As China’s economy slows and corporate debt swells, the country’s banks are turning to retail as a new source of growth. Who is jumping on the bandwagon, and how will banks tap into China’s enormous mass market? Stefania Palma reports.

ICBC embedded

China’s banks have had to address a number of obstacles in the past 12 months: the Shanghai stock market crash of mid-2015, the subsequent downward revision of the renminbi and China’s economic slowdown. At 6.9%, China’s gross domestic product (GDP) growth is at its lowest in 25 years.  

Real estate market volatility and increasing worries about local corporates’ ability to service debt are challenging banks further. At 170% of GDP, China’s corporate debt is one of the highest in the world.

As corporate clients are no longer considered obvious safe havens, banks across China — from big hitters such as Industrial and Commercial Bank of China (ICBC) to local banks such as Tianjin-based China Bohai Bank — have started prioritising their retail business. Meanwhile, as net interest margins in China continue to fall, lenders keep looking for new sources of income involving investment banking or offshore operations. 

Real estate volatility

Volatility in China’s real estate market is shaking up the local banking sector. “Falling real estate prices and sales, slowing land sales and stalling urbanisation rates pose a drag to the real economy and bear risks for the financial sector, given the high linkages between local government finances and real estate developments,” says a report from Deutsche Bank. 

This is the case in second- and third-tier cities, where property prices are falling. But cities such as Beijing and Shanghai face the opposite problem: property prices skyrocketed at the end of 2015 to the point that local governments had to step in to cool down the market. “The Shanghai government has increased downpayments to cool off Shanghai’s real estate market. There is [now] more safety in bank mortgage loans, and risk has decreased. The volume in the Shanghai housing market decreased in April,” says Xu Li, president of Shanghai Rural Commercial Bank (SRCB).

Chinese debt is a further cause for concern. The Bank for International Settlements estimates that total Chinese debt, including government, household and corporate debt, is 249% of GDP. While household debt in China is still manageable at about 35% of GDP, corporate debt is not. 

This is problematic for Chinese banks, which tend to have large exposures to corporate clients, specifically state-owned enterprises (SOEs) that have been at the heart of Chinese economic policy implementation for decades. 

Too much too soon?

But since 2009, SOEs’ losses have grown and returns on assets have dropped as they have struggled to digest the Rmb4000bn ($607.1bn) fiscal stimulus programme set up by China to counter the effects of the global financial crisis.

“When I saw the Rmb4000bn package in 2009 I thought that it was too large an investment in too short a period of time. The whole economy could not have sustained it. The economy was not able to support all the big projects that followed,” says Li Fuan, chairman of Tianjin-based China Bohai Bank. A case in point is China’s steel industry, the overcapacity of which is enough to satisfy demand for steel worldwide.

But although Chinese corporates’ struggles are undeniable, Yi Huiman, chairman of ICBC, has an optimistic long-term view. “There will be challenges and impacts considering the new cycles among Chinese firms and their debt-servicing capacities. That is quite normal. [But] although there are some problems, these will not be systemic,” he says.

An example of an SOE paying the price of China’s overcapacity is Bohai Steel Group, owned by the Tianjin government and now struggling to repay debt totalling Rmb192bn. “In the case of Bohai Steel, the company invested in new product lines and machines were tested, but they stopped running right after testing because there was overcapacity,” says Mr Li. China Bohai Bank is one of Bohai Steel’s 105 creditors. Although the bank’s Bohai Steel position is only Rmb6bn at most, Mr Li remains worried. 

SOE concerns

The central government is looking for a way to extend or restructure Bohai Steel’s debt before making it non-performing. It is also vital, however, for the central government to solve a broader coal industry problem, according to Mr Li. 

To address struggles such as Bohai Steel’s, the State Council (China’s cabinet) announced SOE reform in September 2015 aimed at improving efficiency and reducing losses at SOEs via share sales and management changes. Reuters reported that this reform could translate into 5 million to 6 million state workers being laid off – a tricky scenario for a country keen on minimising social unrest. Yin Weimin, China’s minister for human resources and social security, said China expects to lay off 1.8 million workers in the coal and steel industries alone.

China’s debt ratio in context

However, it is worth noting that Bohai Steel is not representative of all Chinese SOEs. Those in more prosperous regions are largely performing better. “Most of our corporate customers are SOEs,” says Mr Xu of SRCB. “[But] we don’t worry too much about Shanghai SOEs. Our customers are based in Shanghai and most are SOEs with government support. At the moment I am not worried about our asset quality.”

As another Shanghai-based lender, Bank of Shanghai also benefits from strong fundamentals in its region. “The main regions we cover [Beijing, Shanghai and Shenzhen] enjoy good economic foundations,” says Jin Yu, the chairman of Bank of Shanghai.

But looking beyond rich coastal regions such as Shanghai, struggling corporates are indeed affecting the Chinese banking sector as a whole. According to PricewaterhouseCoopers, levels of non-performing loans (NPLs) and the NPL ratio of China’s commercial banking sector have grown over 18 consecutive quarters, reaching Rmb1392bn and 1.75% as of March 2016. 

Retail move 

Even among China’s big four banks – Agricultural Bank of China, ICBC, Bank of China and China Construction Bank – there has been a steady increase in bad loans each year since 2012. At the end of 2015, ABC’s NPL ratio of 2.39% was the highest of the group.

It is worth noting that China’s NPL ratio remains one of the lowest in the world. However, this is down to differences in how China and the rest of the world classify loans as NPLs. If Western banking NPL classification were applied to China, a 3% to 5% NPL ratio would be a more realistic level for the country’s banking sector, according to PwC. What is more, Chinese NPLs might continue to grow given the local economy’s slowdown and challenges in the corporate sector. “We see it as being inevitable that NPLs in China’s banking sector will continue to rise to levels unprecedented since banking reform measures were undertaken 15 years ago,” says PwC.

To counter growing risks in the corporate sector, banks across China – even ICBC, which tops The Banker’s 2016 Top 1000 World Banks ranking by Tier 1 capital for the fourth consecutive year – are now focusing more on their retail business. “In the past, profits in China’s banking industry relied heavily on the scale expansion of the economy,” says Mr Jin. “Banks tended to have large clients so as to achieve scale expansion in a short period of time. It was relatively easy to make profits at that time… [But as] the economy and its scale expansion slows down, banks cannot maintain as high a net interest margin as before.” 

Chinese banks’ historical bias towards large corporate customers means retail clients have been underserved for decades. Today, retail offers huge potential thanks to China’s 1.4 billion people and the rise of financial technology as a new means to offer mass-market products. What is more, compared with corporate loans, retail loans are more diversified, less risky and offer higher margins, according to Chinese bankers.

“All banks have made efforts to develop their corporate banking business. There is over-competition in this field. Retail will bring about many more opportunities,” says Mr Yi.

But focusing on retail is as much about leveraging untapped potential as it is about diversifying risk. “We need to focus on balancing income and risk. We have [therefore] increased our credit to retail. In 2015, 45% of ICBC credit was given to retail,” says Mr Yi. Retail accounted for 39% of ICBC’s revenue growth in 2015. The bank plans to bring this proportion up to 50%.

Growing loans

Meanwhile, smaller commercial banks such as Shanghai-based SRCB are also keen to extend more retail loans. “Loans to individuals have relatively lower risk and higher returns [versus corporate loans],” says Mr Xu. “Corporate loan margins are shrinking quickly because of interest rate leverage. Loans to individuals are smaller and more diversified.”

SRCB wants to boost its retail business mainly through mortgage loans, which increased by Rmb10bn year on year in the first quarter of 2016. But is SRCB’s mortgage business under threat after government policies cooled down Shanghai’s real estate market in early 2016? “[This] will somewhat hit our mortgage business but these are high-quality assets as they are mortgages for Shanghai property. We plan to issue an asset-backed security [ABS] note to use these assets,” says Mr Xu. The lender already printed an ABS note in the Chinese interbank market in 2015.

Mr Jin of Bank of Shanghai also says that one of his objectives for 2016 is to increase the proportion of retail loans. 

As for Tianjin-based China Bohai Bank, having focused on corporate clients and on funding big projects in real estate, infrastructure and manufacturing, the bank will now allocate more resources to retail in light of risky corporate debt in China. The aim is to double the proportion of assets in retail to 20% by 2020, says Mr Li.

International NPL ratios

Bohai’s retail foray

While larger banks such as ICBC can rely on an enormous national branch network to expand their retail business, smaller banks need to pick a niche in which to expand. In China Bohai Bank’s case, this means highly educated young families living in China’s larger cities as well as individuals requiring retirement arrangements. “These young families need to buy cars, houses, consumer goods, whereas people with good salaries who are ready to retire will need retirement services, medical care, support in selling houses in the city and so on,” says Mr Li.

Mr Li also wants to set up an online banking arm in the next five years – Bohai Online Bank – as a new way to reach the mass market. Investing in technology will also be key. “We don’t want to be the frontier investor. We will follow first timers’ technology and be the second in by using technology that has matured in the market already,” says Mr Li.

China Bohai Bank is also co-operating with Chinese ecommerce giant Jingdong, or JD.com, to set up a new consumer finance company. The lender will have a 20% stake in the firm and JD.com will take the balance. “We want to use the online channel to tap into Jingdong’s customer base,” says Mr Li. China Bohai Bank is expecting final approval for this new firm in July.

Expanding within China’s borders will also be crucial to China Bohai Bank’s retail strategy. By the end of 2016, the lender will have new business in Chongqing, a key city of the south-western province of Sichuan, and Changchun, the capital of north-eastern Jilin province. According to local banking regulation, the lender can set up new operations in no more than two provinces per year.

In Shanghai, SRCB is also looking to grow outside its home city, and the lender has already set up cross-regional branches in the provinces of Jiangsu, Zhejiang and Hunan. “In Hunan and Jiangsu, we do more retail business because corporate business is comparatively weaker,” says Mr Xu. 

Chasing fees

While focusing on retail is a way to minimise corporate debt risk, Chinese banks are also looking for new sources of revenue as net interest margins (NIMs) continue to fall. “The market has witnessed accelerated interest rate liberalisation, which means net interest margins have narrowed significantly,” says ICBC’s Mr Yi. “ICBC’s NIM has dropped by 19 basis points between 2014 and 2015, and now sits at 2.47%. This is a good result.”

To counter this trend, Chinese banks are focusing on fee-based business such as private banking, asset management and investment banking. “Given lower production capacity and de-stocking in China, ICBC is focusing on developing its investment banking business. This has added Rmb26.8bn to our revenue in 2015,” says Mr Yi. 

Although investment banking is still driven by the domestic market, ICBC wants to bulk up offshore business too. About 50 of ICBC’s 600 investment banking staff specialise in overseas projects. “World-renowned corporates used to look to Western financial markets to list, but now there is a new trend to look east for initial public offering in Hong Kong. We want to take advantage of this,” says Mr Yi.

NPL balance and ratio

SRCB is not involved in investment banking yet, but entering this business is a possibility. “In the future, since interest margins are so thin, business might be tough for us if we do not expand in capital markets,” says Mr Xu. “We will be targeting rural companies, with whom we have long-term relationships. We know their operations, their business models. If we get the licence we will focus on IPO or mergers and acquisitions advisory.”

And although Chinese commercial banks are not allowed to invest directly into other companies, SRCB wants to set up a venture capital-style investment company targeting hi-tech local firms as a further source of income. “Hi-tech companies are high risk and sometimes high return,” says Mr Xu. “If we just do corporate loans, [then] continuous asset growth and narrowing interest margins will weaken [our] ability to cover risks. With an investment company, we might get good returns.”

Increasing the proportion of fee-based income as well as focusing on high-yielding business is also essential to Bank of Shanghai. “In 2016 we will pay more attention to demands of emerging industries, emerging markets and personal clients [in light] of strong growth in pan-asset management and consumption finance,” says Mr Jin.

Going abroad

For China Bohai Bank, setting up its first overseas branch in Hong Kong this year will help the lender increase fee-based business. This branch will cater to Chinese customers going overseas or engaging in trade and investment abroad, says Mr Li. 

In ICBC’s case, building an offshore presence was a key aspect of former chairman Jiang Jianqing’s mandate. But after setting up operations in 40 countries worldwide, ICBC’s international expansion will be less aggressive in the future, says newly appointed chairman Mr Yi. “We will [now] build the capacity of existing overseas operations so that we can strengthen our presence in local markets,” says Mr Yi. Despite a slowdown in global expansion, ICBC is still running feasibility studies to set up operations in Switzerland, Sweden, Mongolia and Austria.

To diversify risk and chase higher margins, ICBC also wants to extend more credit overseas. The bank’s objective is to increase overseas credit from between 7% and 8% to 10% of total credit.  

Meanwhile, the bank is still involved in a legal case in Spain. In February 2016, Spanish police raided ICBC’s Madrid offices as part of an investigation into alleged money laundering and tax fraud by Chinese gangs. Mr Yi, however, is not worried. “The Madrid case was an isolated event. We are confident in the internal control and management and anti-money laundering [AML] of ICBC Group, ICBC Europe and [our] Madrid branch,” says Mr Yi. “We have put a lot of focus on risk management, AML and the production of ICBC’s brand and reputation abroad – and we want to protect it. We are confident that this case can be appropriately solved.” Investigations are ongoing. The five ICBC managers arrested in February deny any wrongdoing. 

As China’s economic slowdown continues and doubts mount over corporates’ capacity to service debt, Chinese banks are having to rethink their strategies. Retail is the latest growth frontier. And as net interest margins continue to fall, Chinese banks will be pushed into further new territory. The days when large corporates and SOEs were at the centre of Chinese banks’ operations seem to be over.

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