In recent years, a notable trend has emerged concerning the risk profiles of banking institutions in China, particularly among smaller banksThe percentage of high-risk banks has seen a marked decrease, and furthermore, the assets held by these high-risk entities have consistently been lower than their mere numbers would suggestThis evolving landscape indicates a gradual improvement in the asset quality of small and medium-sized banks, combined with a continuous effort to mitigate financial risk, suggesting that there is less cause for alarm than one might assume.

In 2023, the People's Bank of China (PBoC) released its ratings for financial institutions, providing a comprehensive overview of the banking sector's healthThe results demonstrated that, overall, the banking institutions in China are operating on solid ground, with manageable levels of risk

This reassured stakeholders regarding the financial stability within the system.

The PBoC initiated its institutional ratings in December 2017, focusing on various critical components of financial operational stability, such as capital management, asset quality, and liquidityThe evaluations categorize banks into a rating system ranging from 1 to 10, with 'D' denoting failure, closure, or substantial oversightNotably, ratings of 1 to 5 are considered within a "green zone" indicating low risk, while grades of 6 to 7 signify a medium watchfulness marked by the "yellow zone". Ratings of 8 to 'D' fall into a "red zone", which signals significant risk factors.

The 2023 rating review tallied a total of 3,936 banks contributing to the assessment, with collective assets amassing a staggering 396.12 trillion yuan

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Of these, 1,979 institutions were rated within the "green zone", representing a robust 50.28% of the total count and holding an impressive 93.88% of the total assets (371.88 trillion yuan). In contrast, 1,600 banks fell into the "yellow zone" (40.65% by number but only 4.34% of assets), while the "red zone" encompassed 357 banks (9.07% by count, contributing a mere 1.78% of assets). This elucidates the concerning nature of reported high-risk banks, as despite their higher numbers, they hold relatively less asset weight, with average asset sizes hovering at around 19.7 billion yuan—indicating these high-risk banks are generally smaller enterprises.

A closer examination reveals that the high-risk classification primarily encompasses city commercial banks and rural financial institutions, including rural cooperative banks and credit unions

Besides this designation, the PBoC has established a risk monitoring and early warning system since the end of 2020, which periodically scrutinizes these institutions graded from 1 to 7, having conducted 12 alerts to date—identifying potential issues primarily among city commercial and rural banks.

Historically, while there was a slight uptick in high-risk institutions starting from 2022, the overall proportion remains significantly lower compared to pre-2020 figures, indicating a relentless downward trajectory for such classificationsThe asset volume related to high-risk banks also remains marginal compared to the number of institutions, emphasizing that these often represent minor players within the banking landscape.

In addition to the PBoC's assessments, data from the financial regulatory apparatus unveils a picture of stable asset quality dynamics, particularly among city commercial banks which have maintained steady rates of non-performing loans and adequate provision coverage

Rural banks have displayed slight improvements in similar metrics, showcasing an upward trend in asset quality across the board for small to medium-sized banking institutions.

To further enhance the stability of these smaller banks, regulatory bodies have pushed forward with various strategies aimed at managing and alleviating existing risksThis structured approach not only looks to address current challenges but also seeks to solidify the foundational aspects of good governance and operational integrity within these institutions moving forward.

One significant strategy has involved fostering consolidation among small banksBy facilitating mergers and restructures, these financial entities are able to address legacy issues and refine their governance structures, effectively shedding historical burdens and minimizing future risk exposure

Noteworthy cases of consolidation have included banks such as Shanxi Bank, Sichuan Bank, LiaoShen Bank, and Zhongyuan Bank, along with several rural banks across provincesThis trend has noticeably decreased the overall count of banking institutions in recent years as the industry consolidates at various levels.

In addition, a specialized debt instrument termed "Support for the Development of Small and Medium Banks Special Bond" has been introduced, designed to bolster capital bases at these smaller institutionsWith a total issuance cap set at 550 billion yuan, 52 bonds have been floated since its inception, aggregating to approximately 482 billion yuanThis funding mechanism has provided critical support for capital enhancement, particularly through equity agreements and indirect share acquisitions, positioning banks for a more secure operational future.

Finally, the emphasis on governance reforms cannot be understated