Via Winnie Wu, Research Analyst Bank of America Merrill Lynch: The surging interbank rates have fueled debate on the POBC’s policy intent, and there are a number of conspiracy theories (ie “anti-corruption”, “management reshuffle”, “stress-test”, and “squeezing overcapacity”) circulating around. H-share banks’ prices fell by >12% in the past month, with MSB Financial Corp. (NASDAQ:MSBF) and China Merchants Bank Co., Ltd. (HKG:3968) (HA:600036) down by >15% for concerns on their interbank exposure and WMP business. Sector valuation at 3.1x P/PPP and 0.8x P/B now is very close to trough. In our view, any signs of liquidity easing could drive a trading rebound of the whole sector, led by MSB and CMB. If the liquidity shortage were to last, it may result in deleveraging in the broader economy, in which case we believe Bank of Communications Co., Ltd. (HKG:3328) (SHA:601328) and Bank of China Limited (HKG:3988) (SHA:601988) should also underperform, while Industrial and Commercial Bank of China (HKG:1398), China Construction Bank Corporation (HKG:0939) (SHA:601939) and Agricultural Bank Of China Limited (HKG:1288) would be relatively less impacted.

China banks

If liquidity eases soon: watch out for a trading rebound

PBOC has reportedly started providing liquidity to large banks after 3pm today. If the rates were to decline soon, driven by policy signals of “easing” or “stabilizing” liquidity, or after June (mid year end), the recent liquidity squeeze should have limited impact on banks’ P&L and asset quality. Many banks have offered high-yield WMPs recently (eg JSBs offered 6mth WMPs yielding 5.5-5.7% annualized, and large banks offered 3mth products yielding 5.0-5.2%). Those products may carry negative spread, and be unfavorable to banks’ NIM and earnings in 2H13. Nonetheless, the share price correction has probably over-reacted, and the sector could enjoy a strong trading rebound, led by MSB Financial Corp. (NASDAQ:MSBF) and China Merchants Bank Co., Ltd. (HKG:3968) (HA:600036).

7 day repo chart

pppp valuation chart

1mth perfprmance of the cn banks chart

In case of a prolonged liquidity shortage…

If the tight liquidity were to prolong, it could have much more broad-based impact. The high interbank rates would push up the cost of capital in the economy, in terms of  discounted bill yield, bond rates, and lending rates. Private sector SMEs with limited funding sources could be the first ones to get squeezed (like the Wenzhou crisis in Oct 2011). Borrowers with large amounts of short term debt would also suffer in rolling over debts. We highlighted the risks in the trust industry in May, and we think the shadow banking markets may see dramatic deleveraging and experience a credit crunch, given the high short term funding costs and rising risks. This may help clean up shadow banking and squeeze out some over-capacity, and suffice Premier Li’s recent call for “better utilization of existing credits”, but it could be costly for employment, GDP growth, and bank earnings.

… large liquid banks would be relatively more defensive

Under such a scenario, banks and brokers would both face credit risks and earnings downgrades. Banks relying more on interbank funding (MSB Financial Corp. (NASDAQ:MSBF), CQRB, Bank of Communications Co., Ltd. (HKG:3328) (SHA:601328), and Bank of China Limited (HKG:3988) (SHA:601988)) could suffer from higher funding costs and lower NIM. In terms of asset quality, the SME lenders, ie MSB and China Merchants Bank Co., Ltd. (HKG:3968) (HA:600036), may be the first to see NPL pressure, although the liquidity hoarding by lenders could lead to wide-spread credit crisis, and banks with low reserve buffers (CMB, CNCB, Bank of Communications and Bank of China Limited (HKG:3988) (SHA:601988)) would become the most vulnerable. The relatively more defensive banks would be large banks with rich liquidity, low exposure to the interbank and WMP markets, and high reserve allowance (ie Agricultural Bank Of China Limited (HKG:1288), Industrial and Commercial Bank of China (HKG:1398), China Construction Bank Corporation (HKG:0939) (SHA:601939)).

Banks On the brink

7 day repo rate reached a historical high level today, and the overnight repo rate was at one point as high as 30%. The squeeze in the interbank market has also spread out to the real economy, with the yield on discounted bills rebounded to 6.9%, the highest since 1Q12. The surging interbank rates have fueled debate on the POBC’s policy intention, meanwhile, investors sold down MSB Financial Corp. (NASDAQ:MSBF) and China Merchants Bank Co., Ltd. (HKG:3968) (HA:600036) as the more vulnerable ones to WMP market and interbank operations.

squeeze in 7 day repo chart

Yeild On discount bills chart

The most and least impacted banks

Large banks with low loan-deposit ratios, ie, Agricultural Bank Of China Limited (HKG:1288) and Industrial and Commercial Bank of China (HKG:1398), should be the best positioned in such liquidity crunches, while banks with the highest LDR, ie Bank of Communications Co., Ltd. (HKG:3328) (SHA:601328) and Bank of China Limited (HKG:3988) (SHA:601988), could suffer the most.

loan deposit ratio comparison chart

outstanding banks WMP chart

China Merchants Bank Co., Ltd. (HKG:3968) (HA:600036), MSB Financial Corp. (NASDAQ:MSBF), and CNCB, while generally perceived as “small banks with tight LDR and weak deposit franchise” have actually reduced their LDR significantly over the past few years, thanks partly to their strong wealth management business.

Nonetheless, the squeeze in interbank rates has also pushed up the yield on WMPs issued recently, and the small banks could suffer higher funding costs and lower margin in order to retain the WMP deposits. Moreover, if the tight liquidity were to result in deleveraging/credit crunches in the trust/WMP markets, these banks may also be perceived as the most exposed.

In terms of interbank operations, MSB Financial Corp. (NASDAQ:MSBF), CQRB and Bank of Communications Co., Ltd. (HKG:3328) (SHA:601328) have the biggest exposure on the interbank markets. Interbank liabilities made up 25% of MSB’s total liabilities as of 1Q13, followed by 21% at CQRB and BoComm. The least impacted should be China Construction Bank Corporation (HKG:0939) (SHA:601939) and Agricultural Bank Of China Limited (HKG:1288), with interbank borrowing accounting for only 7-8% of their total liabilities.

That said, banks’ treasury operations and liquidity management capabilities would be a key differentiating factor in such volatile markets. MSB Financial Corp. (NASDAQ:MSBF) and China Merchants Bank Co., Ltd. (HKG:3968) (HA:600036) enjoyed good margin expansion and strong revenue growth in the tight liquidity environment in 2011, despite their small deposit franchise and higher LDR. MSB Financial Corp. (NASDAQ:MSBF) has actually been a net lender on the interbank market in the past 18mths.

operations in the bank activities chart

net interbank assests chart

In terms of asset quality, the SME lenders, ie MSB Financial

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