Banking historically is an extremely profitable business in China and last year was no exception.

Combined net profits at China’s commercial banks totaled CNY1.24 trillion (USD197.5 billion) last year, nearly 19 percent higher than in 2011. The industry grew its assets by nearly 18 percent last year as well.

Given this strong earnings growth, Western ratings agencies have maintained their solid ratings on the banks, most recently when Standard & Poor’s reaffirmed its “stable” outlook on Chinese banks.

However, 2013 isn’t likely to be such a positive year for these lending institutions, with all but one of the five largest state-owned banks lowering their forecasts for profit growth this year. They now expect profit growth in the low single digits. The People’s Bank of China (PBOC) has begun clawing back its liquidity injections of the past few years and regulators are expected to cap loan growth at CYN9 trillion (USD1.45 trillion) for the year.

Interest spreads are also expected to narrow, based on the general expectation that the PBOC will begin to push up the nation’s benchmark interest rate as the Chinese economy returns to growth. Further liberalization through the formation of joint stock commercial banks (JSCB) is also expected to eat into loan growth at China’s Big Five state-owned banks: Industrial and Commercial Bank of China (Hong Kong: 1398); China Construction Bank (Hong Kong: 0939); Agricultural Bank of China (Hong Kong 1288); Bank of China (Hong Kong: 3988); and Bank of Communications (Hong Kong: 3328).

However, as explained in this issue’s main feature article, not all Chinese banks are created equal.
The country’s JSCBs, which are subject to much less government influence than other Chinese banks, will fare much better than the state-owned institutions in terms of growth and will be subject to less margin pressure.
Primarily serving small and medium-sized enterprises (SME), the JSCBs have a much larger pool of potential customers and that pool is largely underserved.

A common complaint from Chinese SMEs is that they’re largely locked out of China’s bank loan market, since most only have access to large, state-owned banks which typically choose to loan only to other state-owned enterprises. That problem becomes particularly acute during times of tight credit.

JSCBs also tend to run much higher net interest margins, usually between 1 percent and 2 percent higher than the state-owned banks. Thanks to tentative steps towards liberalizing the country’s interest rates, JSCBs are typically able to charge higher rates of interest on their loans than their larger peers since they aren’t lending to other state-owned enterprises (SOE). Their interest expense also tends to be lower since they tend to finance more of their loans from deposits rather than through government borrowing.

One of the most successful JSCBs in China has been China Minsheng Banking Corp (Hong Kong: 1988).

Formed in 1996, Minsheng was one of the first JSCBs created in the wake of early banking reforms in China. The bank was founded by Jing Shuping, a ardent supporter of China’s Communist revolution in 1949 and a guiding force in the creation of one of China’s first sovereign wealth fund. He is also credited with founding China’s first post-revolution law practice, consultancy and accounting firm.

Despite Jing’s ties to the Chinese Communist Party, he firmly believed that banks should be market-oriented businesses, even when that view was completely in line with prevailing ideology. But given his status, he faced little government opposition to how he believed the bank should be run and, as a result, over the past 17 years it has grown to 640 branches across China and more than RMB2.5 trillion in total assets.

As with the other JSCBs that have come since, Minsheng primarily serves SMEs and nonstate-owned enterprises that make up 84.2 percent of its client base.

Thanks to sound, market-oriented management, the bank consistently generates a better than 25 percent return on equity, a measure that would be the envy of many Western banks. Its net profits have consistently grown by better than 20 percent annually, with earnings per share of RMB0.69 in the first half of last year.

Minsheng has also done an excellent job of growing its non-interest income by about 15 percent annually, by steadily introducing wealth management services for retail clients and a variety of services for corporate clients.
At the same time, Minsheng has maintained solid credit underwriting practices, with a nonperforming loan ratio average of about 0.65 percent.

The bank will continue to benefit from the liberalization of JSCB regulations. While that does have the potential to create additional competition over the long-term, over the short- and intermediate-terms the persistently high barriers to entry will allow it to operate in a relatively protected market.

The bank is also working to better integrate its technology platforms, which will allow it to offer service on a more national scale, with clients easily able to conduct business in any of its branches nationwide, rather that its current local level of service.

It has also embarked on an aggressive marketing campaign to grow its visibility to medium-sized enterprises, working to lure their business in by providing a widening array of corporate banking services and offering trade finance at very competitive rates.

Although already prudent in its lending, the bank has also worked to adopt standardized risk management systems that will reduce some of the subjectivity in its underwriting process by using credit ratings that have become available in China over the past few years.

Minsheng should maintain its impressive track record for growth, particularly as the central government continues to shift its economic focus to a more service-oriented economy, necessitating better access to capital for SMEs.

China Menshing Banking Corp, a new addition to our Long-Term Portfolio, rates a buy up to HK15.