Fitch Ratings has upgraded China Guangfa Bank Co., Ltd.'s (CGB) Viability Rating (VR) to 'b+' from 'b'.

At the same time, Fitch has affirmed CGB's Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'BB+', Short-Term IDR at 'B' and Government Support Rating (GSR) at 'bb+'. The Outlook on the Long-Term IDR is Stable. The assigned VR is in line with the implied VR but does not drive its IDRs.

The upgrade of CGB's VR is driven by our assessment that, like other similarly sized banks in China, its intrinsic credit profile has benefitted from regulatory developments in recent years, resulting in a reduction in its off-balance-sheet activity as well as a moderating risk appetite. These were factors we had identified as potential outcomes at the time we raised our operating environment (OE) assessment to 'bbb-' from 'bb+' in 2021.

Key Rating Drivers

Government Support-Driven IDR: CGB's Long-Term IDR reflects Fitch's assessment of a moderate likelihood of government support in the event of stress, as expressed by the GSR. Our view considers the bank's limited market share nationally and modest domestic systemic importance. CGB's 'B' Short-Term IDR is mapped to its Long-Term IDR.

Differentiation in D-SIB Status: Chinese authorities designated CGB a domestic systemically important bank (D-SIB) in 2021. However, we believe the formal D-SIB designation alone may not significantly affect the state's propensity to support CGB to the same extent as peers with higher systemic importance or closer government linkages. This is because the government's ability to support a large number of D-SIBs may be constrained by the size of China's banking system under stress.

Stable OE: We expect China's economic growth to recover in 2023 as Covid-19 restrictions have been lifted, which will support consumption. Our OE score of 'bbb-'/stable is above the 'bb' category implied score, as we believe China's robust external finances and a record of stable economic performance, which are incorporated in the Chinese sovereign rating, will provide greater financial and economic stability than the implied OE score indicates.

Improvement in Retail Franchise: The revision of CGB's business profile score to 'bb' from 'bb-' reflects an improvement in its retail franchise that has resulted in a higher proportion of retail deposits in its mix. That said, the 'bb' business profile score is below the 'bbb' implied category score to reflect management and governance limitations and exposure to shadow-banking activity, similar to most Chinese banks rated by Fitch.

Management and governance limitations are not uncommon in China because of pressure from the authorities to support segments of borrowers during challenging times. High exposure to riskier types of unsecured loans also renders CGB's business model susceptible to market volatility and economic challenges.

Reduction in Shadow-Banking Activity: We revised both CGB's risk appetite and asset-quality score to 'b+' from 'b' to reflect the reduction in its shadow-banking activity, in line with the regulatory tightening enforced by China's authorities, and its non-performing loan (NPL) resolution in recent years. This is balanced against CGB's large lending exposure to sectors that we regard as riskier, such as credit card receivables, and its high growth appetite relative to its capitalisation.

Still, CGB's asset-quality score of 'b+' is below the implied 'bbb' category score due to its relatively large high-risk exposures and growth appetite compared with larger mid-tier banks, and our perception of underwriting standards relative to state banks and large mid-tier banks. CGB has a large exposure to riskier loan types and its loan-loss allowance ratio is modest compared with that of other mid-tier banks. CGB's reported NPL ratio under local regulatory standards was 1.6% at end-2022, compared with its impaired-loan ratio of 2.1%.

Profitability Lags Peers: CGB's earnings and profitability score has been revised to 'b' from 'b-' as we expect its underlying profitability to become less volatile, supported by regulatory changes and reduction in its off-balance-sheet activity. However, we expect CGB's profitability to remain below the peer average. The earnings and profitability score of 'b' is still below the 'bb' category implied score to reflect potential risk-weighted asset understatement due to its high non-loan exposure.

Limited Capital Buffers: CGB, as a D-SIB, is subject to a minimum common equity Tier 1 (CET1) requirement of 7.75%. Its CET1 ratio rose to 8.8% by end-2022 from 7.9% at end-2021 after a private placement of CNY18.4 billion in 2022. Still, the bank's weak profitability and large growth appetite may continue to suppress its CET1 capital. As such, its capitalisation and leverage score of 'b' is unchanged and below the 'bb' category implied score to reflect understatement in its risk-weight calculations due to its high non-loan exposures.

Improving Funding Profile: The revision of CGB's funding profile score to 'bb-' from 'b+' reflects the rising contribution of retail deposits to total funding due to the bank's efforts to improve its retail contribution to total deposit funding. The revised funding and liquidity score of 'bb-' is below the 'bbb' category implied score, given the bank's greater reliance on non-deposit funding (similar to most other Chinese banks) relative to higher-rated banks, which makes it more vulnerable to market volatility in funding.

Rating Sensitivities

Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade

The Long-Term IDR and GSR will come under pressure if Fitch perceives that the central government's propensity or ability to provide timely extraordinary support has diminished. For example, a sovereign rating downgrade could reflect diminished ability to provide support, while lower propensity may be reflected through an enhanced resolution framework and strong intention by the authorities to permit losses on senior debt obligations as a means of resolving banks, although we do not expect either scenario to occur in the near term.

A significant reduction in state ownership or indirect influence over CGB through its largest shareholder, China Life Insurance Company Limited (A/Stable), or if the bank's systemic importance were to deteriorate, may also lower the propensity of the state to support the bank.

The Short-Term IDR will not be downgraded unless the Long-Term IDR is downgraded to 'CCC+' or below, which we view as highly unlikely in the short-to-medium term.

The VR could be downgraded if the OE score is lowered or if we assess the bank to have materially increased its risk appetite, especially in credit-card lending, or aggressively increases exposure to entrusted investments or wealth-management products, eroding its modest capital buffer. A sustained deterioration in financial metrics could lead to a VR downgrade, including a combination of the following reported core metrics without having largely addressed perceived risks around the transparency of its exposures, including off-balance sheet and non-loan exposures:

The four-year average of the impaired loan/gross loan ratio increasing to and remaining at around 8%, although Fitch's assessment of asset quality will also consider other indicators, such as 'special-mention' loans, loan-loss provisioning and whether (and to what extent) we believe reported metrics understate any deterioration in asset quality; and

The CET1 ratio falling below 8.0% without a credible path to return to existing levels.

Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade

An upgrade of the sovereign ratings could lead to positive rating action on the GSR and the support-driven IDRs if that were to indicate greater ability to support the bank with no less propensity to provide support.

The Short-Term IDR will be upgraded if CGB's Long-Term IDR is upgraded.

An improvement in CGB's capitalisation such that its CET1 ratio is maintained at around 10% in conjunction with a further reduction in risk appetite and greater transparency in asset-quality metrics would be positive for its VR assessment.

OTHER DEBT AND ISSUER RATINGS: KEY RATING DRIVERS

CGB's IDRs (xgs) are driven by its VR. The Long-Term IDR (xgs) has been upgraded to 'B+(xgs)' from 'B(xgs)' following the upgrade of the VR, while the Short-Term IDR (xgs) has been affirmed at 'B(xgs)'.

OTHER DEBT AND ISSUER RATINGS: RATING SENSITIVITIES

Factors that could, individually or collectively, lead to negative rating action/downgrade:

The bank's Long-Term IDR (xgs) could be downgraded if the VR is downgraded. The Short-Term IDR (xgs) could be downgraded if the VR is downgraded below 'b-'.

Factors that could, individually or collectively, lead to positive rating action/upgrade:

The bank's Long-Term IDR (xgs) could be upgraded if the VR is upgraded. The Short-Term IDR (xgs) could be upgraded if the VR is upgraded above 'bb+'.

VR ADJUSTMENTS

The OE score of 'bbb-' has been assigned above the 'bb' category implied score for the following adjustment reason: sovereign rating (positive).

The business profile score of 'bb' has been assigned below the 'bbb' category implied score for the following adjustment reason: management and governance (negative) and business model (negative).

The asset quality score of 'b+' has been assigned below the 'bbb' category implied score for the following adjustment reason: non-loan exposure (negative) and underwriting standards and growth (negative).

The earnings and profitability score of 'b' has been assigned below the 'bb' category implied score for the following adjustment reason: risk-weight calculation (negative).

The capitalisation and leverage score of 'b' has been assigned below the 'bb' category implied score for the following adjustment reason: leverage and risk-weight calculation (negative).

The funding and liquidity score of 'bb-' has been assigned below the 'bbb' category implied score for the following adjustment reason: non-deposit funding (negative), and deposit structure (negative).

Best/Worst Case Rating Scenario

International scale credit ratings of Financial Institutions and Covered Bond issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

Public Ratings with Credit Linkage to other ratings

CGB's IDRs are directly linked to China's sovereign ratings.

ESG Considerations

CGB has an ESG Relevance Score of '4' for Financial Transparency due to structural issues around financial transparency and disclosure. These are not captured in headline performance metrics in China and affect our assessment of the OE and the bank's financial profile. CGB, like other mid-tier banks, is more exposed to this risk relative to state banks because of its larger exposure to WMPs and entrusted investments. This stems from the use of off-balance-sheet transactions. This has a negative impact on the credit profile, and is relevant to the ratings in conjunction with other factors.

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg

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