Moody’s Investors Service says in a new report that China’s new loan prime rate (LPR)–which was reintroduced in August 2019 and has functioned well to bring down lending costs in the coronavirus economy in 2020–will further weaken banks’ profitability as more loans come to be repriced on lowered LPR.

“We expect banks’ lending income will weaken as more outstanding floating rate loans switch to being LPR-based and as the government grants loan-rate caps and regulatory forbearance on loan payments to support economic recovery,” says Yan Li, a Moody’s Assistant Vice President and Analyst.

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The LPR is now broadly used as the reference rate of Chinese bank loans, with more than 90% of new floating interest rate loans already repriced at the end of 2019.

Moody’s expects the People’s Bank of China (PBOC) will continue using the LPR to drive down lending rates.

A central bank mandate

The central bank has mandated that banks use the LPR as the benchmark for all new floating interest rate loan contracts that commence after 1 January 2020, and all outstanding loans must be repriced under the new benchmark by August 2020.

“We expect the decline in average loan yields will quicken as more loans are repriced under it, especially as the LPR has declined by 46 basis points between August 2019 and June 2020,” adds Li.

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Profitability pressure will vary across banks, with small banks under more pressure in an interest-rate-sensitive market as they rely more on interest and investment income.

Managing credit risk

To make up for lost profit, banks may shift their risk appetite in terms of credit selection, which could challenge their loan underwriting and raise their asset risk. Some banks could also seek to change the tenor of their loan portfolios’ composition to adjust the exposures to be repriced.

This could add to their interest rate risk and asset-liability duration mismatch, which they may not be able to hedge effectively given China’s underdeveloped derivatives market and banks’ limited experience using such tools.