By Engen Tham and Matthew Miller
SHANGHAI/BEIJING (Reuters) - After a tough two years, China's largest banks are reporting green shoots, with the top four turning in consensus-beating profits and promising an upbeat second half.
But smaller, national and regional lenders - which control about a third of China's banking assets - are still feeling the strain, hit by a regulatory crackdown on risky activity that has made it difficult to sell some products and access the capital on which they have often relied. Many have reported shrinking balance sheets after years of expansion.
The result, analysts say, is likely to be a funding squeeze for China's struggling firms, which have depended on these banks for life-or-death credit and could now be pushed to costlier borrowing or gray market offers.
"Small- and medium-sized companies would suffer along with smaller banks," said Du Yang, acting head of the asset management team at China Securities International.
Lending may slow in any case into the second half, as some banks have exhausted most of their annual credit quota amid the push to bring shadow financing activities to the main loan book, raising the specter of corporate defaults as financing costs climb in the world's No.2 economy.
And the pain, as ever, is likely to be concentrated in China's rust-belt regions.
Sophie Jiang, analyst at Nomura, however, believes smaller balance sheets at mid-tier and regional lenders will lead to better capital allocation, as inefficient firms are squeezed out. "We think this is good for the real economy."
TWO HALVES
For now, it is a tale of diverging paths.
"This year, there has been some differentiation among banks. Large banks have experienced relatively better stability in their operations," Fang Heying, the vice president of China CITIC Bank, told reporters last week.
By contrast joint stock banks - smaller lenders that are not fully state-owned - have "generally seen a decline in revenue". Fang's own bank saw operating income slip and assets shrink.
At Shengjing Bank Co, a regional bank based in the northern province of Liaoning, first-half operating income fell almost 17 percent. Total assets, after increasing 29 percent in 2016, slowed to a more modest 3.7 percent growth.
China Minsheng Bank, the nation's biggest private lender, saw assets drop 2.18 percent in the first half, after increasing more than 30 percent in 2016. Deposits also fell.
"A lot of these small banks need to rely on the interbank market to seek their source of funding," said Ken Shih, a DBS analyst, adding that higher interest rates have also increased costs. Larger banks fare better.
Indeed, most medium-sized listed banks reported contracting net interest margins (NIMs) - the difference between interest paid and earned, a key indicator of profitability.
But recovery seems to have set in for the bigger players, such as Industrial and Commercial Bank of China Ltd (ICBC) and Bank of China Ltd (BoC), that saw NIMs widen for the first time in more than two years, following six benchmark interest rate cuts in 2014-15.
GOOD NEWS AT THE TOP
The emerging gulf in the sector comes as China's financial watchdogs unleash a 'regulatory storm' aimed at controlling risk, reckless loans and at improving supervision.
The government has focused particularly on non-traditional interbank borrowing and financing, a key source of balance sheet expansion for many smaller national and regional banks.
Xiao Yuanqi, head of the prudential regulation bureau of the China Banking Regulatory Committee, has said the crackdown, including efforts to tighten disclosure rules on off-balance sheet wealth management products - a key component of shadow banking credit - was working.
"Taking the ox by the nose, we grasped the three main problems of the banking sector: interbank, wealth management products and off-balance-sheet business," Xiao said.
But for the top lenders, pushing into the consumer segment with a boost in personal loans, 2017 still looks good, with asset quality, even overdue loans, improving.
Bankers at ICBC, BoC and Bank of Communications Co Ltd (BoCom) expect core lending business to improve during the rest of this year.
At the world's largest bank, ICBC, personal loans were up 9 percent at the end of June from end-2016, helped by a 11.6 percent rise in residential mortgages.
For China Construction Bank Corp, personal consumer loans more than doubled over the same period.
Investor confidence in the biggest five state-owned banks has soared and fueled a share price rally, led by ICBC which has gained more than 30 percent in Shanghai so far this year.