China Moves Closer to ‘Riskiest’ Step by Removing Loans Cap

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China took one of its biggest steps in banking reform, moving to end a two-decade-old rule that has capped lending relative to deposits as Premier Li Keqiang seeks to usher in market-based economics.

An amendment to the banking law will remove the 75 percent limit, the State Council said on its website Wednesday. The Standing Committee of the National People’s Congress needs to give approval at its meeting in March.

While the change has the potential to boost credit growth, a bigger constraint may be limited demand for funds in a faltering economy. Looming now is what the central bank has called one of the “riskiest” parts of financial reform: ditching a ceiling on the interest rates that lenders pay on deposits, a move that may come in the second half of this year.

“The real constraint on bank lending is risk aversion,” said Qu Hongbin, an economist at HSBC Holdings Plc in Hong Kong. “More aggressive monetary policy easing is still the most effective antidote to the slowdown in lending growth.”

Shares of lenders rose in China, bucking a market decline. Industrial & Commercial Bank of China Ltd. gained 1.2 percent as of 10:03 a.m. local time, compared with a 0.5 percent decline in the Shanghai Composite Index.

The State Council plans for authorities to continue to monitor banks’ loan-to-deposit ratios.

Market Forces

Over the past two years, China’s government has removed a floor on lending rates, allowed banks to pay up to 50 percent more than benchmark deposit rates and established a deposit insurance system. Premier Li aims to boost the role of markets in a state-run banking industry that has $29 trillion of assets, almost twice the amount of its U.S. counterpart.

The central bank has indicated that a cap on deposit rates is likely to be scrapped this year. The risk: excessive competition for deposits could flow through to higher borrowing costs for companies and instability in the financial system.

The loan-to-deposit move doesn’t affect a separate constraint on lenders, the reserve-requirement ratio, which stipulates the amount of money that lenders must park at the central bank. That ratio is at 18.5 percent of deposits for the biggest lenders after two cuts this year.

Distorted, Outdated

Larry Hu, head of China economics at Macquarie Securities Ltd., said the loan-to-deposit change “marks another key step in China’s financial deregulation, a major market theme now and in the coming years.” Hu described the reserve ratio and the loan ratio as “the two most outdated and distorted regulatory measures in China’s financial system.”

The shake-up is five years after the nation completed the stock market listings of the last of its dominant big four banks, which include ICBC. The law limiting lending to 75 percent of deposits has been in place since 1995.

Removal of the cap will be good for bank earnings and valuations, easing competition for deposits, according to Sanford C. Bernstein & Co. analysts led by Hou Wei. They estimated that a 1 percent increase in the ratio would lead to a 1 to 2 basis-point improvement in net interest margins and up to a 1.2 percent increase in banks’ 2016 earnings.

While the loan-to-deposit level for the industry was 66 percent in March, and the China Banking Regulatory Commission eased the requirement last year by changing the method of calculation, it has remained a constraint for some listed lenders. Bank of Communications Co.’s ratio was about 74 percent in March, while China Construction Bank Corp.’s was 72 percent.

Smaller Banks

Analysts including HSBC’s Qu said that some smaller banks, whose ratios have been higher than average, may benefit from the new policy.

Wu Xiaoling, a former central bank deputy governor, has argued that the ratio and state-imposed quotas for lending have undermined banks’ abilities to manage their assets and liabilities, and led to distortions such as the use of illegally obtained deposits to boost lending.

The government may rely on indicators such as a Basel III liquidity coverage ratio, which measures the amounts of easy-to-sell assets that banks have available in times of stress, according to China International Capital Corp.

For more, read this QuickTake: China’s Rate Risk

— With assistance by Jun Luo

(Updates with analyst’s comment in fourth paragraph.)
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