OREANDA-NEWS. A plan to remove the 75% statutory limit on the loans/deposits ratio (LDR) for China's commercial banks should contribute to enhancing financial system transparency around credit exposures, reduce the incentive to retain risk off-balance sheet and ease deposit competition, says Fitch Ratings. This signals the authorities' commitment to financial reform, together with other recent measures, while responding to challenges from a slowing economy. Yet constraints will still remain for banks to bring assets back on balance sheet.

The 25 June announcement from the State Council that the LDR limit would be removed as a statutory requirement is part of a broader effort to deregulate China's banking system and free up liquidity to boost lending. The short-term implications from the removal of the LDR limit are likely to be limited. But any improved transparency from reducing banks' incentives to shift risk off balance sheet will eventually improve the accuracy of risk-weightings and reliability of credit quality metrics. This could in turn have positive rating implications for banks' Viability Ratings (VRs).

Fear of breaching prudential ratios, including the LDR limit, has contributed to banks' expanding off-balance sheet exposures in the last few years, in part through the shadow banking system. This means that the effective LDR of some banks is already likely to be higher than 75% versus the reported system-wide LDR of 65% at end-1Q15, according to the China Bank Regulatory Commission. Off-balance sheet exposures can affect the credit profiles of Chinese banks owing to their rapid growth and limited transparency and disclosure around these risks, including uncertainty over where ultimate default liability lies.

Restrictions still exist in terms of banks' lending to certain sectors, but allowing for more credit to be brought back on the balance sheet will give greater insight as to the sufficiency of bank capital. To the extent that problematic assets are brought back on balance sheet, it could increase pressure on reported asset-quality metrics, but will also make asset quality and provisioning data more meaningful for analysts.

It may also reduce the need for wealth management product (WMP) funding for banks over the longer term, when coupled with deposit-rate liberalisation. More broadly, this should help to ease deposit competition within the system and enhance net interest margins (NIM). However, NIMs for the sector are still likely to remain under pressure this year owing to interest-rate cuts. Friday's announcement to lower the one-year benchmark lending rate by another 25bp - to 4.85% - brings the total reduction in rates to 115bp since November 2014.

Lifting the LDR cap will not entirely eliminate the constraints which incentivise banks to maintain risk off-balance sheet including via the shadow banking sector. Banks will still be reluctant to re-classify exposures immediately if it leads to much higher risk-weighted assets and pressuring capital ratios. Furthermore, the benchmark reserve requirement ratio (RRR) remains high at 18.5% (though this is lower for some banks with larger exposures to agriculture and micro and small enterprises) despite the recent reductions.

Removing the LDR cap has the potential to lead banks to expand credit, especially to potentially higher-risk small- and medium-sized enterprises and micro-enterprises - sectors being specifically targeted for increased credit by policymakers. The targeted RRR cut on Friday further emphasised the authorities' efforts to make further room for banks to increase credit to these sectors. Fitch has consistently highlighted the potential that easing measures could result in another lending boom, raising the risk profile of banks' loan books and putting further pressure on capital.

That said, the potential for a sudden increase in lending is likely to be limited in the short term - especially as credit demand remains weak relative to the last few years. It is also important to note that according to the plan, the LDR will remain as a guideline for measuring liquidity risk, indicating that Chinese banks will still be subject to regulatory guidance regarding their LDRs.

Data suggests that excessive lending has not emerged as a result of decisions this year to ease monetary conditions. Credit continues to grow in excess of GDP, but the composition has changed. Notably, the increase in total social financing (TSF) is down 20% year-on-year over the first five months of 2015 while shadow financing now comprises a far smaller proportion of the increase in TSF. Bank loans made up 76% of the increase in TSF during January-May 2015, up from 59% over the same period in 2014.