Industrial and Commercial Bank of China (ICBC) has added another plaudit to its prestigious list of accolades. Not content with staging the world’s most lucrative share listing and becoming the largest bank on the planet by market value, ICBC revealed at the end of August that its first-half profit grew 57% to reach US$9.48 billion, larger takings than any other lender in the world. While its global rivals struggle with the ongoing credit crisis, ICBC appeared untouchable.
However, the bank’s August 21 filing came with a rider attached.
ICBC warned of “pressure on the loan quality of commercial banks” in the second half of the year. It cited domestic macroeconomic controls, renminbi appreciation, weakening international demand and reduced profitability for local companies due to rising production costs as key contributors to this.
The other major listed lenders – China Construction Bank (CCB) and Bank of China (BoC), both of which delivered robust first-half profits – made similar announcements.
Industry analysts are blunt in their assessment of the situation: For the first time since the banks were reformed and commercialized, their risk management skills are going to be put to the test.
“It is a crucial period,” said Laurie Cang, vice president and senior analyst for financial institutions at Moody’s Investor Service. “Their systems haven’t been tested yet. The economy has been doing well – asset growth is up and non-performing loans (NPLs) are down – and so we have not been able to see how well they are doing with risk management.”
Concerns about troubled global markets and a potentially less buoyant domestic economy are not limited to the major players. Average profit growth for the 14 banks listed on the A-share market was 98.6% in the first half of the year. Repeating that performance in the last six months of 2008 is a tall order.
The upper hand
The banks’ bottom lines were undoubtedly strengthened by the 8 percentage-point tax cut that came courtesy of China’s new Enterprise Income Tax Law. But Charlene Chu, director of financial institutions research at Fitch Ratings, believes pricing power in the loans business was more important.
This pricing power derives from Beijing’s own macro policies. On four occasions in the first half of 2008, Beijing increased the proportion of total funds that commercial banks must hold in reserve. These hikes, along with other measures targeting particular areas (notably real estate), effectively reduced the amount of money that could be loaned out.
The banks already operate in a tightly controlled market where customers are charged interest on loans that far exceeds interest earned on deposits. Now banks could push the lending rates to the top end of the scale.
“Credit restrictions got so tight that you had a high demand for loans and low supply,” said Chu. “This puts pricing power in the hands of the supplier.”
Pricing power is manifested on a bank’s balance sheet in a wider net interest margin – the difference in the interest income generated by banks and the amount they pay out to their depositors – and rising net interest income. ICBC saw its net interest margin expand to 3.01% in the first half, from 2.65% a year ago. Interest income rose 28.9% to US$19.27 billion.
The potential Achilles’ heel lies in the property sector. It was reported in July that Liu Mingkang, the chief banking regulator, had made the rounds of local lenders and warned them to tighten up their approval processes for real estate loans.
According to Chu, Chinese banks’ direct exposure to the real estate industry – through mortgages and loans to property developers and construction companies – accounts for about 25-30% of their total loan bases. However, she believes this figure is understated, with a fair number of property loans being listed in other categories in order to get the green light.
Although mortgage delinquency rates are low and property prices nationwide remain robust, individual markets have shown signs of weakness. This has sparked fears that the problems may spread, leaving banks with a stack of new NPLs.
“We’ve noticed some lenders like Industrial Bank and CITIC Bank extended a large amount of mortgage loans in the first half of 2007 when property prices surged,” said Wu Yonggang, an analyst at Guotai Jun’an Securities. “Now housing prices have showed signs of declining, especially in Shenzhen and Guangzhou. Banks need to guard against risks of a housing price slump.”
Guo Min, an analyst at Shanghai Securities, said his concerns stretched beyond mortgages to asset quality as a whole. He believes particular attention should be paid to loan quality in the manufacturing sector.
If the banks fail in this examination of their risk management, analysts agree that the evidence would not present itself immediately – it would take six months or so before balance sheets start to suffer.
But volatility in the property and stock markets could still pose a quicker, albeit indirect, threat to net interest margins. Moody’s analyst Cang notes that investors looking to cut their property and stock exposure are likely to opt for time deposits in banks, which command a relatively high rate of interest. A significant shift from short-term to time deposits would increase funding costs for banks.
Guo of Shanghai Securities suggests that these rising funding costs could be offset by fee and commission-based income through bank cards, settlement and clearing fees, and sales of wealth management products. This may be optimistic. While business is certainly growing in this area, fee and commission of income only accounts for about one sixth a major bank’s total operating income.
A day after announcing its first-half profit figures, ICBC said it would issue US$14.6 billion in bonds, prompting much excitement about potential overseas acquisitions. The bank is certainly ambitious – it wants overseas contributions to its business to increase from 3% to 10% in the next few years – but the general consensus is that external factors are conspiring against it.
“Global financial uncertainties and worries over economic slowdown have slowed the pace of domestic banks seeking overseas acquisitions,” said a Shanghai-based senior executive at a Chinese bank, who asked to remain anonymous. The executive noted that, although Chinese lenders are still in contact with foreign targets, Beijing would probably block transactions it deemed too risky.
At least for the time being, the proceeds of ICBC’s bond issue will likely be used to boost capital levels in preparation for more difficult times ahead.