Chen Daofu: The decision on macro interest rate cuts should be separated from the interest margin decisions of micro entities

On January 5, 2025, at the China Wealth Management 50 Forum seminar "Research on Capital Supplementation of Commercial Banks under Low Interest Rate Spread: Challenges and Responses," Chen Daofu, Deputy Director of the Financial Research Institute of the State Council Development Research Center, stated that under the background of low interest rate spreads, it is necessary to distinguish between the trend and cyclical factors of spread decline, analyzing its driving factors, including macroeconomic downturn, asymmetric interest rate cuts, and additional policy costs borne by banks. These factors lead to a decline in banks' willingness and ability to take risks, resulting in a downward trend in spreads that has self-reinforcing characteristics. It is possible to calculate the bearable spread level in different scenarios, considering three extreme situations: the limit under normal circumstances, the spread level when risk reserves are exhausted, and the extent of low spreads when banks incur losses, as well as three levels of capital supplementation robustness.

It is necessary to separate macro interest rate cut decisions from micro entity spread decisions. Macro policy tools and financial stability tools are different; interest rate cut policies are primarily for macro regulation, while the stability of the financial system requires other tools. Currently, interest rates are higher than corporate asset returns, leading companies to shrink marginal businesses, an increase in bank non-performing loan rates, and a self-sustaining reduction in spreads. Macro policies, financial stability policies, and micro transformation reform policies need to be implemented to cut off the bad process. The housing loan business should adopt market-oriented interest rate cuts, adjusting both existing and new personal mortgage rates to balance with the rent-to-sale ratio, forming a reasonable housing price balance mechanism.

Seeking Truth

First, under the current background of low interest rate spreads, it is necessary to distinguish between the trend factors and cyclical factors of spread decline. Is there a situation where the spread has declined too quickly during this period? Will there be a rebound in some parts in the future? Which parts are experiencing a sustained decline? Against the backdrop of spread changes, both long-term capability transformation and structural adjustments are needed, as well as support from macro policies to smoothly navigate this phase.

Currently, macroeconomic downturns, asymmetric interest rate cuts, and the requirement for banks to bear some additional policy costs have jointly led to a decline in spreads. In this environment, banks' willingness and ability to take risks are also declining, with banks increasingly inclined to support low-risk leading enterprises, concentrating assets more on leading enterprises in the industry, resulting in intensified price competition in the red ocean market, further triggering a continuous decline in spreads. This downward trend has self-reinforcing characteristics. Therefore, it is essential to first analyze the driving factors behind the spread decline, distinguishing between long-term and short-term factors.

Second, it is possible to calculate the bearable spread level in different scenarios. Specifically, the basic logic for calculating the safe spread level currently is to ensure that banks' profit retention, i.e., endogenous financing can continuously meet capital supplementation requirements. This is merely a calculation approach for the bearable spread level of banks under a specific scenario. If there are some non-trend factors contributing to low spreads in the short term, banks may temporarily exceed the safe spread level. Therefore, it is possible to calculate the bearable spread level under different scenarios.

Extreme situations can be subdivided into three types. First, the limit under normal circumstances, which needs to be calculated based on different endogenous sustainable capital supplementation logics. Second, the spread level when various risk reserves are exhausted. For example, if various risk reserves are reduced to the levels stipulated by regulatory authorities, then to what extent can the spread be allowed to decline over what period, i.e., the extent of spread decline that can be tolerated in the short term Third, under the bottom line scenario, if banks incur losses, to what extent can the low interest margin be reduced, and for how long can it last without jeopardizing the bank's ongoing operations? Therefore, three levels can be considered: first, capital replenishment meets regulatory requirements, ensuring that banks can maintain a stable operational position; second, after the depletion of reserves, banks can still operate steadily, but the degree of stability decreases; third, when banks are in an unstable but still operational state.

Third, the macro interest rate reduction decision should be separated from the micro entity's interest margin decision. From a macro perspective, interest rate adjustment tools are more focused on macroeconomic stability, while interest margins are a response from banks under the corresponding policy context. Currently, it is indeed the case that interest rate cuts will lead to corresponding changes in interest margins, but if interest rates are not cut, it may lead to a contraction of the entire macro economy, and even trigger a gradual increase in the bank's non-performing loan ratio. Macro policies will affect and be constrained by micro entities, but the formulation of macro policies must be based on the current realistic characteristics of micro entities. In the context of the macro market, some micro policies can be employed, including the use of fiscal resources and public resources for capital injection, but it is not advisable to rigidly link them with the macro decision of interest rate cuts; the two should actually be separated.

For the central bank, banks are the carriers of credit expansion. If the stability of the banking financial system is to be maintained, macro policies must take into account the stability of the financial system and the robustness of each node. However, the tools of macro policy and the tools for financial stability are two different sets of tools; interest rate cut policies are primarily a tool of macro policy, while the stability of the financial system should be achieved through other tools.

Currently, it is actually difficult to achieve asset expansion of micro entities through interest rate cuts. The current interest rate level (weighted average loan interest rate) is higher than the asset return rate (ROA) of the vast majority of enterprises. In this situation where there is a significant difference between interest rates and ROA, the rational decision for enterprises is to shrink marginal businesses and focus on core businesses. If the return rate of core businesses is still lower than the financing interest rate, the rational decision should be to exit the market. Over the past year, more and more enterprises have shown this trend of contraction.

Since last year, the non-performing loan ratio in certain areas of banks has been rising rapidly, especially in the small and micro enterprises and retail sectors. From credit cards to business loans, and now to personal mortgages, the non-performing loan ratios are all rising rapidly. Against the backdrop of a continuously declining macro economy and banks increasingly concentrating their risk preferences on high-quality clients, the narrowing of banks' interest margins will become self-sustaining. If, in order to protect short-term bank profits (revenue), micro entities are allowed to shrink and exit, and social risk preferences are allowed to decline, then banks' interest margins will face a "boiling frog" decline, ultimately leaving banks without means to respond. Therefore, measures must be taken in macro policy to cut off this adverse cycle. I personally believe that this can be achieved through three different policy systems: macro policies, financial stability policies, and micro transformation reform policies.

Regarding the stability of the housing loan business sector, housing loans themselves belong to low-risk, high-yield business types. If this business can operate fully in a market-oriented manner, then its interest rates should also be correspondingly reduced. Specifically, both the interest rates of existing personal mortgages and the interest rates of new personal mortgages should be adjusted downwards as soon as possible, gradually bringing them to a state close to balance with the rent-to-sale ratio, thereby forming a reasonable balancing mechanism in terms of housing prices The author of this article: Chen Daofu is the deputy director of the Financial Research Institute of the Development Research Center of the State Council , Source: China Wealth Management 50 Forum, Original title: "Chen Daofu: The decision on macro interest rate cuts should be separated from the interest margin decisions of micro entities"

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