(Yicai Global) Aug. 5 -- China's small and medium banks face a great increase in non-performing loans and an imperfect governance system that has prompted domestic credit rating agencies to downgrade some as fallout of major operating risks from a narrower rate spread as they have lent to the real economy for less interest since the Covid-19 outbreak.

Shanghai Brilliance Credit Rating & Investors Service lowered Jiaohe Rural Commercial Bank's credit rating to BBB from BBB+ on July 30, and China Chengxin International Credit Rating demoted Yantai Rural Commercial Bank to A+ from AA-. Jiaohe Rural Commercial Bank in Northeast China is temporarily unable to recoup CNY3.6 billion (USD517.5 million) in receivables investment, which will greatly impact its asset quality, liquidity management, profitability and capital adequacy level. East China’s Yantai Rural Commercial Bank is suffering a swift and sustained increase in NLPs, a provision coverage which is falling consistently and well below regulatory requirements, a higher concentration of industries and clients to whom it lends, a larger proportion of overdue loans and new loans used to pay off earlier ones as well as further downward pressure in asset quality, according to its rating report.

Raters predict the asset quality of commercial banks will still be under downward pressure in the second half, with SMBs the hardest hit.

Policy support for these lesser players continues to rise. The State Council, China's cabinet, called for a reasonable capital increase for SMBs at a meeting in June, urging them to improve internal assessment and incentive mechanisms and redoubled efforts to write off and deal with NLPs.

Reform of smaller lenders must improve their governance system and internal controls and lift their risk control and profitability, Wu Xiaoling, a former vice governor of China's central bank, said in an Aug. 3 report. Even if banks temporarily solve financial problems by replenishing capital, fundamental risks otherwise inherent in their governance and operations will remain, Wu stressed.

Addressing CNY200 billion regulators plan to appropriate for SMBs from the year's special debt quota, Wu suggested the government should set this as an opportunity for reform, supplementing the banks' capital while defusing existing risks to redress problems in the bank governance system.

Editors: Xu Wei, Ben Armour