Chinese authorities recently asked commercial banks to cut deposit rates, a move that could ease some pressure on lenders whose net interest margins are likely to remain weak due to low interest rates.

Starting May 15, commercial banks were permitted to pay only up to 20 basis points (bps) above benchmark rates, compared with the previous 35-bps cap, on certain time deposits, according to a Weibo post from state-owned Xinhua Finance. Bloomberg reported June 6 that large banks received a new directive to further reduce their deposit rates.

The People's Bank of China (PBOC) adjusts the ceiling, in part, through the market interest rate pricing self-regulatory mechanism composed of the country's major lenders.

Regulators may reduce the cap on deposit rates again if banks face greater pressure on net interest margins (NIM) or demand slows in the housing market, Morningstar senior equity analyst Iris Tan told S&P Global Market Intelligence on May 23. This would require further cuts to the benchmark five-year loan prime rate (LPR). The narrower cap benefits large banks by reducing the gap in deposit rates offered by their smaller counterparts that were paying up to 50 bps above benchmark rates, Tan said.

While the central bank has maintained an easing bias to support the economy, banks' NIMs have been squeezed by lower lending rates and stubborn credit costs. Commercial banks reported an aggregate NIM of 1.74% in the first quarter, according to China's banking regulator, compared with 1.97% a year earlier.

NIM pressure

An EY survey of 42 listed lenders, including major state-owned banks, led by Industrial and Commercial Bank of China Ltd., and nine national joint-stock banks, revealed an aggregate 1.80% year-over-year decline in net interest income, according to a May 16 report. Of the 23 banks that reported NIM figures, 21 saw declines.

"Besides protecting banks' NIMs, the authorities might also aim to push household deposits to capital markets, insurance savings products and bank wealth management products," Morningstar's Tan said.

System-wide NIM in the first quarter fell 23 bps compared with the same period in 2022, the steepest drop in seven years, according to data from the banking regulator. Large banks suffered the sharpest decline at 29 bps.

"We expect NIM pressure to persist," Nomura analysts said in a May 22 note. The contraction may gradually narrow in the second quarter due to limited downside for corporate loans, controlled deposit costs and a likely rebound in retail loan growth.

Market mechanism for rates

Chinese banks' weak profitability in the first quarter was likely due to declining net interest income, given margin contraction from LPR repricing, Nomura analysts said.

On May 16, the PBOC released its first-quarter monetary policy report, mentioning a market-oriented adjustment mechanism for interest rates and raising the possibility of lower deposit rates.

"For the first time, the PBOC proposed improving the system of policy interest rates, stressing the importance of the market-oriented adjustment mechanism for deposit interest rates," China International Capital Corp. (CICC) Hong Kong Securities analysts said in a May 18 note.

CICC attributed recent declines in deposit interest rates to "an oversupply of funds relative to demand." Narrowing NIMs, faster growth in deposits than loans in 2023, a rising proportion of time deposits and an intensifying shortage of assets in the bond market all signal the oversupply, CICC added.

Mortgage prepayments

But early repayment of home mortgages, a steady and low-risk source of interest income, could undermine authorities' efforts to save banks' NIMs. According to analysts and bank executives, many Chinese homeowners have sought to prepay expensive mortgages taken when rates were higher.

"We think these elevated mortgage prepayments would accentuate banks' NIM pressure," said CGS-CIMB's Hong Kong-based banking analyst Michael Chang in a May 23 note, as "the prepayments are concentrated in mortgages originated in 2018 through early 2022, which have higher margins than those originated in other years."

Mortgage prepayment rates hit a record high in April and have continued rising since, according to CGS-CIMB's residential mortgage-backed securities early repayment index, indicating subdued home sales and sluggish mortgage growth into 2024.

The accelerated mortgage prepayment pace could also reduce the likelihood of rate cuts because NIM is a significant consideration for the 18 banks that determine the LPRs announced by the PBOC on the 20th of each month, Chang said.