Moody's: China's latest interest rate cut will lower bank profitability; loan rates to fall more than deposit rates

Moody's Investors Service says that the People's Bank of China's (PBOC) lowering of interest rates for the third time in less than six months will lower the profitability of banks operating in China, because overall loan rates will fall by a larger margin when compared to deposit rates.

"We estimate that the interest rate spread between loans and deposits will narrow to 1.95% from 2.10%, based on the assumption that deposit rates will rise to 140% of benchmark rates," says Sherry Zhang, a Moody's Associate Analyst.

"The narrower spread will in turn lower the banks' profitability profile," adds Zhang.

Moody's points out that earlier this week, the PBOC moved to counteract the slower GDP growth in China and to reduce corporate borrowing costs by lowering both the benchmark deposit and lending rates by 25 basis points. The bank also relaxed the cap on deposit rates to 150% of the benchmark deposit rate from 130%.

Moody's conclusions are contained in its report "China: China's Interest Rate Reduction Is Credit Negative for Banks" released on 13 May 2015.

Moody's says that the higher deposit rate cap will give banks enough pricing freedom under normal circumstances to compete against alternative cash investments, attract deposits and stabilize their deposit bases. While the change will enhance the banks' liquidity position, it will also heighten competition for deposits and therefore pressure margins.

Moody's further points out that small- and mid-size banks are most vulnerable to the margin compression because deposits at smaller banks tend to be more price-sensitive. These banks' weaker deposit franchises also suggest that it is more likely that they will have to offer higher returns to attract deposits.

As for asset quality, Moody's says the effect of the rate cut on bank asset quality is mixed. While the reduction in loan rates will lower the overall substantial repayment burden of bank customers, real borrowing costs have not come down as rapidly as the nominal rate cuts would imply.

In addition, there is a risk that lower loan rates and margins will increase the banks' appetite to expand their lending to high-risk borrowers -- such as small- and mid-size enterprises -- because of the higher yield that such loans offer to compensate for rising margin pressure. Such a situation would likely raise asset quality risk for banks that have no experience in servicing high-risk borrowers.

Moody's notes that the higher cap on deposit rates, together with China's deposit insurance scheme, suggest that the country is accelerating its pace of deposit rate liberalization.