The pricing of loans based on short-term policy rates may usher in significant transformations within the banking sectorThis could lead to a revival of the bond-loan rate linkage, allowing banks greater flexibility in asset allocationThe adjustments to policy interest rates in the future may have a direct impact on internal loan costs, aiding in the reduction of financing costs for the real economyIn this dynamic landscape, the competitive significance of loan pricing wars diminishes, as banks may need to adjust their bidding strategies accordingly.

The Loan Prime Rate (LPR) marked its official launch in October 2013. Initially, a select group of nine financial institutions provided quotations over a one-year term, calculated by discarding the highest and lowest rates from the submissions each working day and averaging the remaining quotes

The establishment of the LPR represents a pivotal advancement in the journey toward the marketization of interest rates within China.

Before 2013, the central bank largely dictated and altered commercial banks' loan prices directly through a fixed benchmark lending rateCompared to the money market, the marketization of China's loan interest rate system was relatively lowThe lifting of controls on lending rates on July 19, 2013, allowed financial institutions to independently decide on pricing, yet the presence of an "implicit lower limit" restrained the downward adjustment of actual interest rates, significantly diluting the effectiveness of interest rate transmission.

The introduction of the LPR prepared the groundwork for advancing interest rate marketization reformsConcurrently, regulatory measures aided banks in reducing liability costs, resulting in a stable net interest margin that remained unaffected.

The strengthening link between borrowing and lending rates emerged prominently in 2019, when the LPR reform dismantled the hidden lower limit on loan pricing, thereby lowering actual financing costs

The People’s Bank of China and the Banking and Insurance Regulatory Commission's stringent oversight of shadow banking and P2P lending since 2018 contributed to declining liability costs, enhancing bank margins, which peaked at 2.2% in 2019.

The core aim of the 2019 LPR reform was to streamline monetary policy transmission channels and reinforce the relationship between borrowing and lending ratesFollowing the reform, the methodology of quoting the LPR, the number of quoting banks, the frequency of quotes, and the computation method all underwent substantial enhancements.

In terms of quoting methodology, the new LPR is set based on a benchmark from open market operation rates, closely tracking the medium-term lending facility (MLF) ratesThe pool of institutions providing LPR quotes expanded from the original group to 18, and as of January 22, 2024, the number of quoting banks reached 20. Additionally, the frequency of quotations shifted from daily to monthly, and the computation method was adjusted to exclude the highest and lowest quotes, with the average rounded to the nearest 0.05 percentage point.

With the LPR reform in 2019, the correlation between borrowing and lending rates was notably strengthened

Starting from the third quarter of 2019, the central bank included the application of the LPR and competitive behavior in loan pricing into its macro-prudential assessment, thereby mobilizing banks to rely on the LPR more significantlyAs a result, the monetary policy transmission chain linking MLF rates, LPR quotes, and loan rates became established.

The MLF, introduced in September 2014, gradually emerged as the principal tool for the central bank in supplying base currencyBy the end of September 2024, the MLF balance stood at 6.88 trillion yuanThe preference for MLF rates as a reference for LPR linkage was due to their characterization as central bank medium-term policy rates, representing the marginal funding costs for banks sourcing medium-term base currency from the central bank—making them suitable for loan pricing.

Recent trends reveal that the decline in new loan rates has outpaced the LPR drop

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By September 2024, the weighted average rate for new corporate loans was 3.63%, while the weighted mortgage loan rate was 3.32%, both at historic lowsSince 2023, the mortgage loan rate has dropped by 94 basis points, compared to just 45 basis points for the five-year LPR and 75 basis points for the MLF rate.

The rigidity and higher rate of the MLF compared to banks' liability costs may have caused a fragmented liquidity transferIf banks prefer to issue interbank certificates instead of seeking MLFs to bolster liquidity, the sluggish demand for real economy financing, coupled with a scarcity of high-quality assets, emphasizes their focus on managing liability costsIn such scenarios, banks are more inclined to supplement their funds through the issuance of interbank certificates.

From a loan pricing perspective, the current LPR, tied to MLF, struggles to accurately represent actual loan supply and demand

Available data from the monetary policy reports indicate that a significant proportion of loans operate below the LPR; however, the LPR is fundamentally designed as the optimal loan rate for a bank's preferred clientele.

In June 2024, the central bank governor emphasized during a forum that there is a need to continuously reform and refine the LPRHe addressed the issue of certain quoting rates diverging significantly from the actual best customer rates, outlining an emphasis on enhancing the quality of LPR quoting to better reflect the prevailing lending market ratesThere is speculation that the LPR may soon decouple from MLF and shift its focus to the seven-day open market operation rate (OMO).

The existing dual-track fund transfer pricing (FTP) system often precipitates interest rate inversion situations

Internally, FTP decision-making reflects discrepancy, as the dual-track system, combined with the fragmented loan and funding markets, frequently leads to interest rates inverted between various financial instrumentsSince 2024, significant inversions have been observed between liquidity rates and short-term debt rates.

Based on analysis from an investment institution, the policy interest rate transmission within the current dual decision-making system of asset-liability departments and financial market divisions has been inadequateThe primary challenge lies in how the less market-oriented asset-liability department substantially impacts overall FTP, while the more market-oriented financial markets division has limited influence over FTP formulationConsequently, logical shifts in bond market rates do not efficiently transmit to the loan market

When the central bank injects liquidity via OMOs, this liquidity primarily infiltrates the financial markets before gradually seeping into the loan market, resulting in delayed impacts on loan volumes and prices.

Disclosing segment data from financial reports, the net interest income banks collect can be divided, reflecting both external and internal componentsInternal interest net income is calculated as deposits FTP income minus loan FTP costs, evaluated based on average daily balances for both deposits and loans.

Tracking the FTP for bank divisions has proven complex due to limited proprietary data availabilityThis analysis from financial reports reveals varying proportions of internal net interest income among listed banks, indicating potential mismatches in funding sources and uses, notably between surplus and deficit divisions or influenced by strategic business initiatives.

State-owned banks exhibit lower internal net interest income ratios in corporate segments but higher in retail operations

According to the internal net interest income formula, greater deposit volumes paired with higher deposit FTP will yield increased internal net interest incomeIn corporate financing, many state-owned banks have recorded negative internal net interest incomes in 2023, largely for two reasons: 1. The scale of corporate deposits/loans is less than 1, with deposits disproportionately low negatively affecting internal net interest income; 2. Corporate deposits predominantly comprise current accounts, leading to lower deposit FTP rates.

In contrast, retail operations demonstrated comparatively high internal net interest incomes during the first half of 2024. This can be attributed to a high ratio of deposits to loans, as evidenced by the Postal Savings Bank's 2.8 ratio, coupled with state-owned banks’ extensive service networks, which have allowed for substantial absorption of long-term residential deposits at favorable rates.

Meanwhile, shareholding banks and certain city commercial banks exhibit a balanced distribution of internal and external net interest income within corporate business, yet retail operations see lower ratios of internal net interest income

Banks like CITIC, Minsheng, and others report negative figures in retail business units, primarily due to their reliance on corporate funding channels while showing a ratios of retail deposits to loans below 1.

Bank funding sources rely heavily on deposits from corporate and retail segments, with financial markets and interbank operations functioning predominantly as capital buyersAs an example, analysis of a state-owned bank's FTP metrics is conducted based on H1 2024 data, revealing an FTP of approximately 1.78% for corporate lending versus deposits and around 2.55% for retail lending against deposits.

This calculation involves the assumption that state-owned banks primarily engage in deposit and lending business; thus, net interest income derives fundamentally from this activityMoreover, ignoring the effects of internal transfer pricing on mismatch of terms further simplifies estimations of internal net interest incomes based on daily deposits and loans balances

If we standardize laundry FTP, we would establish a computation ratio of internal net interest income as net interest income divided by the difference in average daily deposits and loans balances.

Adjustments based on the September 2024 data suggest a trajectory where the central bank is guiding commercial banks to align older mortgage rates closer to those of newly issued loans, with an anticipated average reduction of around 50 basis points factored into the 3.05% retail loan FTP, resulting in a revised figure of 2.55% for recently issued retail loans.

This transformation may reshape asset pricing within banksUnder the cost-plus pricing methodology, the loan rates are the aggregation of costs associated with funding, management, credit, capital, and target premiumsPreviously, non-market LPR augmented with the cost-plus formula led to ineffective FTPs

The future adjustments in policy rates could have a direct effect on internal loan costs, aiding in decreasing financing costs in the real economy; banks will likely favor stabilizing revenue through reinforcing client bases and adjusting structures, rendering competition over loan pricing less significant.

As the bond-loan pricing linkage shows potential for revival, banks will see increased dynamism in asset allocationLooking at the current pricing table across commercial banks, there’s a notable strong pricing effect between mortgage loans, long-duration rate debts, and bond fundsThe historical dynamics of the bond-loan pricing since 2017 suggest the existence of an upper and lower limit on the comprehensive net yield spread, flexibly fluctuating within a range of [-24 BP, 72 BP].

Between 2017 and 2018, this pricing effect was comparatively weak as the liquidity cost divergence between the credit and financial market sectors caused the banking asset-liability department to struggle in strategically managing fund allocations effectively based on bond-loan pricing effects.

Post-2019, the pricing effect strengthened significantly; the LPR reform spurred a transition towards syncing FTP alongside lending rates and bond rates, enhancing the inter-referential nature of interest rates between loans and bonds, as they became linked through principles of MLF rate transmission within banking internal decision-making processes.

However, beginning in April 2024, the bond-loan pricing effect once again diverged, primarily due to sluggish demand for real economy financing

This shift repositioned the pricing dynamics into separate trajectoriesOn one hand, the flow of loan issuance is obstructed by market conditions, with remaining liquidity now dominating asset allocation decisions, while on the other hand, a dissonance in pricing between loans and bonds has emergedBond market rates have rapidly declined while corporate loan rates have reached historical lows, limiting further downward adjustments.

Using the current loan rates, further evaluation of bond yield equilibrium points led to the following conclusions:

Conclusion 1: Should loan yields remain constant, based on the underlying comprehensive net yield spread calculations, approximately 8-28 basis points are available for a downward adjustment in the current 10-year national bond yield.

While these conclusions provide useful insights, they have limitations; particularly concerning potential oversight of the differing capital costs associated with loans and bonds when evaluating the relative value propositions of both avenues

As the disconnect between LPR and MLF deepens, the relationship between funding FTP and credit FTP will become increasingly exacting.

Assuming a treasury-funded operational premise: the funding costs for loan-related businesses will employ the calculated FTP values mentioned above, while the investment operations will benchmark against the yield rates of national bonds (5-year maturity). This will facilitate a structured evaluation of the contributions to Economic Value Added (EVA) across various asset categories under a defined hypothesis:

1. Corporate and mortgage loan interest rates align with the weighted average rates from newly issued loans as of September 2024; 2. Various bond yields correspond with the 21st of October 2024 maturity rates; 3. Aggregate yield is computed as nominal yield minus funding, taxation, and capital costs plus deposit-derived incomes and credit costs; 4. EVA equals the composite yield multiplied by 1000, delineating the EVA contributed by each additional 100 billion yuan in business; 5. RAROC equals net profit divided by economic capital iterated with capital conversion coefficients based on risk weighting.

Conclusion 2: If loan yields remain constant, in order to generate commensurate EVA contributions from enterprise loans or bond investments, the yield of a 10-year bond must be adjusted to approximately 1.89% and for a 30-year bond to 2.09%; similarly, the yield adjustments for mortgage loans’ EVA equivalence would equate to roughly 1.92% for 10-year bonds and 2.12% for 30-year bonds.

It is crucial to factor in the diverse impacts of varying interest rate environments, particularly regarding the differences in loan repricing gaps

Banks with larger loan-repricing gaps are more susceptible to significant impacts from rising rates on their net interest incomesObservations from H1 2024 illustrate that listed banks predominantly lend to corporate clients with substantial mortgage representation, resulting in predominant application of floating LPR+ add-on interest ratesConsequently, average loan repricing durations tend to fall below one year, with deposit durations comparatively brief, enhancing the rapid repricing capacity of assets and stabilizing net interest income amidst interest rate elevations.

On the other hand, smaller regional banks focusing on micro-enterprise financing typically employ fixed-rate loans, leading to slower repricing rhythmsThese banks often feature longer-term, fixed deposits, resulting in a prolonged liability repricing cycle; therefore, they may experience pronounced reductions in net interest income when interest rates increment.

Analysis of sensitivity with respect to interest rates among listed banks underscores that a rise in interest rates benefits those exhibiting negative loan-repricing gaps, whereas a decrease favors institutions with positive gaps in their lending frameworks.