The current financial landscape is demonstrating a notable structural rise in the cost of capital, characterized particularly by an inversion where short-term interest rates exceed those for the medium to long-termThis phenomenon has significant implications for market dynamics and banking operations, leading to a necessity for adaptation among financial institutions.

As of February 20, the interbank repo market is reflecting this trendAt the moment of reporting, the rates for the DR007, DR014, and DR021 instruments stand at 2.123%, 2.040%, and 2.080%, respectively, all exceeding the rate of 1.97% for the one-month periodOn a macro scale, there is an observable upward shift in the average funding rate, with the DR001 rate moving from around 1.5% at the end of the previous year to approximately 2% now.

This rising pressure on the banks' liabilities has become apparent, prompting many to turn to the interbank certificate of deposit market as a means to bolster their capital positionsBy February 20, approximately 40 banks have disclosed their plans for issuing certificates of deposit for 2025, collectively exceeding a staggering 10 trillion yuanBank insiders are suggesting that the pressures on liabilities remain unresolved, compounded by multiple disturbancesConsequently, February has seen a tightening in the liquidity of the financial landscape, posing challenges ahead for cash flow managementThe upcoming sessions of the National People's Congress (NPC) are expected to shed light on the central bank's commitment and cadence in utilising counter-cyclical tools.

As we approach 2025, stark pressures on bank liabilities have begun to emergeData from Wind indicates that between December 2024 and January 2025, there was a substantial reduction in non-banking deposits amounting to 4.48 trillion yuanSpecifically, January alone witnessed a drop of 1.04 trillion yuan, with the deposits from major banks also seeing a decrease of 393.3 billion yuan during that month

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This situation correlates closely with newly instituted self-discipline regulations for non-banking deposits introduced in the fourth quarter of 2024, which capped interest rates, diminishing the traditional pricing advantages of major banks and redirecting capital towards smaller financial institutions.

According to a representative from a state-owned bank’s asset-liability department, the bank has noticed a decline in deposit rates compared to smaller banksAdditionally, more lucrative products such as structured deposits and agreement deposits are now under stricter regulations, leading to a discernible loss of customersThis exodus of deposits directly impacts banks' asset management capabilities, constraining their ability to lendTo mitigate this funding gap, banks have proactively reduced their lending volumes, leading to a decrease in the scale of asset purchases and repo transactions, as evidenced by a reported 2.09 trillion yuan year-on-year drop in bank repurchase agreements in January 2025.

This reduction in balance sheet size exacerbates the liquidity stress within interbank markets, continuing to push money market interest rates upwardWith a higher liability pressure compounded by banks’ robust lending activities in January—often termed as a ‘New Year lending boom’—the surplus cash levels within the banking system are tighteningResearch from the Kaiyuan Securities team estimates that by the end of January, the excess reserve ratio had fallen to 0.93%, down by 0.17 percentage points from the prior monthModels suggest that considering other factors like a net monetary policy contraction of 1.5 trillion yuan by the central bank and government bond payments of 500 billion yuan, this ratio could dip further to approximately 0.52%, significantly below the industry’s safety threshold of 1%. This scenario indicates that without an urgent infusion of around 1.3 trillion yuan in liquidity, the banking system could face payment and clearing risks.

A myriad of factors has intensified the pressures on the banking sector’s liabilities

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There is a pronounced outflow of the base currency via multiple channels, leading to a tight liquidity positionA representative from a joint-stock bank’s funds operation center explained that a large-scale remittance of fiscal deposits due to debt transfer has significantly drained capitalSimultaneously, the festive cash withdrawal rush during the Spring Festival has resulted in roughly 800 billion yuan leaving the banking sector.

Amidst the newly implemented regulations on non-banking deposits, large state-owned banks have experienced more significant capital outflows compared to smaller institutions; however, smaller banks, particularly urban and rural commercial banks, are facing a decline in stability on their liability side due to the continuous shrinkage of local fiscal depositsA representative from a city commercial bank noted that the proportion of fiscal deposits has substantially diminished compared to before.

Recent statistics from the Ministry of Finance reveal a 12.2% year-on-year drop in local government fund revenues in 2024, caused by reduced land transfer revenues coupled with the debt transfer, which has adversely affected the liability side of banks relying heavily on fiscal depositsFurthermore, the accelerated issuance of government bonds is also impacting the liabilities of banksData from Wind indicates that in February, net financing from government bonds is projected to reach a historic peak of 1.8 trillion yuan for a single monthLi Qinghe, Chief Analyst of Fixed Income at Guolian Securities, argued that while the front-loaded issuance of replacement bonds may help alleviate local debt risks, the short-term surge in payments further drains liquidity from the banking system, creating a negative feedback loop characterized by "fiscal income flowing in — banks being drained of capital."

Additionally, the combination of policies related to self-regulation of non-banking deposits and manual interest adjustments has compelled banks suffering from deposit losses to pivot towards issuing interbank certificates

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Notably, by February 20, over 40 banks had revealed their certificate of deposit plans for 2025, surpassing a total scale of 10 trillion yuanCITIC Bank leads this surge with a staggering quota of 1.48 trillion yuan, followed closely by urban commercial banks such as Jiangsu Bank and Beijing Bank, both reporting over 20% growth in their registered volumes.

This wave of registrations can be traced back to the end of 2024 when numerous state-owned banks, including Agricultural Bank and China Construction Bank, increased their issuance amounts drasticallyIn response to a liquidity gap exceeding one trillion yuan in February, the central bank has refrained from lowering reserve requirements or interest ratesOn February 20, it was confirmed that the Loan Prime Rate (LPR) would remain unchanged, maintaining status quo for both one-year and five-year terms.

Chief Economist Mingming from CITIC Securities pointed out that the central bank's decision not to adjust reverse repo rates in February adds pressure to the banks’ interest marginsFollowing the end of the Spring Festival holiday, there has been a noticeable improvement in credit demand; however, limited operations by the central bank in open market transactions have led to heightened tension in commercial banks’ liability sides, leaving them with insufficient incentives to lower LPRs or adjust reverse repo ratesAt the same time, the cooling pace of quantitative easing from the Federal Reserve since the beginning of 2025, along with significant uncertainties in interest rates and exchange rates between China and the United States, has kept the offshore Chinese yuan trading around 7.3 after the holiday period.

Furthermore, the hot start to the credit market at the beginning of the year signals a fundamentally stabilizing economy; thus, the urgency and feasibility of lowering the LPR in February appear limitedMoving forward, the Q4 monetary policy report for 2024 continues to advocate for "moderately loose" monetary policy, emphasizing the comprehensive use of various monetary policy tools, including interest rates and reserve requirements

This demonstrates the central bank’s sustained commitment to a proactive monetary policy stanceConsequently, potential adjustments to the LPR in conjunction with reductions in reverse repo rates may remain feasible, contingent on insights derived from the upcoming NPC regarding the intensity and pace of counter-cyclical adjustments.