As the year draws to a close in 2023, the banking sector faces a concerning decline in its net interest margin (NIM), reaching as low as 1.69%. This figure highlights the ongoing struggles that banks are encountering, especially as the first quarter of 2024 witnesses a broader reduction in net interest margin across various categories of listed banks, with a decline exceeding 12 basis points. This scenario has sparked significant pressures in the banking industry. The previous rounds of deposit rate cuts in response to market conditions have yielded limited effects due to a growing trend towards fixed deposits, which has ironically pushed up the interest costs for banks. In an unexpected move, the recent monetary policy did not implement a clean break between old and new practices regarding compensatory interest payments, leading to a complete abolition of such measures even for existing stock. There’s an urgent need for banks to reduce deposit rates further to maintain a reasonable NIM of over 1.8%. This would likely contribute to a downward trend in overall interest rates across the board.

The pricing of loan interest rates on the asset side primarily follows a model of LPR (Loan Prime Rate) plus additional spread. However, the changing economic cycle has adversely affected the internal dynamics of China's real economy, resulting in weakened credit demand across the board. In response to regulatory nudges, the LPR has undergone a few rounds of reductions to inject liquidity into the economy. Nevertheless, with limited demand, competition for interbank lending has intensified, thus diminishing banks' bargaining power and substantially squeezing the spread. Consequently, this leads to a continued decline in the net interest margin, which has now fallen to 1.69% by the end of 2023.

When compared to their overseas counterparts, banks in Mainland China demonstrate relatively lower net interest margins. Data from publicly available financial statistics of European and American banks show that the NIMs are significantly higher than those of Chinese banks. In some categories, the margins are approximately double those found in China. While it's essential to acknowledge the differences in operational models between Chinese banks and their Western peers, with distinct variances in deposit and lending practices, the significant gap in numerical terms highlights that the net interest margin of Chinese banks has fallen to relatively low levels.

The accelerating depreciation on the asset side, combined with a strengthening trend of fixed deposits, implies that multiple rounds of deposit rate cuts have not significantly improved the NIM. The competition among banks for credit has resulted in a more rapid decrease in asset yields compared to the liabilities side. Despite regulatory efforts to encourage reductions in the posted interest rates of deposits, the trend towards fixed deposits continues to deepen. This has resulted in an increase in the overall interest payment rates, further complicating the banks' ability to reduce costs as they struggle to retain deposits. The cumulative effect has only tightened net interest margins.

Looking ahead into 2024, it appears that banks' NIM will continue to be under pressure. Most loans provided by banks have a term of over a year; thus, the impact of any reductions in rates could take up to three years to fully materialize. The effects of the rate decreases initiated in 2023 are likely to gradually become evident throughout 2024. Given the economy's weak recovery trajectory, which has not shown substantial improvement, further reductions in the LPR may be necessary to bolster the growth of the real economy. Therefore, we anticipate enduring pressures on banks' NIM throughout 2024. This trend has already been validated by the data from the first quarter of 2024, which indicates a decline of at least 12 basis points across various categories of listed banks compared to the previous quarter.

In light of these dynamics, it appears that a net interest margin of 1.8% or higher could be viewed as a more sustainable level for banks. To support the development of the real economy, commercial banks must align their credit growth rates closely with GDP and M2 growth rates over the long term. When lending to the real economy, commercial banks inevitably deplete their capital, which is often constrained. The price-to-book ratio (PB) for Chinese banks has consistently remained below 1X, thus increasing the risks associated with equity financing and potential state asset depletion. Debt issuance can only supplement Tier 1 and Tier 2 capital further. Therefore, maintaining an adequate level of net interest margin is essential for the banking sector’s profitability and continuous replenishment of core Tier 1 capital. Our analysis suggests that a sustained net interest margin above 1.8% is a comparatively secure target.

The necessity of reducing deposit rates seems inevitable, which may subsequently drive down broader interest rates in the bond market. To achieve quality economic growth, banks are unlikely to raise lending rates; instead, they are more inclined to adjust deposit rates downwards to keep their NIM within a reasonable range sustainably. Hence, the regulatory environment reflects a departure from traditional practices concerning compensation for interest, opting to eliminate outdated measures for stock across the board entirely. Moving forward, banks will likely need to implement further cuts to deposit interest rates, which would lower the minimum yield expectations for assets, potentially allowing products such as insurance, wealth management, and monetary funds to become more appealing. This may lead to a phenomenon of “deposit migration,” exacerbating the pressure on the asset market while pushing down interest rates throughout the bond market.