By Li Xiang

With large State-owned enterprises becoming more reliant on direct financing in the capital market, Chinese banks are increasingly turning their attention to the country’s cash-strapped small- and medium-sized enterprises (SMEs) as a new profit driver.

Instead of passively implementing the regulator’s policies to help SMEs obtain loans, the banks are actively seeking clients that have small operations but promising business models.

“It is strategically important for banks to explore the SME market, which will become a crucial part of their growth engine in the future,” said Wei Zengran, the general manager of the SME division at the branch of China Construction Bank Corp (CCB) in Shijiazhuang, the capital of Hebei province.

Wei said that the branch aims to increase the amount of loans to SMEs to one-third of its total corporate lending during the next three to five years.

China’s large State-owned lenders, which have traditionally catered to the financing requirements of State-owned enterprises, are gradually losing their premium pricing power over large clients, as many of those clients are seeking funds directly from the capital market at a much lower cost.

Demand for sophisticated financial services is rising rapidly among SMEs after many of them were hit hard by a capital crunch caused by a succession of interest rate rises and tighter credit controls as the central bank seeks to rein in inflation.

“Competition among banks for small-business clients, especially those of high quality, has become more intense than ever since last year,” Wei said.

CCB extended 1.4 trillion yuan ($218 billion) in loans to more than 160,000 small businesses between 2007 and last year. The bank’s loans to SMEs in the first six months of this year accounted for 68 percent of its total new-yuan corporate lending. That figure has grown by 40 percent on average during the past three years, according to Yu Jiang, the head of the SME division at CCB.

Domestic lenders are also enjoying a raft of favorable policies provided by the regulator to encourage loans to SMEs, including a lower risk weighting when calculating capital-adequacy ratios and the exclusion of loans of less than 5 million yuan to SMEs in calculations of lenders’ loan-to-deposit ratios.

Lending to SMEs has not only become a requirement for the top-tier banks to support the country’s private economy - which contributed 65 percent of GDP last year - but has also become a key driver in the transformation of the banks’ profitability models and the restructuring of their assets, industry analysts said.

In a recent report on China’s banking industry, the global accounting company Ernst & Young LLP (E&Y) noted that the provision of financial services to small-scale companies will become a new driver of profit for commercial banks this year.

The total net profit of China’s 17 listed banks was 687.3 billion yuan last year, a 33 percent increase from 2009, according to the E&Y report.

Chinese banks’ lending to SMEs had reached 9.45 trillion yuan by the end of April, an increase of 7.1 percent year-on-year. The loans accounted for 28.8 percent of their total corporate lending, according to the China Banking Regulatory Commission.

The high costs of assessing, approving and monitoring loan requests from SMEs, in addition to their greater risk of default when compared with large clients, have long been major factors that have made large banks reluctant to lend to small businesses.