China's midsize and locally focused banks reported faster increases in borrowers failing to repay their loans on schedule in the first quarter as the economy contracted, suggesting a rising risk of bank failure among smaller and less capitalized lenders, experts say.

Among all bank types, city commercial banks reported the highest year-over-year increase in nonperforming loan ratio to 2.45% as of end-March, from 1.88% a year earlier, according to the latest data released by the China Banking and Insurance Regulatory Commission. It was followed by privately owned banks, with their aggregate ratio rising to 1.14% from 0.68%. Rural commercial banks continued reporting the highest NPL ratio in the country at 4.09%, up from 4.05% a year earlier.

As of end-March, these three types of banks sat on 1.141 trillion yuan of nonperforming loans, or 43.7% of all bad loans in the nation's banking system. It was up from 880.30 billion yuan a year earlier, or 40.8% of the system's total.

"If asset quality continues to deteriorate, rural banks would have pressure [to book] higher provisions which would weigh on profits, as well as capital levels," said Cindy Wang, an analyst at DBS Group Research.

"Then [the People's Bank of China] might need to ask [state-owned] banks to save small bank[s]."

There have been several bank failures in China since May 2019 but Beijing either seized management of the lender or launched state-backed bailouts to prevent them from collapsing. This was seen to have helped prevent financial contagion from spreading to other parts of the system.

"It's likely to see failures and takeovers of some weaker regional banks like what we did in 2019," said Iris Tan, senior equity analyst at Morningstar. She added that apart from NPL ratios, special-mentioned loans, overdue loans, and capital adequacy ratios are some of the indicators to keep an eye on to monitor this situation.

Pressure on bank capital

Most banks in China remain reluctant to heed Beijing's call to lend more aggressively to small businesses and rural borrowers as the economy shrank. Still, NPL ratios rose for most bank types in the first quarter, with the average NPL ratio of all Chinese commercial banks rising to 1.91% as of end-March from 1.80% a year earlier.

Locally focused, smaller and less capitalized banks are seen more vulnerable, as their main customers are the population that has some of the weakest credit profiles but needs the money most.

China's central bank has introduced measures such as boosting the relending and rediscount quotas as well as slashing the required reserve ratios of small and midsize banks to recapitalize banks.

"Compared to [state-owned enterprises], [privately owned enterprises] are more fragile in terms of a shortage of working capital and funding channels," said DBS' Wang. "During the city lockdown and business suspension in [the first quarter], a lot of private companies face operation difficulties which lead to higher default risks."

Morningstar's Tan said the sharp increase in NPL ratios for city commercial banks was "surprising," given the industry and geography mix in their overall loan books.

"Such sharp increase in NPL [ratios] probably suggested its weaker borrower base, with high exposure to inclusive finance, SMEs and personal consumption loans," she said.

DBS's Wang added that city commercial banks and rural commercial banks need to look out for their capital adequacy levels, which reached near 13% in the first quarter, not much above the 10.5% requirement for non-systemically important banks.

"They need to be more careful to balance lending and bad debts" in case of an acceleration in capital consumption, she said.

As of May 18, US$1 was equivalent to 7.11 Chinese yuan.