In recent years, the landscape of dividend distribution among banks in China has shifted, expanding beyond the state-owned giants to include a select number of smaller regional banksMajor state-owned banks have maintained stable cash dividend ratios, providing a reliable income stream for investorsHowever, some mid-sized banks are emerging with attractive characteristics, such as low valuations and stable dividend payouts, while simultaneously experiencing favorable or improving fundamentalsWith the slowing expansion of balance sheets that reduces capital consumption, banks appear poised to sustain high dividend ratios.

As we step into 2024, there are two primary factors that could influence the increase in bank stock valuationsFirst, the decline in non-risk interest rates suggests that the logic of dividends will continue to play a significant role in investment decisions

Second, as annual performance reports come to light, banks that show stronger-than-expected results may help restore market confidence and expectationsDespite these positive signs, the price-to-book (PB) ratio of banks has only recovered to a level of 0.56 times, indicating that there is still potential for improvementIn the first quarter of 2024, the industry's net interest margin dropped to 1.54%. Although there has been a year-on-year decline, the rate of decline has slowed, suggesting that 2024 could be a year for banks' performance to stabilizeIf earnings gradually recover, valuations are likely to rise alongside them.

Typically, the performance of the banking sector has been closely linked to fluctuations in nominal GDP growthIf GDP growth expectations stabilize, indices are likely to trend upwardsHowever, if expectations remain under pressure, substantial upward movements in indices could be difficult to achieve

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Looking ahead, the recent optimization of real estate policies could provide a boost to the economy.

From a fundamental perspective, narrowing interest margins and pressure on intermediary business income have posed significant challenges to the banking sector's performance in 2023. Moving forward into 2024, it is crucial to monitor the improvement of funding costs for liabilitiesRevenue might still exhibit slight fluctuations throughout the year, extending the recovery phase of overall performance, although select high-quality regional banks may demonstrate better performance resilience.

Net interest margins are expected to hit their lows this yearOn the asset side, rates of loans might continue to trend downward in the context of LPR (Loan Prime Rate) reductionsThis could impact new loan pricing negatively and may also affect existing loans subject to repricing, mainly impacting the first three quarters of 2024.

On the liabilities front, cost optimization has become a critical factor in managing net interest margins

Regulatory measures have included four reductions in deposit benchmark rates since 2022, and the cessation of “manual interest subsidies” as of April 2024. At the banking level, some banks have halted the issuance of long-term large-denomination certificates of deposit, with expectations of gradual improvements in cost savings on the liability side.

The cessation of manual interest subsidies and reductions in deposit rates may lead to slight improvements in wealth management scales; however, the fee rates for the distribution of these financial products are anticipated to continue their downward trendThis can be attributed to decreasing rates for fund and wealth management products and residents' preferences for lower-yielding fixed-income products that negatively impact fee performance.

Other sources of non-interest income are likely to show a gradual slowdown in their contribution to revenue

This is due to the inherent uncertainties in the bond market, some banks having realized gains on bond disposals in the first quarter, and regulatory guidance directing regional banks back to their core business, likely resulting in a decline in the volume of financial investments made by banks.

Regarding asset quality, there has been a slight increase in risks for personal loans, while the bad loan ratio for corporate loans continues to declineThe retail sector has seen a noticeable uptick in bad rates, particularly in credit card loans and personal business loans, but these assets typically have shorter durations, allowing risks to be identified and resolved more quicklyAlthough the bad rates of housing mortgages, which are long-term and secured by collateral, have also experienced some fluctuations, they remain at relatively low levels.

The declining bad loan ratios for corporate loans suggest that while risks associated with real estate continue to surface, the rate of marginal increases in corporate real estate bad loans was already slowing in 2023. Different banks are at different stages of risk exposure and resolution, with some showing that their corporate real estate bad loan ratios have already peaked.

The pace at which provisions are being reabsorbed may marginally decrease

On one hand, the continuum of provisioning has persisted for multiple quarters, and amid fluctuations in forward-looking indicators, certain banks may need to increase their provision levelsAlternatively, attention should be paid to the provisioning coverage ratio for Stage 3 financial assets, as some banks may need to supplement their impairment provisions for these assets.

Looking ahead, the revenue growth for banks in 2024 is expected to stabilize after a bottoming phaseThe pace of expansion is likely to slow down, maintaining relative steadinessThroughout the year, net interest margins might still trend downward, but as funding costs improve gradually, these margins are anticipated to stabilizeIn addition, intermediary business incomes are predicted to remain under pressure, with non-interest income contributions to revenue experiencing marginal slowdowns.

The space for reabsorbing provisions may be limited, with profit growth gradually aligning with revenue growth

As of the end of the first quarter of 2024, the ratio of provisions to loans for listed banks fell to 3.06%, which may reduce the supporting effects of provisions on profitsThroughout 2024, the overall performance of listed banks may exhibit slight fluctuations, prolonging the bottoming period, although certain high-quality regional banks may continue to outperform the sector as a whole.

The potential for sustaining high dividend payouts among banks appears promisingCurrently, the emphasis remains on stable, high-dividend investments as a primary strategy for securing fundsWith insufficient domestic financing demands and declining long-term bond yields, the average yield of 10-year government bonds had dipped below 2.5% by mid-June 2024. In the context of the new “Nine Measures,” regulatory oversight of delisting has tightened, leading to increased volatility in smaller-cap stocks

The new policies also aim to enhance cash dividend regulations for listed companies while intensifying incentives for dividend-paying firms, thus reinforcing the dividend investment strategy.

For banks, the expansion of dividend distribution from state-owned banks to selected regional banks has become evidentThe cash dividend ratios of major state-owned banks remain stable, with an average dividend yield of 5.48% as of mid-June 2024, surpassing government bonds by 323 basis points, cementing their attractivenessMoreover, some smaller banks exhibit favorable characteristics such as low valuations and stable cash dividend ratios, with dividend yields exceeding 5%, as seen in institutions like Bank of Beijing and Chongqing Rural Commercial BankAdditionally, several banks have announced mid-term dividend plans, further amplifying the sector's dividend attributes.

Capital requirements inherently constrain the dividend ratios of banks, ultimately influencing their dividend yields

A comprehensive assessment reveals two main reasons why banks can continue to maintain high dividend distributions: first, the slowing expansion of balance sheets can alleviate capital consumptionAccording to the monetary policy execution report for the first quarter of 2024, "the existing monetary credit volume is sufficiently high and will continue to exert influence," alongside mentions of "efforts to minimize idle funds and vigorously develop direct financing measures, likely causing the overall credit growth rate to decelerate." Regulatory measures, such as the halting of “manual interest subsidies,” indicate a future slowdown in the growth of the banks' credit scales.

Second, the implementation of new capital regulations may create certain capital savingsThe newly implemented capital rules since the beginning of 2024 have resulted in an average Core Tier 1 capital adequacy ratio rising by 16 bp at the end of the first quarter of 2024 compared to the end of 2023.

Certain regions have maintained rapid growth in credit scale, particularly high-quality regional urban commercial banks and rural commercial banks that are expected to enjoy continued positive performance

Even though there is a national downward trend in loan growth, regions such as Zhejiang, Sichuan, Jiangsu, Beijing, and Shandong continue to maintain relatively high loan growth rates, with these locales exhibiting double-digit growth as of April 2024.

The revenue growth of high-quality regional urban commercial banks and rural commercial banks demonstrates sturdy resilience, benefiting from strong local credit demandsTheir robust revenue growth suggests ongoing favorable performance in these particular areas.

Notably, the asset quality of high-quality regional urban commercial banks and rural commercial banks remains sound, with sufficient provisions likely supporting their ability to achieve solid profit growthThe sustainability of profit releases correlates with asset quality and provision levels

In 2023, listed banks saw substantial instances of provisions being reabsorbed to bolster profitsThis necessitates maintaining a favorable level for bad loans and asset quality forward-looking indicators, as well as ensuring ample provisionsMoreover, many regional urban commercial banks and rural commercial banks operate in better economic environments and possess solid client bases, which bolsters their asset quality foundation.

Optimizing real estate policies enhances pro-cyclical expectationsThe "New 517 Real Estate Policy" has unleashed demand, catalyzing sales in the real estate market, with most regions aligning with nationwide policies to refine mortgage regulationsCurrently, the exposure of banks to existing real estate risks has been sufficiently assessed, and should the sales and liquidity of real estate developers improve, potential loan risk pressures in the banking sector are likely to recede, allowing for further recovery in valuations across the sector.

Reports for 2023 indicate that bad loan ratios for public real estate loans began to decline among major state-owned banks, with Industrial and Commercial Bank of China and Agricultural Bank of China showing early signs of improvement

Likewise, among joint-stock banks, entities like China Merchants Bank and Minsheng Bank are also witnessing reductions in bad loan ratios.

Data from listed banks reveals that peak bad loan ratios typically hover between 5% and 8%. Presently, not all real estate enterprises are confronting risk events, and conservatively assuming 40% of these firms are at risk, specific projects within those groups may not all face exposureEach project company has varying circumstancesIf it is assumed that 40% of the risky projects amongst identified firms face exposure, then the proportion of risky loans would yield 16%.

Commercial banks manage to recognize and simultaneously handle and write off bad loans; as such, the peak of corporate real estate bad loan ratios is unlikely to attain the theoretical value of 16%. Consequently, it is inferred that the banking sector is at a turning point concerning corporate real estate bad loans, with listed banks poised to maintain bad loan ratios below 8%.

In terms of funding sources for real estate development, domestic loans accounted for only 12% as of 2023, implying that bank loans are proportionately close to this figure in the total project value

Furthermore, such development loans typically require collateral, ranking higher among creditors in repayment priority; given the low ratio of loan amount to total value, actual loss ratios remain comparatively low.

Development loans are primarily allocated to project constructionAssuming average construction and installation costs amount to 30% of total project value, developers also need to self-fund a portion of their capital, as projects do not need to be entirely completed before pre-sales can begin, resulting in development loan funding requirements significantly under 30%. Early on, when housing prices were lower, the proportion of construction costs was somewhat higher, leading to a relative increase in domestic development loansHowever, as housing prices have surged, this cost proportion has decreased.

In 2023, listed banks managed to write off 848.1 billion yuan worth of bad loans, while at the end of 2023, the total bad loan balance stood at 2.03 trillion yuan, reflecting 2.4 times the write-off amount for that year

On average, bad loans can be expected to be written off within a period of 2.4 yearsBeginning in 2021, bad loan rates for real estate companies rose sharply, indicating that banks are expected to initiate substantial write-offs starting in 2023 and extending into 2024.

If the bad loans reduced through write-offs or recovery measures surpass newly generated bad loans during a given period, the total outstanding bad loan balance can begin to decrease, without waiting for the complete exposure of real estate risks.

Analyzing the order of debt risk exposures and resolutions in China reveals a pattern: it is not a case of "real estate driving downstream risk exposure," but rather a sequence where "risks in other sectors are cleared first, followed by the resolution of risks in real estate." During periods of increased real estate bad rates, other sectors' bad rates would have already started to decline, leading to an overall improvement in bad loan ratios

Currently, only real estate developers are grappling with heightened risks, while other associated industries have yet to experience a systemic debt crisis.

From the standpoint of residents' asset-liability ratios, China’s figures remain below those of developed countries such as Japan, the United States, Germany, and the United KingdomMoreover, the ratio of loans to deposits for Chinese residents has been in a steady decline since the end of 2021 after a long-term upward trend post-2009. As of the end of 2021, this ratio finally turned a corner, indicating a reduction in risk within the household sector.

Additionally, the Chinese banking sector has not engaged in subprime lending or adjustable-rate mortgage loans that accompany interest rate hikes; on the contrary, there are even indications of early loan repayments and proactive efforts to reduce leverage among residents.

Currently, the personal bankruptcy system in China is still in its pilot phase, with enhanced measures anticipated to target efforts against debt evasion

Chinese banks are unlikely to enforce blanket demands for customers to provide additional collateral or call for early repayments simply due to falling housing pricesIn the past, locations such as Wenzhou and Ordos have experienced significant drops in housing prices, but defaults among borrowers have not constituted the majority; residential mortgage bad rates have consistently remained low.

A decreasing speed of risk exposure serves as a positive indicatorBanks, as creditors to property developers, witness that the turning point in real estate risk does not correlate with a "turning point in transaction volumes" or "a turning point in housing prices," but rather signifies a "turning point in developer risks." From the perspective of profit and loss statements, a decrease in the speed of risk exposure among developers will correspondingly reduce provisioning losses recognized on banks' profit and loss statements, leading to a recovery in profitability.

As discussed above, several banks have seen marginal declines in bad loan ratios related to property loans, indicating signs of a turning point in developer risks

However, neither transactional volume nor housing price turning points have yet been evident in statistical data.

The market tends to focus on banks' financial reports and directly disclosed interest margin data from regulatorsIt is important to note that this data constitutes cumulative figures, meaning that annual reports from 2023 and regulatory indicators reflect averages across all four quarters of the yearThis creates an impression that the first quarter of 2024 has experienced significant declines compared to 2023; however, our calculations suggest that the decline in interest margins in the first quarter of 2024 relative to the fourth quarter of 2023 amounted to only 2 basis pointsWith regulatory measures advancing since the second quarter, it is anticipated that interest margins will stabilize in the second quarter of 2024.

Reviewing the valuation performances of bank stocks from the end of 2022 to the end of 2023, it becomes apparent that during a period of weak fundamental confidence, stocks with high dividend yields were favored

As the economic fundamentals began to recover, the dividend yields of urban commercial banks approached those of their state-owned counterparts, and the gap between the valuations and fundamentals of high-quality stocks shrankShould real estate risks decline and macroeconomic confidence gradually improve, the valuations of joint-stock banks are likely to rise in tandem with these developments.

Theoretically, the beta values of urban commercial banks are comparable to those of joint-stock banks; however, in the short term, valuations of many smaller banks may be affected by convertible bond mechanics, either triggering mandatory redemptions or facing impending maturity issues.

Overall, it appears that valuations for joint-stock banks are currently relatively low, largely influenced by their significant exposure to the real estate sector