China's banks are increasingly feeling the pressure of thinning interest margins and growing credit risks in the real estate sector, leading to an uncomfortable situation. This is particularly evident at the four largest banks, directly controlled by the central government. It's almost a matter of pride for these flagship institutions of the domestic banking sector to consistently demonstrate moderate to high single-digit profit growth across all economic cycles. However, this trend is now showing signs of strain. In the first quarter, the top four banks reported profit declines ranging from 1.6% to 3%.

Such fluctuations in profits may seem minor in other countries, but in the Chinese context, they are revealing. It takes quite a bit to disrupt the ultra-solid trend of earnings that is closely guarded at all levels of the state and financial regulation. Even during the pandemic, the banking giants maintained this trend.

China's post-pandemic economic landscape is characterised by weakened consumer and investor confidence, and an unprecedented squeeze in the residential real estate market. In this environment, flagship banks like the market leader Industrial and Commercial Bank of China (ICBC) are struggling to achieve a respectable profit, despite accounting maneuvers. This does not bode well for broader segments of the banking industry, particularly regional banks that are less resilient, to cope with the challenges.

The earnings profile of Chinese banks is compromised by the situation with margins. For more than two thirds of listed institutions, the net interest margin has fallen below the official regulatory warning threshold of 1.8%. ICBC and the other three megabanks controlled by the central government are at levels between 1.5% and 1.7%. Smaller banks, which typically face higher refinancing costs, are sometimes seeing margins below 1%.

There are indications that gains from maturity transformation in the bread-and-butter business of loans and deposits are shrinking further. This is evident in government bonds as a reference point for market interest rates. In line with reduced long-term growth expectations for China's economy, long-term interest rates are trending further downward. A reduced spread between short- and long-term interest rates exacerbates the downward trend in bank margins.

To maintain the appearance of attractive results despite imminent profitability pressures, banks may need to take greater liberties with provisioning for risks. Given the dire conditions in China's real estate sector, it's somewhat surprising that this does not significantly impact the asset quality of the institutions. The non-performing loan (NPL) ratio, representing the proportion of non-performing loans in the total portfolio, remains stable at under 1.6% for China's commercial banks. One can assume that this benign level is due to an extremely lenient assessment practice for credit default risks.

Analysts attempt to arrive at a more realistic assessment of the risk situation through various methodological approaches. They arrive at an average NPL ratio of about 10%, which should not leave any regulator sleeping soundly. When isolating loans in the real estate sector, the presumed ratio shoots up to 40%. Currently, China's state media are gleefully contrasting the seemingly unshakable stability of the domestic banking system with the rampant problems at some US regional banks, and the anniversary of the collapse of the Silicon Valley Bank. The satisfaction seems quite misplaced. The situation in the US is uncomfortable but transparent. In China, the latter is certainly not the case.