Risk management for small and medium-sized banks shifts to long-term governance; credit reconstruction is the key.

Ask AI · How can risk transmission mechanisms in small and medium-sized banks form a negative feedback loop?

21st Century Business Herald reporter Zhang Xin

Under the strategic guidance of high-quality development of finance and the building of a financial power, the work of resolving risks in small and medium-sized banks is undergoing a deep transformation from emergency tackling to long-term governance.

On March 26, Chen Xutong, Deputy General Manager of the Financial Rating Department 1 of United Credit, said at the United Credit 2026 China Bond Market Credit Risk Outlook Forum, “Overall risks of small and medium-sized banks are controllable, but tail risks still need to be kept in mind. The ultimate goal of risk resolution is to achieve credit reconstruction through the combined efforts of multiple parties, enabling the industry to achieve ‘improved quality while reducing volume’, and to return to the original purpose of serving the real economy.”

From the perspective of top-level design, the policy direction for risk disposal in small and medium-sized banks is already very clear. From building a financial system in the “14th Five-Year Plan” to building a financial power in the “15th Five-Year Plan,” strategic objectives place even greater emphasis on balancing high-quality development with security. The development model is shifting toward promoting differentiated, high-quality development, while risk disposal is shifting from “emergency handling” to long-term governance.

At the same time, regulators have already clarified the core framework of long-term governance, including the overarching requirements of early correction, closed-loop disposal, and reducing volume while improving quality; a coordinated mechanism in which the central government, local governments, and regulators work together; the responsibility-tightening principle of “who approves, who regulates, who is responsible”; and a tri-track approach to disposal—mergers and acquisitions, online remediation, and market-based exits running in parallel.

Chen Xutong analyzed that, currently, small and medium-sized banks in the industry exhibit four major features: declining share and proportion, narrowing profitability net interest margins, relatively high asset risk appetite/level, and relatively tight capital replenishment. Meanwhile, some small and medium-sized banks have complex equity structures and weak corporate governance, laying hidden risks that make them key risk areas that the market and regulators focus on.

So how do risks in the small and medium-sized banking industry form and transmit?

Chen Xutong believes the main reason is that, as regional banks, the root causes of risk for small and medium-sized banks are deeply tied to regional industrial structure and the characteristics of economic entities. Once the economy enters a downturn cycle, competitive pressure among major regional industries rises, triggering a negative feedback loop. On the one hand, borrowers’ repayment capacity declines, leading to early-warning signals for asset quality. On the other hand, an economic downturn also reduces corporate loan demand, and coupled with competition from large banks, small and medium-sized banks are forced to move down-market to customers with weaker qualifications, thereby increasing risk-control pressure.

Chen Xutong said that under these two dual factors, asset quality at small and medium-sized banks declines; banks need to set aside more provisions, which erodes profits. Their ability to replenish capital endogenously is weakened, the capital adequacy ratio faces pressure, and this in turn leads to passive adjustments to business strategies, forming a transmission chain in which risks gradually become more visible. Currently, asset quality in corporate real estate and urban investment (chengtou) sectors has been brought under certain control under policy protection, but risks in the retail sector are still being continuously exposed. Some banks’ consumer loans and credit cards’ non-performing loan ratios still show an upward trend, becoming risk points that need to be given key attention.

Lin Qing, General Manager of the Research and Development Department of United Credit, added that small and medium-sized financial institutions generally face challenges such as pressure on business growth, difficulty in improving profitability, risks of falling asset quality, and potential intensification of divergence in capital adequacy ratios. Although “village-to-branch reforms” (cun gai zhi zhi) and mergers and acquisitions can help reduce risks, the effectiveness of their transformation still needs to be observed.

Although challenges remain, through concentrated resolution during the “14th Five-Year Plan” period—especially in the past five years—using measures such as mergers and acquisitions, state-owned capital taking equity stakes, special-purpose bond supplements to capital, and local governments’ assistance in stripping non-performing assets, overall risk at small and medium-sized banks has clearly narrowed, and systemic risk has been effectively controlled. However, Chen Xutong cautioned that tail risks still need sustained attention.

The risk rating results from the People’s Bank of China show that, currently, the number of high-risk banking institutions has declined from 357 at the end of 2023 to 312 in the first half of 2025, a reduction of 45. The total number of participating institutions decreased from more than 3,900 to about 3,500, a reduction of 400, directly reflecting the industry’s results of reducing volume while improving quality. Regionally, nine provinces have already achieved zero for high-risk institutions, and regional financial ecosystems continue to improve.

“The ultimate purpose of resolving risks is not simply to wipe out risks, but to help small and medium-sized banks rebuild credit and return to high-quality development,” Chen Xutong emphasized. Credit reconstruction needs to be jointly supported by the “five major pillars”: first, to strengthen the foundation of corporate governance; second, to build a comprehensive risk-control system; third, to strengthen the driving engine of technology empowerment; fourth, to build a professional talent team; and fifth, to improve external policy safeguards.

Based on this, it is necessary to implement categorized policies for small and medium-sized banks. High-quality city commercial banks and provincial rural commercial banks should grow strong regional champions and build distinctive features in inclusive finance and green finance. Newly established banks formed after integration, such as Sichuan Bank and Shanxi Bank, need to accelerate the unification of risk-control and IT systems to achieve “chemical integration” and repair market credit. Weak regional small and medium-sized institutions should focus on basic services, strictly control cross-regional operations, and speed up restructuring or market-based exits. In risk-weak regions such as Northeast and Northwest China, it is possible to explore an extraordinary model of “provincial-level coordination + large bank custody + centralized risk disposal (centralized化险).”