provide some relief for banks feeling the squeeze.

"We expect this to be partly offset by further reduction in the reserve requirement ratio and deposit rates," Xue said.

Moreover, S&P analysts suggest that stabilizing mortgage balances could help banks' capital ratios, which measure a lender's capacity to absorb losses.

"Chinese banks have been moderating loan growth and capital consumption to mitigate the hit on profitability from lower interest rates," S&P analysts said.

"On a dynamic basis, the mortgage measures could slow prepayments and reinvigorate investment demand. The stabilization of banks' mortgage balances would help their capital ratios."

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