Major Chinese commercial banks have benefited enormously from massive money inflow and the infrastructure boom in recent years. However, the good old days have long gone and they are now facing huge challenges ahead amid the changing economic landscape.

Interest rate liberalization has been a fearsome term for many Chinese bankers and I think it is a reasonable fear. People's Bank of China Governor Zhou Xiaochuan signalled in March that China has met the basic requirements for interest rate liberalisation and the PBOC would push forward the process.

The first blow finally came on June 7 when the central bank announced benchmark interest rate cuts on yuan deposits and loans while enforcing two other changes on the same date: (i) raising the upper limit of the interest rate floating range to 1.1x of the benchmark rate, and (ii) revising down the lower limit to 0.8x of the benchmark rate. Just one month later, the PBOC declared another rate cut while revising down the lower limit of the lending rate floating range to 0.7x of the benchmark rate. After the two revisions by the PBOC, if one-year deposits are priced at 1.1x benchmark rate and one-year loans priced at the lower limit of 0.7x, then the interest spread would be compressed to a mere 0.9 percent. In short, net interest margin (NIM) compression has become reality.

On the other hand, the pressure of interest rate liberalisation may be more manifest on deposit costs than loans. Under a strict loan-to-deposit ratio (LDR) requirement, banks ferociously compete for deposits. After the PBOC lifted the upper limit of the floating range to 1.1x of the benchmark rate, most banks immediately raised the deposit rates to above the benchmark. Banks are likely to revise upward deposit rates again in accordance with the central bank's future upward revision to the upper limit of the floating range, due to the pressure to keep deposits.

The potential impact of interest rate liberalisation on banks' profitability can be quite significant. As of the first half of this year, banks' deposit and loan interest spread was around 5.12 percent. If the banking industry does not introduce timely adjustments to mode of operation and customer mix, then the interest rate liberalisation would reduce the interest spread to 3.32 percent, 3.92 percent and 4.48 percent under the bear, base and bull cases, respectively.

Second, increasing off-balance sheet businesses may bring troubles in future. Against the regulators' stringent credit caps, banks have launched off-balance-sheet businesses to satisfy clients' financing needs and meet their own targets. These businesses evade credit caps on one hand and virtually sidestep the interest rate control on the other. Despite facing regulators' harsh and frequent constraints, banks' off-balance-sheet businesses are still expanding rapidly.

These activities pose huge challenges to banks' risk control capability. Currently, most of the regulatory requirements and internal risk management focus on the balance sheet. Off-balance-sheet businesses may easily give rise to problems such as unclear delineation of risk responsibilities and business areas.

Last, tightening control on capital requirements for financial institutions. In the wake of the subprime crisis, regulators worldwide started to evaluate the risks caused by financial institutions' pursuit for high leverage and high yields. The G20 leaders have put the Financial Stability Board and the Basel Committee on Banking Supervision in charge of international financial supervision reform. In November 2010, the G20 Summit in Seoul approved Basel III regulations drafted by the Basel Committee, which laid down the new standards for banks' capital and liquidity. Member states are required to start implementing them in 2013, and fully meet the standards by 2019. The major contents of Basel III include higher requirements on capital adequacy ratio and a series of new liquidity indicators.

In keeping with the new trend of international supervision, the China Banking Regulatory Commission (CBRC) will actively promote the new standards within China's banking sector while establishing a comprehensive and prudent capital regulation and risk management system. Under the new system, the CBRC will make use of the four new regulatory tools of CAR, provision ratios, leverage ratios and liquidity to implement counter-cyclical measures targeting commercial banks.

The author is executive director at BOCI Securities. The opinions expressed here are entirely his own.