China's moves to deregulate interest rates may cut banks' 2012 profits by 28.5 billion yuan ($4.5 billion), or 3 percent of last year's figure, by squeezing loan profitability, according to Moody's Investors Service.

"Allowing banks greater flexibility in setting rates will narrow their net interest margin as they will need to offer more competitive rates on their broad deposits and loans," Moody's analysts led by Bin Hu and Yi Zhang wrote in a report released on Tuesday.

The People's Bank of China in June allowed lenders to widen the discount on official borrowing rates to 20 percent, and then broadened the limit to 30 percent the following month, accelerating the liberalization of interest rates. The banks were permitted to offer deposit rates at 10 percent above the benchmark, the first time a premium has been permitted.

As a result of the increased flexibility with which the banks can set their own rates because of the latest PBoC decisions alone, lenders' net interest margins may contract by 4 to 6 basis points this year, followed by a further 10 to 13 basis points, and a profit reduction of 79.6 billion yuan, in 2013, the ratings company said in a statement.

"Their abilities to adapt to a fully market-driven pricing environment remain untested," the Moody's analysts said in the report. "These issues come on top of the current risks posed by rising asset quality pressures and a slowing economy."

Aside from the anticipated squeeze on NIMs, interest rate deregulation may increase liquidity risks as it could encourage depositors to seek greater yields and permanently introduce market-driven volatility into the entire funding structure.

A risk associated with the current liberalization is that even depositors who are uninterested in deposit-substitute products will become more disposed to taking advantage of the potential rise in yield across all banks. One effect would be greater volatility in the banks' traditional funding pool.

Meanwhile, in view of the likely compression in NIMs, the desire to maintain profitability may prompt banks to lend more to higher-risk borrowers or become involved in complex business activities, Moody's reckoned.

"We note that Chinese banks have been stepping up lending to small- and medium-sized enterprises, a segment that has allowed them to maintain loan returns close to, or above benchmark loan rates, but which can be highly prone to more asset quality issues, as shown in the latest round of bank results."

Moody's also expect more Chinese banks to expand into new business areas, such as capital market operations or overseas expansions, to compensate for profitability lost on their traditional lending businesses. The latter development is a result of pressure on NIM and tighter regulations on the fees they can charge.

Shares of Chinese banks fell in Hong Kong on Tuesday, extending their average decline this year to 1.6 percent. That compares with a 14.9 percent gain in the Hang Seng Index.

Bloomberg - China Daily