China intends to boost bank dividends with proposed cap on bad loan provisions, but will this backfire?

China’s Finance Ministry has proposed a new rule that would cap the amount banks have to set aside for bad loans, a move that could boost dividends to shareholders but weaken banks' capabilities to absorb losses in the future.

The minimum loan loss provision is currently set at 150 per cent of impaired loans - in other words, a bank has to set aside 1.5 yuan (0.21 US cents) for every 1 yuan (0.14 US cents) of loan losses it expects. The proposed new rule would cap the loan loss reserve ratio at 300 per cent.

Virtually all Chinese banks already set aside more money than the required minimum to project an image of trustworthiness. At the end of June, at least seven listed Chinese banks had loan loss provisions of more than double the amount regulators required, according to their interim reports released by stock exchanges.

The Agricultural Bank of China, one of the country’s big four state-owned banks, has a provision coverage ratio of 278 per cent, while Bank of Ningbo set aside 522 per cent, and China Merchants Bank and the Postal Saving Bank of China had provision coverage ratios of about 400 per cent.

The ministry is seeking public comment on the proposed changes until October 26. If implemented as currently drafted, the changes would have a have a lasting impact on Chinese banks’ balance sheets.