Sharp liquidity tightening could usher in new prudent banking era

With the overnight interbank lending rate falling back to 6 percent, from previous highs of above 13 percent, analysts and economists are of the view that the worst of the banking sector's recent credit crunch appears to have passed.

But the pressure on banks to improve their act will continue to build, after the government came out in the open for the first time earlier this week to urge them to better manage their liquidity positions instead of counting on the central bank to save them, whenever they get themselves into a tight spot.

That message, economists agreed, has marked a key turning point in China's financial reform and ushered in a new banking era in which self-discipline, prudent management, accountability and fiduciary duty will count for more than government support and patronage.

Those banks that fail to adapt to the new market-oriented rules are likely to be left out to dry, analysts said.

But if and when they do adapt, their customers will stand to reap the benefits of less central control, they said.

"The central bank and the China Securities Regulatory Commission are not 'wet-nurses'. Government rescues do no good to the financial market," the People's Daily said on Tuesday, after China's equity market suffered its worst performance in almost four years, with a 5.3 percent plunge on Monday.

News reports on Tuesday said small commercial banks were suffering from a capital squeeze that forced some to stop lending.

Economists said that the sharp and sudden liquidity tightening will hit the shadow banking sector that is based largely on low interbank interest rates.

But it will also crush small financial institutions and increase credit costs, which will hurt the real economy.

Prepared for decontrol

The People's Bank of China issued a statement after its second-quarter monetary policy committee meeting on Sunday afternoon, which reiterated its commitment to interest rate reform.

On the same day, Zhang Chenhui, director of the finance research institute at the State Council Development Research Center, was reported as saying that China may lift the lower limit for lending rates before the end of 2013.

Analysts said the central government is urging the banks to improve their ability to manage liquidity, and prepare for reform of the financial markets that will see the introduction of more market mechanisms in the future.

"Chinese banks have become increasingly dependent on a loose monetary environment and low interbank market rates," said Yang Guoying, a researcher with the Beijing-based China Finance Thinktank.