2018 Banking Sector Outlook

Transcription

1 Equity Research Financials 2018 Banking Sector Outlook Positive (maintained) Fundamentals steadily improving Wang Wen SFC CE No. BGL * With contribution from the GF A-share research team. GF Securities (Hong Kong) Brokerage Limited 29-30/F, Li Po Chun Chambers 189 Des Voeux Road Central Hong Kong Steady economic growth and monetary policy Against the backdrop of ongoing supplyside reform and economic restructuring, domestic economic growth is expected to slow moderately. Monetary policy will remain prudent and neutral with enhanced expectation management and directional regulation in operation. Liquidity in the banking system should therefore remain broadly stable to provide a moderate monetary and financial environment for supply-side reform and better-quality development. While M2 growth is expected to remain at a lower rate in this new environment, money market rates are unlikely to rise continuously in They may retrace slightly but should remain at a relatively high level. Regulation strengthened to prevent risks 1) Targeted RRR cuts will be aimed at qualified commercial from 2018, which could release considerable liquidity to help stabilize medium to long-term liquidity expectations while also alleviating pressure on debt at commercial after NCDs ( 同业存单 ) are included in interbank liability assessments in 1Q18. 2) The main impacts of IFRS9 include: non-standard investment is expected to be classified as financial assets at amortized cost; provisions are expected to increase but have a limited impact on net profit; limited positive impact on pricing while the credit costs of some financial assets rises. 3) New asset management regulation: the volume of off-balancesheet wealth management products issued by is expected to continue to see low growth with more products to disclose net asset values instead of previously negotiated fixed returns. Further regulations on guaranteed return wealth management products should be monitored. Banks net capital will be enhanced and total revenue will come down by less than 1% after a 10% risk reserve is taken from their wealth management fee income. A reasonable transition period has been put into place to mitigate the pressure on commercial in the short term. NIM rebounded with slower formation of NPLs 1) Under strengthened MPA checks and financial deleveraging, asset expansion momentum at will remain moderate and stable. In terms of structure, bank credit is expected to be strong with more loans to the retail sector; bond investment will increase along with a shrinking proportion of interbank assets. 2) NIM will improve steadily with divergent sub-sector performance: loan interest rates may increase slightly while slowing deposit growth will put pressure on borrowing costs. Specifically, thanks to the more advantageous rates on their deposits, large state-owned and rural commercial could see a more significant NIM rebound. 3) With the macroeconomic stabilization, the accelerated promotion of market-based DES and the implementation of distressed asset securitization, overall asset quality will stabilize further in 2018 with an ongoing decline in NPL ratio. Net fee and commission income growth will pick up in 2018, as unfavorable factors are gradually digested. Overall, fundamentals in the banking sector will improve steadily with divergent sub-sector performance. Retail banking transformation with fintech development Against the backdrop of slowing economic growth and stringent regulation, commercial are shifting to more valueoriented business to replace the previous extensive asset-expansion-driven business model. With characteristics including anti-cyclical, anti-disintermediation, capital light, flexible pricing and diversification, retail banking is likely to push forward the transformation. Along with the introduction of various financial technologies such as cloud computing, big data, AI, the block chain and biometrics, are actively entering into the field of consumer financing to seize business opportunities. Positive rating on the Chinese banking sector With capital structure adjustments at small and medium-sized, financial deleveraging will continue, while the stage of greatest pressure has passed. Given steadily improved fundamentals as well as investment opportunities brought about by valuation enhancement, we maintain our Positive rating on the Chinese banking sector and continue to recommend with good fundamentals, such as China Merchants Bank ( CH/3968 HK) and Bank of Ningbo ( CH), as well as large state-owned such as ICBC ( CH/1398 HK) and ABC ( CH/1288 HK).

2 Steady economic and monetary policy environment Real GDP growth expected to slow moderately The new normal: According to the report from the 19 th CPC National Congress, China's economy has shifted from a phase of rapid growth to a period of high-quality development and is now tackling the key issues of optimizing economic structure and finding new growth drivers. Supplyside structural reform will continue in order to promote more efficient and healthy economic development and improve total factor productivity. There is still significant potential for economic growth in China, given strong economic resilience and the many opportunities in new-type urbanization, service industries, high-end manufacturing industries and consumption upgrades. GDP rose by 6.9% in 9M17 with YoY growth in the % range for nine consecutive quarters. Steady GDP growth is expected to continue in Growth may slow moderately but with better quality. Figure 1: GDP growth (YoY) 16% 14.2% 14% 12.7% 12% 9.7% 9.4% 10.6%9.5% 10% 8% 7.9%7.8% 7.3%6.9% 6.7%6.9%6.9%6.9% 6% 4% 2% 0% Stable Rmb exchange rate in 2018 External: The global economy continues to recover with the US economy maintaining strong growth and the euro area economy recovering. Meanwhile, strong expectations of a rate hike by the Fed and the adoption of Trump s tax reform could lead to a rebound for the US dollar. Internal: China's economy is generally stable with structural optimization continuing. There was strong economic resilience in 2017 while quality and efficiency improved steadily. Besides, the twin-pillar regulatory framework of monetary policy and macro-prudential regulation continued to improve. Driven by fundamentals, cross-border capital flows and foreign exchange supply and demand in China will be more balanced. The stability of the Rmb exchange rate has strengthened further with the overall exchange rate expected to be stable in 2018, with improving floating flexibility. 2

3 Figure 2: Stabilized Rmb exchange rate Rmb/USD Steady monetary stance The key phrases to come out of the 19 th CPC National Congress and the National Financial Work Conference were "Serving the Real Economy," "Preventing and Controlling Financial Risks," and "Deepening Financial Reform" Against the backdrop of ongoing supply-side reform, overall monetary policy is expected to remain prudent and neutral with enhanced expectation management and directional regulation in operation. The goal is to keep liquidity in the banking system broadly stable and provide a moderate monetary and financial environment for supply-side reform and better-quality development. With further financial deleveraging to better serve the real economy, M2 growth has slowed this year and is expected to remain at a lower rate during the new normal stage. As factors affecting the monetary aggregates become more complicated, the measurability and controllability of M2 will be significantly reduced. Money market rates expected to remain high Targeted RRR cuts will be aimed at qualified commercial in 2018, which could help to stabilize long-term liquidity expectations. The report from the 19th CPC National Congress also set forth the goal of "enhancing the financial system s capability to serve the real economy and raising the proportion of direct financing". Money market rates are unlikely to rise continuously in They may retrace slightly but are expected to remain at a relatively high level. 3

4 Sector Outlook Figure 3: M2 growth has slowed since 2017 Figure 4: Shibor rates increased significantly in % 20% 15% 10% 5% 20% M2 (YoY) 14%14%14% 12% 13% 11%11%11% 11%11%10% 9% 9% 9% 9% 9% 6% 5% 4% 3% 2% 1% SHIBOR:overnight SHIBOR:1W SHIBOR:3 months SHIBOR:1Y 0% 0% Regulation strengthened to prevent risks Serving the real economy by enhancing inclusive finance The State Council issued its Plan for promoting inclusive finance ( ) in 2016, which stated that inclusive finance refers to providing appropriate and effective financial services to wide range groups of society, at an affordable cost based on the principle of equal opportunity and commercial sustainability. Special groups such as microfinance, small to medium-sized enterprises, farmers, urban low-income groups, disabled individuals and the elderly are the key targets for inclusive finance in China. According to the "PBOC s notice on Targeted RRR cut for Inclusive Finance" [2017] No. 222 ( 中国人民银行关于对普惠金融实施定向降准的通知 银发 号 ), inclusive financial loans include: Business loans with credit-lines of less than Rmb5m for a micro-to-small enterprises Operating loans for individual industrial and commercial households Operating loans for micro-to-small business owners Production and operation loans for farmers Guaranteed start-up loans for laid-off workers Consumer loans and student loans for poor people with related records in the Poverty Alleviation Information Network System Targeted RRR cuts to help stabilize long-term liquidity expectation Targeted RRR cuts will be aimed at qualified commercial from 2018, according to the 2017 inclusive financing loan assessment results. Qualified commercial should meet the following criteria: 1) Be in line with macroprudential management standards: MPA ratings should be B level or above for at least three quarters 2017; 2) Inclusive financing requirements: Commercial whose annual outstanding or new loans in inclusive financing accounts for more than 1.5% will enjoy a 0.5% RRR cut from the central bank s benchmark level; commercial whose annual outstanding or new loans in inclusive financing accounts for more than 10% will enjoy a further 1% RRR cut, indicating a total 1.5% RRR cut from the central bank s benchmark level. 4

5 Most commercial should qualify for a 0.5% RRR cut, indicating a directional liquidity release comparable to an ordinary RRR cut of 0.5% and an amount of more than Rmb780bn, according to our estimates. The targeted RRR cut could help stabilize medium to long-term liquidity expectations and alleviate pressure on debt at commercial after NCDs ( 同业存单 ) are included into interbank liability assessments from 1Q18. The impact of IFRS 9 application IFRS 9 implies significant changes in financial assets classification and credit loss accounting. From 4 possible classification categories to 3 for financial assets: The three classification categories for financial assets include: Financial assets at amortized cost, Financial assets at fair value through profit or loss (FVTPL) and Financial assets at fair value through other comprehensive income (FVOCI). IFRS 9 requires financial assets classification to be based on the contractual cash flows and the business model for managing those assets. The assessment process is as follows: Figure 5: Financial assets classifications Sources: GF Securities (Hong Kong) Expected credit losses (ECLs) IFRS9 applies an expected loss approach for credit loss accounting which uses a dual measurement approach that requires robust estimates of ECLs: 12- month ECLs for those assets that have not suffered a significant increase in credit risk since initial recognition; lifetime ECLs for those that have. It also requires to increase estimates in time when significant changes in credit risk occur. 5

6 Figure 6: ECL approach Sources: GF Securities (Hong Kong) The overall impact of IFRS 9 IFRS 9 will be applied by 9 dual-listed and 14 HK-listed commercial from the beginning of Given financial assets account for the majority, IFRS will have a significant impact on commercial in following three ways: 1) How a bank classifies its financial assets, which could affect how its capital resources and capital requirements are calculated. Non-standard investment is expected to be classified as financial assets at amortized cost. As there is no active trading market for non-standard investment, its classification should rely on the underlying assets, which are usually loan-similar products. 2) Provisions expected to increase but limited impact on net profit. Loans overdue 30 days, loans overdue 90 days, off-balance-sheet business and long-term assets may be subject to a provisional supplement under IFRS 9. The impact on different varies, depending on its business structure, asset quality and adequacy of impairment allowances. But the overall increase in provision may be limited, mainly due to: 1) the ECL accounting being in line with the regulation requirements for general risk reserves (no less than 1.5% of the ending balance of risk assets) for the purpose of making up the possible losses which have not been identified. 2) some commercial have already replaced the weigh method with an internal rating-based approach (IRB) for credit risk assessment, which has some overlap with ECL accounting. 3) given the existing capital replenishment pressure for listed, the new accounting standards have a more significant impact on further strengthening the risk management in the banking sector. 3) Limited positive impact on pricing while the credit costs of some financial assets will rise The credit costs of some financial assets will increase as corresponding provisions increase. However, given that expected risks have been taken into account in asset pricing, there is limited positive impact on pricing despite of rise in credit cost. No significant pressure with NCDs included into MPA From 1Q18 assessment, the NCDs (Negotiable Certificates of Deposit, 同业存单 ) with maturities of less than 1 year will be included into MPA for commercial with assets of over Rmb500bn. Continued monitoring and appropriate requests will be carried out for other. After the regulation in 2Q17, the market has expected this regulation inclusion and adjusted its interbank 6

7 Bank of Hangzhou SPD Bank Bank of Jiangsu Bank of Shanghai Industrial Bank China Minsheng Bank Bank of Ningbo Hua Xia Bank Bank of Guiyang Everbright Bank Bank of Beijing Ping An Bank China Citic Bank Changshu Rural Commerical Bank of Nanjing Rural Commercial Bank of CMB Jiangyin Rural Commercial BOC Wuxi Rural Commercial Bank ICBC CCB ABC Wujiang Rural Commercial 2018 Sector Outlook business accordingly. Most could pass the standards based on operational data in 2017 and no significant pressure is expected from MPA regulation in Figure 7: Most could meet the regulation requirements 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 1Q17 NCDs (Rmb, m) 1H17 NCDs (Rmb, m) 1Q17 NCDs/Interbank liabilities 1H17 NCDs/Interbank liabilities Regulation requirement (ratio 1/3) 600, , , , , ,000 0 New asset management regulation In Nov 2017, the PBoC, CBRC, CSRC, CIRC and SAFE jointly issued a public consultation paper on a new set of policy guidelines for financial institutions asset management businesses. The paper clearly defined the asset management business, and proposed to control leverage, control risks, minimize channel businesses and distinguish between businesses conducted before and after the new policy. The main points included: Prohibition of implicit guarantees and promotion of net asset value products; Reducing the risks of shadow banking by redefining non-standard assets and risk reserve requirements; Preventing liquidity risk by prohibiting fund pooling business and strengthening risk management of maturity mismatch; Deleveraging by restrictions on multi-layer product structure & channel business and uniformed leverage requirements on asset management products; Preventing operational risk through requirements on capital and risk reserves. The impact on the banking sector includes: Non-standard investment business: small to medium-sized will face increased pressure on risk reserves, which will likely affect their asset expansion momentum. Outsourcing investment: only one layer of investment outsourcing is allowed, which will help identify risks and minimize the spread of risks between financial institutions. Wealth management business: The volume of off-balance-sheet wealth management products issued by is expected to remain at a low level of growth as the new normal state, with more products to disclose net asset values instead of previously negotiated fixed returns. Further regulations on guaranteed return wealth management products should be watched. 7

8 16/09 16/10 16/11 16/12 17/01 17/02 17/03 17/04 17/05 17/06 17/07 17/08 17/ Sector Outlook Capital and risk reserves: Based on 1H17 data from listed, net capital will be enhanced and their total revenue will decrease by less than 1% after a 10% risk reserve is taken from their wealth management fee income. A reasonable transition period has been put in place to mitigate the pressure on commercial in the short term. NIM rebounded with slower formation of NPLs Slower asset expansion Under strengthened MPA checks and financial deleveraging, asset expansion in the banking industry slowed in Overall interest-bearing assets at listed increased by 2.83%, 1.18% and 0.91% QoQ as of end-march, June and Sept respectively. Small to medium-sized appear to have had the greatest impact as they used to enjoy much higher growth momentum than large state-owned. We expect asset growth momentum at listed in 2018 to remain stable and moderate. Against the backdrop of strengthened regulation, commercial will gradually reduce reliance on the previous extensive asset expansion model. On the one hand, the proactive adjustment of business structure will further increase the proportion of retail loans and deposits. On the other hand, with enhanced management and trading capabilities for assets and liabilities, listed will speed up capital structure adjustment. The proportion of interbank assets and investment in accounts receivable will come down and bond investment will continue to increase. Figure 8: Slower asset expansion (%) Figure 9: Small to medium sized slowed more significantly Total assets YoY(%) Total liabilities YoY(%) Asset allocation: strong bank credit with more loans to the retail sector Credit expansion is expected to remain strong in 2018, mainly due to: 1) steady economic growth in China; 2) with strengthened regulation of inter-bank business, off-balance sheet business and channel business, credit financing demand should increase as non-standard investments shift back onto statements; 3) Debt financing and debt replacement of local governments will be further constrained, weakening the substitutability of credit financing. 8

9 Retail loans With the advancement of the retail transformation strategy, loans to the retail sector are expected to account for a higher proportion of total loans. Personal consumption loans are expected to be the focus of development, as the 19 th CPC National Congress report mentioned Improving the institutional mechanism to promote consumption and enhancing the fundamental role of consumption in economic development". Individual housing mortgages to maintain modest growth to support reasonable housing needs of residents, as the 19 th CPC National Congress report mentioned "housing should be for living in, not for speculation". Corporate loans Corporate loans will continue their innovative transformation to focus on high-quality industries and high-quality customers, while there will be less lending to or even no investment in industries with excess capacity and high level of debt. More investment will shift to national strategic projects such as the One Belt One Road initiative, the Tianjin-Hebei coordinated development area, and the Yangtze River Economic Belt, so as to better support economic restructuring, transformation, and upgrading. PPP projects Infrastructure Micro to small enterprises "Three Rural" Green finance Asset allocation: more bond investment with shrinking interbank assets As of end-sept, listed overall bond investments had increased by 3.51% from end-june, while interbank assets and receivables decreased by 4.74% and 6.32% respectively. Under strengthened MPA checks and financial deleveraging, the scale of interbank assets could continue to have a smaller proportion. Receivables may experience a similar trend, mainly due to: 1) more stringent supervision of non-standard investments according to new asset management regulation; 2) an increase in risk reserves for non-standard investments. Taking into account the market environment, may increase bond investment given expectation of relatively stable interest rates. 9

10 15/12 16/03 16/06 16/09 16/12 17/03 17/06 17/09 15/03 15/06 15/09 15/12 16/03 16/06 16/09 16/12 17/03 17/06 17/ Sector Outlook Figure 10: Asset allocation of listed commercial 60% 50% 40% 51.17% 53.40% 30% 20% 10% 21.88% 22.43% 7.62% 6.57% 7.09% 5.86% 12.24% 11.74% 0% Loans Bond investments Receivables Interbank assets Balance at central Q17 1H17 3Q17 NIM will improve steadily with divergent sub-sector performance Loan interest rates may increase slightly Market interest rates have risen since 1H17, leading to an increase in lending rates for the credit market QoQ as well as the proportion of loans with higher-than-benchmark rates. The pricing of newly-issued loans is expected to remain at a relatively high level as market interest rates are likely to stabilize or decrease slightly in Besides, demand for loans will continue to be robust in Given strong financing demand and the interest rate environment, the pricing of assets may increase slightly in Figure 11: More loans with higher-than-benchmark rates (%) Figure 12: Lending rates have increased loans with rates lower than benchmark rates(%) loans with benchmark rates(%) loans with rates higher than benchmark rates(%) 7.0% 6.78% 6.5% 6.0% 6.01% 5.5% 5.0% 4.5% 4.0% Lending rate for corporate loans Mortgage rates 6.46% 6.01% 5.64% 5.67% 5.58% 5.65% 5.63% 5.71% 5.44% 5.53% 5.02% 4.70% 4.63% 4.69% 4.55% 4.52% 4.52% 4.55% 5.86% 5.01% Slowing deposit growth has put pressure on borrowing costs Total deposits at listed increased just slightly by 0.41% in 3Q out of 25 listed reported a decrease in deposits, including 1 large state-owned bank, 7 joint-stock, 2 city commercial and 2 rural commercial. Against the backdrop of a slowdown in M2 growth as well as in total deposits in financial institutions, the pressure from competition in the deposit business will remain intense. Given customer structure and geographical distribution, joint-stock and city commercial will come under more pressure while rural commercial and large state-owned performance should be relatively better. 10

11 Figure 13: Liabilities structure 120% 100% 80% 60% 40% 20% Deposits Lending from central bank Interbank liabilities Bonds payable 0% large state-owned Joint-stock City commercial Rural commercial NIM improving with divergent sub-sector performance Given gradual interest re-pricing amid rising market interest rates, NIM at listed commercial may continue to increase in Borrowing cost control is expected to cause divergent sub-sector performance. Specifically, thanks to the more advantageous rates on their deposits, state-owned and rural commercial could see a more significant NIM rebound. As for net interest income, we expect overall growth in net interest income to continue, mainly thanks to: 1) subsiding influence of VAT reform; 2) the positive effect of an improved NIS outweighing the negative effect of slower interest-earning asset growth. Again, state-owned and rural commercial may have better net interest income growth thanks to advantages in terms of cheaper liabilities. Figure 14: NIM changes in 2017 Figure 15: Quarterly net interest income growth YoY 3.0% 2.5% 2.0% % 10% 9.56% 12.18% 6.89% 11.85% 10.25% 7.45% 1.5% 1.0% 0.5% 0.0% Large state-owned Joint-stock City commercial Rural commercial 5% 0% -5% -10% -0.01% 1.61% -2.55% -3.43% -4.50% -6.54% -8.10% Large state-owned Joint-stock City commercial Rural commercial 1Q17 2Q17 3Q % 4.18% Average 11

12 Stabilized asset quality with slower formation of NPLs Amid accelerated economic restructuring, NPL balance still increased in 2017 while NPL ratio stabilized. With macroeconomic stabilization, the accelerated promotion of market-based DES and the implementation of distressed asset securitization, the overall asset quality will be more stabilized in 2018 with continuously declining NPL ratios. Favorable factors include: 1) strong economic resilience and continued steady growth; 2) the NPL ratio of the banking industry has remained flat at 1.74% during 2017; 3) The leading special-mention loan ratio indicator decreased continuously during 2017; 4) 19 th CPC National Congress report proposed to intensify the disposal of distressed assets for deleveraging". Potential unfavorable factors include: 1) Economic growth momentum may be weakened in the process of structural adjustment; 2) the risks caused by deleveraging of state-owned enterprises; 3) potential risk cannot be ignored given the balance of special-mention loans remained high. Figure 16: Stabilized NPL ratio 12

13 Figure 17: NPL ratio has improved at most listed NPL ratio NPL balance (Rmb m) M17 Δ M17 Δ CH/1398 HK ICBC 1.62% 1.56% -0.06% 211, ,043 8, CH/939 HK CCB 1.52% 1.50% -0.02% 178, ,949 12, CH/3988 HK BOC 1.46% 1.41% -0.05% 146, ,746 6, CH/1288 HK ABC 2.37% 1.97% -0.40% 230, ,834 (21,000) CH/3968 HK CMB 1.87% 1.66% -0.21% 61,121 60,224 (897) CH/998 HK China Citic Bank 1.69% 1.66% -0.03% 48,580 52,579 3, CH/1988 HK China Minsheng Bank 1.68% 1.69% 0.01% 41,435 47,060 5, CH Industrial Bank 1.65% 1.60% -0.05% 34,416 37,643 3, CH Shanghai Pudong Development Bank 1.89% 2.35% 0.46% 52,178 72,779 20, CH Hua Xia Bank 1.67% 1.70% 0.03% 20,348 22,974 2, CH Ping An Bank 1.74% 1.75% 0.01% 25,702 28,796 3, CH Everbright Bank 1.60% 1.58% -0.02% 28,702 31,702 3, CH Bank of Beijing 1.27% 1.25% -0.02% 11,426 13,021 1, CH Bank of Shanghai 1.17% 1.15% -0.02% 6,498 7, CH Bank of Jiangsu 1.43% 1.42% -0.01% 9,318 10, CH Bank of Nanjing 0.87% 0.86% -0.01% 2,896 3, CH Bank of Ningbo 0.91% 0.90% -0.01% 2,765 3, CH Bank of Hangzhou 1.62% 1.60% -0.02% 4,004 4, CH Bank of Guiyang 1.42% 1.34% -0.08% 1,452 1, CH Changshu Rural Commerical Bank 1.40% 1.23% -0.17% (12) CH Wuxi Rural Commercial Bank 1.39% 1.27% -0.12% (67) CH Jiangyin Rural Commercial Bank 2.41% 2.42% 0.01% 1,266 1, CH Zhangjiagang Rural Commercial Bank 1.96% 1.95% -0.01% CH Wujiang Rural Commercial Bank 1.78% Net fee and commission income growth will rebound in 2018 Net fee and commission income saw decreased growth in 2017, mainly due to the impact of regulation, but with a smaller decline in net fee and commission income seen in 3Q17. We expect net fee and commission income growth to pick up in 2018, as these unfavorable factors are gradually digested: 1) net fee and commission income growth at listed slowed in 2017, partly due to the higher base in the first five months of 2016, when VAT reform was not fully adopted. 2) regulatory policies which have a negative impact on net fee and commission income have been gradually digested. Related policies include: a new round of banking service fees reductions, new insurance policies and related new regulatory rules introduced in Net fee and commission income from wealth management business is still under pressure with a greater impact on large state-owned : 1) under new asset management regulation, the volume of off-balance-sheet wealth management products issued by is expected to maintain its low growth rate in the new normal state. The whole banking sector will confront the challenges of stringent regulation, slower volume growth momentum and narrower profits with higher requirement for risk reserves. 2) A value-added tax will be imposed on asset management businesses from 2018, which will increase tax costs for wealth management businesses and reduce their profit margins. ( Notice on Relevant Issues Concerning Value-added Tax on Asset Managed Products will come into force on Jan 1, 2018.) 13

14 Figure 18: Net fee and commission income breakdown ICBC (Rmb bn) Figure 19: Net fee and commission income breakdown - PingAn Bank (Rmb bn) 1, Others Others Investment banking Guarantee and commitment business Settlement, clearing and cash management Investment banking Guarantee and commitment business Settlement, clearing and cash management H16 1H17 Wealth management business Trust and agency services Bank card business H16 1H17 Wealth management business Trust and agency services Bank card business Sources: Company data, GF Securities (Hong Kong) Reduced capital replenishing pressure All 25 A-share listed announced refinancing plans in 2017 with a total planned amount of Rmb929bn, of which Rmb391bn has been accomplished as of Nov 27. Refinancing will effectively enhance capital strength and reduce capital replenishing pressure in Figure 20: Capital adequacy ratio requirements Figure 21: Refinancing plans Capital adequacy ratio regulation Systemically important Other Core Tier 1 capital ratio Capital adequacy ratio Core Tier 1 capital ratio Capital adequacy ratio By the end of 2016 By the end of 2017 By the end of % 9.10% 9.50% 10.70% 11.10% 11.50% 7.70% 8.10% 8.50% 9.70% 10.10% 10.50% Tier Ⅱ capital bond To be raised (Rmb bn) Amount raised (Rmb bn) CB Preferred stock Private placement 14

15 Retail banking transformation with fintech development Stringent regulation has pushed towards value-oriented businesses Against the backdrop of slower economic growth and stringent regulation, commercial are shifting towards more value-oriented businesses to replace the previous extensive assetexpansion-driven business model, which put more stringent requirements on capabilities in terms of pricing, cost control, asset quality management and capital efficiency. The new normal: According to the 19 th CPC National Congress report, China's economy has shifted from a phase of rapid growth to a period of high-quality development and is now tackling key issues of optimizing economic structure and finding new growth drivers. Stringent financial regulation: Under strengthened MPA checks, financial deleveraging and the twin-pillar regulatory framework of monetary policy and macro-prudential regulation, asset expansion momentum in the banking sector is under pressure. Retail banking transformation Oriented according to customer demand, retail banking transformation aims to provide one-stop financial product shopping and integrated financial services, which includes: 1) customer financing products such as: mortgages, credit cards, consumer loans, car loans and so on; 2) wealth management services such as: wealth management products and agency business for funds, trusts and insurance; 3) micro to small business loans. Figure 22: Retail banking transformation Sources: GF Securities (Hong Kong) 15

16 Sector Outlook Positive market outlook for consumer financing Positive market outlook for consumer financing with policy support Along with the gradually increasing contribution from consumption in GDP growth, China has entered a phase of being consumption-driven economy. In 9M17, the contribution from final consumption expenditure to GDP growth was 64.5%. However, consumer financing services became available relatively late in China. We expect consumer financing volume to continue the strong growth seen in recent years given the positive market outlook and supportive policies, as the 19th National Congress report mentioned "Improving the institutional mechanism to promote consumption and enhancing the fundamental role of consumption in economic development". Recent progress in consumer financing Banks have actively entered into consumer financing to take advantage of business opportunities. ICBC, CCB, BOC, ABC, CMB and Ping An Bank are the few names which launched consumer loan products. A lot of these products adopted internet plus and fintech characteristics, such as pure credit, online self-service and risk control through big data and cloud computing. Future direction: commercial should further promote the development and innovation of consumer financing with continuous progress in fintech, in order to meet expanding demand from residents consumption upgrades. The favorable environment includes: 1) residents willingness to consume being enhanced along with accelerated consumption upgrades; 2) with the construction of new-type towns and cities, more consumption related supportive policies are expected, in particular, in tourism, culture, health and the elderly care. Figure 23: Increased contribution of consumption to GDP growth (%) Consumption Investment Imports and exports Fintech innovation in banking Fintech: definition and impact According to the definition from the International Financial Stability Board, Fintech is technologically enabled financial innovation that could result in new business models, applications, processes, products, or services with an associated material effect on financial markets and institutions and the provision of financial services. Fintech is defined on the CMB website as internet companies or high-tech companies substantially enhancing the operational efficiency of traditional financial services and customer 16

17 experience through cloud computing, big data, mobile internet and other emerging technologies, which promotes the spirit of inclusive finance. Despite lacking a uniform standard definition, fintech has gradually changed and redefined the traditional banking business model, through technologies such as cloud computing, big data, AI, the block chain and biometrics. So far, fintech has had a significant impact on the banking business in following three ways: 1) Financial products and service innovation such as Robo-Advisor, intelligent upgrading in traditional banking branches. 2) Improve financial service efficiency, such as the application of biometrics in remote risk control system and the use of big data to improve the efficiency of document reviews and business approvals. 3) Broaden customer base and promote the development of inclusive finance. A majority of long-tail customers can enjoy financial services as the cost and risk control advantages decrease thresholds. Fintech at China Merchants Bank Positioning itself as a "Fintech Bank", CMB aims to become network-based, digitized and intelligence-oriented. The company has continued to enhance its financial technology capabilities and promote fintech innovations in channel optimization and services upgrades. 1) To enhance Fintech innovation: The bank established financial technology innovation projects funded by taking 1% of pretax profits from the previous year to encourage the application of emerging financial technologies. Strengthened communications and cooperation with outside leading technology companies, proactively carrying out exploration, research and introduction of external emerging technologies. 2) To support retail financing: Adhered to the strategy of mobile priority, continued to improve customer online activity and viscosity, and optimized personalized information recommendations through big data. Risk management: the company continuously introduced credit information data from third parties and customers borrowing records on platforms such as P2P, small loan companies and consumer finance companies; continued to optimize its rating model and early-warning mode; introduced biometrics for customer identity verification. Wealth management: "Machine Gene Investment" introduced for dynamic asset allocation adjustments and provided customers with six monthly investment operation reports. 17

18 3) To support wholesale finance Service model innovations based on technologies including mobile internet, big data and the block chain. For example, online corporate banking system: U-Bank X. 4) To promote diversified collaboration with partners from other industries to build a distinctive fintech ecosystem Cooperated with China Unicom (762 HK, NR) to build a consumer finance company MUCFC; set up the CMB Qianhai Financial Assets Exchange with China Merchants Group; strategic cooperation with DiDi. Investment suggestions With capital structure adjustments at small and medium-sized, financial deleveraging will continue, while the stage of greatest pressure has passed. Given gradual interest re-pricing of assets and better liabilities management, overall NIM should improve steadily in Banking asset quality will also improve amid an economic recovery, helping to enhance the sector s valuation. Given steadily improved fundamentals as well as investment opportunities brought about by valuation enhancement, we maintain our Positive rating on the Chinese banking sector and continue to recommend with good fundamentals, such as China Merchants Bank ( CH/3968 HK) and Bank of Ningbo ( CH), as well as large state-owned such as ICBC ( CH/1398 HK) and ABC ( CH/1288 HK) given less exposure to policy risks, controllable cost of debt and stable dividend yields. Risks Domestic GDP growth is weaker than expected; sharp deterioration in banking asset quality; regulations more stringent than expected. 18

19 Rating definitions Benchmark: Hong Kong Hang Seng Index Time horizon: 12 months Company ratings Buy Stock expected to outperform benchmark by more than 15% Accumulate Stock expected to outperform benchmark by more than 5% but not more than 15% Hold Expected stock relative performance ranges between -5% and 5% Underperform Stock expected to underperform benchmark by more than 5% Sector ratings Positive Sector expected to outperform benchmark by more than 10% Neutral Expected sector relative performance ranges between -10% and 10% Cautious Sector expected to underperform benchmark by more than 10% Analyst Certification The research analyst(s) primarily responsible for the content of this research report, in whole or in part, certifies that with respect to the company or relevant securities that the analyst(s) covered in this report: (1) all of the views expressed accurately reflect his or her personal views on the company or relevant securities mentioned herein; and (2) no part of his or her remuneration was, is, or will be, directly or indirectly, in connection with his or her specific recommendations or views expressed in this research report. 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