The banking landscape in China is undergoing a profound transformation, particularly impacting small and medium-sized banks (SMBs) that have faced daunting challenges since 2023. As banking profitability declines and both asset and liability issues proliferate, more stringent regulations are pushing these institutions toward reforms such as risk mitigation and mergers with larger entitiesAt this crucial juncture, a deep dive into the current state of SMBs, their regulatory responses, and possible lessons from international experiences becomes imperative to charting a future path.

Since the beginning of 2023, the banking sector has been under severe pressure, particularly smaller institutions that find the traditional aggressive growth models unsustainableFor decades, SMBs relied on generating profits through interest rate spreads derived from credit lending, prioritizing the expansion of their loan portfolios as their chief objective

Responding to local GDP growth pressures and various performance metrics imposed by local governments, small banks have been under constant demand to expand their lending activities.

However, with the recent slowdowns in economic growth and insufficient demand in the real economy, the model of reckless growth through extensive lending to sensitive borrower segments has become increasingly untenableThis challenging environment means that banks are now facing significant pressures on the liability side as wellCosts have risen markedly; in 2023 alone, deposit interest rates were slashed multiple timesStarting in 2024, price-setting regulations will incorporate non-bank interbank demand deposit rates, but this has not translated into decreased deposit costs across the boardEven banks widely regarded as leading institutions, like China Merchants Bank, have begun shifting towards longer-term deposits, signaling diminishing net interest margins across the industry

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Smaller banks, in their bid to attract interest-sensitive customers amid ongoing scrutiny from regulatory and self-disciplinary associations, have resorted to high-interest deposit campaigns.

On the asset side, regulatory limitations prevent small banks, especially rural and commercial banks, from extending their business operations beyond their local provinces, restricting their capacity for resource allocation and credit distribution akin to larger banksThe concentration of branches within certain regions, coupled with limited professional expertise, further complicates their ability to expand their service offeringsTheir reliance on inclusive finance and agricultural lending is fraught with uncertainties; these lending activities, often subject to unpredictable repayment rates and unfavorable economic conditions, can lead to a rise in non-performing loans—a situation exacerbated by SMBs' fragile capital bases.

An alarming phenomenon observed in 2024 involves these rural commercial banks aggressively competing for long-term government bonds, a clear indicator of their asset-side struggles

As larger banks effectively monopolized the credit market through competitive pricing, many SMBs, particularly rural banks, increasingly invested in long-term bonds with durations of 10 years or moreThis results from a logic of inadequate asset allocation, pushing bond yields to unprecedented levelsAn examination of the latest quarterly reports from listed agricultural banks reveals that investment income has replaced commission fees as a primary revenue driver, with some of these banks seeing investment income constituting 20-30% of their total revenue—an extraordinary contribution that can be likened to “half the kingdom.”

However, this trend poses significant risks that have raised red flags among regulatorsOn August 7, 2024, the Trading Dealers Association announced investigations into four rural commercial banks suspected of market manipulation and collusion within the government bond secondary market

On December 2, the Chinese interbank market regulator formally released reports detailing violations by these banks in their dealingsSubsequently, the People's Bank of China convened discussions with financial institutions, focusing on potential risks associated with highly aggressive bond purchasesThe precarious position of these smaller institutions, characterized by insufficient capital and poor risk management capabilities, could render them highly vulnerable, particularly in light of the Silicon Valley Bank incident, prompting tighter monitoring measures.

From the regulatory perspective, the current pressure on SMBs is compounded by a myriad of operational challengesMany of these banks contend with weak capital bases, poor risk management practices, and ineffective governance, diminishing their ability to withstand the strains of economic downturns and fierce competitionNotably, village banks have displayed particularly acute weaknesses, with several experiencing crises over the past few years

These institutions often have weak shareholder backing, limited access to capital markets for financing, low levels of capital, and inadequate provisions to buffer against market volatility, making them especially susceptible to risks.

Thus, it has been imperative for policy regulators like the central bank to prioritize risk prevention in their strategiesThe government’s directives in 2023 underscored the urgency of reforming rural financial institutions to mitigate risks while initiating structural consolidationsAs early as January 2024, the National Financial Supervision Administration convened a meeting emphasizing reform and consolidation for small banks and credit cooperatives as pivotal objectives for the coming yearSubsequent initiatives have seen several provinces effectively advancing their regulatory reforms, with the restructuring of rural and community banks intensifying across multiple regions.

The present wave of mergers and consolidations among smaller banks follows regulatory mandates as institutions respond to directives for streamlining

In 2024 alone, approximately 199 small banks have been dissolved—significantly surpassing the closing rates of previous years combinedAs efforts to cement a more reliable financial infrastructure continue, these restructuring efforts are essential in building a more resilient banking sector.

Looking outward, the experience of Japan during the 1990s provides a compelling context for understanding possible paths forwardThe Japanese banking sector faced similar challenges in the wake of the real estate bubble bursting, leading to significant non-performing loans that prompted substantial restructuringsThis period can be categorized into two distinct phases: the early 1990s to 2002 focused primarily on aiding failing banks through interventions, while the period post-2002 concentrated on reducing excessive competition among banking institutionsJapan's government initially sought to pair larger banks with weaker counterparts to stabilize the sector, but this approach faced hurdles that hindered timely resolution of non-performing assets

Ultimately, through rigorous implementation of financial restructuring measures, Japan navigated through its banking crisis, demonstrating the need to balance risk management with competitive equity.

With the evolution of its economic landscape, Japan saw a considerable decline in the number of regional banks, illustrating a successful withdrawal from oversaturation in the market brought about by strategic consolidationsThis trajectory yields valuable lessons for China, particularly in understanding how achieving a delicate balance between healthy competition and market saturation can enhance bank profitability.

In conclusion, while SMBs in China are at a critical crossroads, the tide of change opens up significant opportunities for revitalizationThe ongoing reforms aim to bolster these institutions’ resilience and adaptability, allowing them to better contribute to a stable financial landscape