China's rise to the economic ascent will not be without its hiccups, as the country must negotiate the transition from an investment- to a consumption-driven economic model and put its local government expenditures into check.

China is facing two juxtaposing trends. On the one hand, it remains home to some of the largest and fastest growing banks in the world, such as ICBC, the single largest by Tier 1 capital according to The Banker’s 2015 Top 1000 World Banks ranking. On the other, the country is facing an indisputable economic slowdown. At 7.4%, gross domestic product growth in 2014 was its lowest in 24 years.

The declining growth rate is putting pressure even on China’s top banks. As the country's economy slows, pressure on asset quality is growing and non-performing loan ratios are rising, albeit still remaining below those of many of their international peers, slightly above the 1% mark.

China is also in a delicate transition as it shifts from an investment- to a consumption-driven economic model, and accelerates the banking sector reforms that are working towards interest rate liberalisation. As with any liberalisation, China’s is shaking local financials. Deposit insurance and deposit rate loosening, for instance, are both increasing banks’ costs and squeezing margins. In this scenario, non-interest income has become more crucial than ever, and Chinese banks are now realising that theirs is, on average, too low. They are therefore looking to develop fee-based business, such as investment banking. They are also looking for new revenue sources. Even larger banks are now renewing their focus on small and medium-sized enterprises (SMEs), for instance.

With all these changes under way, smaller, province-focused banks will face greater challenges than top local financials. Their profits are lower and their revenue sources are fewer. But they might have an edge over their larger peers in servicing SMEs, since smaller local lenders have historically paid more attention to this client group.

What could jeopardise small banks’ course in this transitioning phase, as well as China’s national finances, are local governments’ books. Government intervention to support local governments’ expenditures and minimise their ballooning high-cost, unmonitored and unsustainable shadow banking borrowing is essential if China wants to succeed in its economic model upgrade, and in its banking sector liberalisation.

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