LPR reform credit negative for Chinese banks' profitability

    On 17 August, the People's Bank of China (PBOC), the central bank, announced reforms to the loan prime rate (LPR) mechanism. Beginning on 20 August, the new LPR will average the lending rate quoted by 18 banks on that same day to determine the lending rate for all banks when they originate new floating rate loans. This process will then be repeated on the 20th of each month.
  Moody's Investors Service said this reform will narrow Chinese banks' lending margins, a credit negative. The narrower margins on loans will also encourage banks to increase their risk appetite and, as a result, weaken asset quality.
  According to the PBOC, the National Interbank Funding Center will announce the new LPR at 9.30am on the 20th of every month. A five-year tenor will be added to the existing one year LPR to serve as a reference rate for banks pricing long-term loans such as mortgages.
  To expand the representativeness of the LPR, the PBOC also included eight small banks - including two city commercial banks, two rural commercial banks, two foreign banks, and two private-invested banks - to the existing 10, including state-owned and joint-stock commercial banks, participating in LPR quotations. Banks' use of LPR as a pricing reference will be included into and evaluated by China's Macro Prudential Assessment (MPA).
  The new mechanism liberalizes interest rates because it will explicitly replace the current loan pricing based on benchmark rates, which are not sensitive to changes in market rates.
  Under the current practice, introduced in October 2013, 10 banks decide the LPR on a daily basis. This gives them little incentive to price their LPR differently than the PBOC's benchmark lending rate, which has not changed since October 2015. Although this mechanism was designed to approximate market-oriented interest rates, the actual rate has closely matched the government's benchmark lending rate. In recent months money market rates and bond yields have declined substantially but actual bank loan rates have remained high, resulting in a wider gap above-market interest rates, protecting Chinese banks' lending margins.