The Impact of Lowering Policy Rates on the Banking System

Abstract: There are two main concerns with using policy rate cuts to boost aggregate demand. One is the pressure on the RMB exchange rate and capital flows. This pressure has been significantly eased in the current context of U.S. interest rate cuts and large China's trade surplus. The other concern is that lowering policy interest rates would narrow interest margins, impacting the stable operation of the banking sector. The basic logic behind this is as follows:

(1) China still relies on an indirect financing system dominated by banks, and thus the stability of the banking system is crucial. (2) The core business model for most banks is still “accepting deposits and making loans,” and their ability to operate sustainably depends heavily on the net interest margin between deposits and loans. (3) Historically, lowering the benchmark interest rates has led to a narrowed interest margin, which directly impacts banks’ profitability and, in turn, affects their ability to operate as financial intermediaries, even posing potential risks to financial stability.

In response to this issue, this report first analyzed the theoretical impact of policy rate cuts on banks and proposed a preliminary framework for understanding this impact. Second, the report analyzed the impacts of sharp interest rate cuts in developed countries on their banking systems and drew preliminary conclusions based on those impacts. Finally, the performance of China's banking system during the interest rate cut cycle of 2014-2015 was reviewed. Based on the above analysis and combined with several characteristics of the Chinese banking system, we explored the potential impact of significant policy rate cuts on China's banking sector, and proposed policy recommendations.