After a two-year hiatus, the Loan Prime Rate (LPR) quoting institutions list in China has expanded once againThe People's Bank of China (PBOC) has recently announced that the number of LPR quoting banks has increased from 18 to 20, with China CITIC Bank and Jiangsu Bank being the new additions.

Industry experts highlight that this expansion aims to enhance the representation and diversity of the LPR, which will benefit various types of banks, particularly small and medium-sized ones in accessing liquidity supportHistorically, smaller banks have faced challenges in the LPR quoting process, often suffering from low participation rates and liquidity stratificationThe trend indicates that the proportion of smaller banks in the LPR quoting institutions may further increase in the future.

Further suggestions for deepening LPR reforms include enhancing oversight on quoting institutions, establishing a survival of the fittest mechanism to consistently improve LPR quote quality, and widening the range of primary dealers in market operations

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This would ensure these quoting institutions are incorporated, creating consistency in the operation frameworkAdditionally, experts call for a more robust LPR interest rate term structure to improve continuity across various loan maturities such as three months, six months, two years, and three years, thus enriching the LPR options available.

The adjustment of the quoting institutions is a consequence of the self-regulatory mechanism established by the PBOC under its guiding rate guidelinesThis mechanism evaluates the qualifications of LPR quoting institutions both on and off the market, leading to a comprehensive overhaul of the quoting banks after assessments were conductedThe new adjustments will take effect on January 22, 2024, and they reflect the PBOC’s continued efforts to enhance liquidity and adjust the financial landscape for medium and small banks.

A closer examination reveals that this marks the second adjustment to the LPR quoting mechanism since the reforms initiated in 2019. Currently, the list comprises six large state-owned banks, five joint-stock banks, three city commercial banks, two rural commercial banks, two private internet banks, and two foreign banks

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This diversification represents a significant shift towards a wider range of representational banks participating in LPR settings, further fostering a competitive banking environment.

In August 2019, the PBOC announced reforms aimed at deepening interest rate marketization as a means to effectively lower financing costs for the real economyThe reforms mandated changes to the LPR formation mechanism, which originally included only national banks but later expanded to include city commercial banks, rural commercial banks, foreign banks, and private banks to better reflect market conditions.

The first adjustment in the quoting institutions occurred on January 19, 2022, when the list was refined to include a mix of national banks, city banks, rural banks, private banks, and foreign banksAccording to Li Peijia, a researcher at the Bank of China Research Institute, the prior roster primarily featured 18 financial entities, where a significant proportion comprised larger national banks

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With the addition of CITIC Bank and Jiangsu Bank as quoting entities, the representation and diversity of the LPR are expected to improve markedly.

This diversification is critical, as smaller banks previously faced significant barriers when it came to liquidity access during the LPR quoting processSpecifically, the PBOC's Medium-term Lending Facility (MLF) requires banking institutions to provide eligible collateral, which has often limited smaller banks due to their lesser amounts of qualifying assetsThis reality left them at a disadvantage during MLF transactions, which predominantly favored larger state-owned and joint-stock banksConsequently, smaller banks found it difficult to tap into the PBOC's liquidity support, perpetuating a cycle of limited participation in LPR quoting.

Wang Qing, the chief macro analyst at Dongfang Jincheng, pointed out that the recently added institutions, being joint-stock and city commercial banks, operate on a more market-oriented basis

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Their involvement in the LPR quoting process is expected to provide a truer reflection of market interest rate dynamics and actual credit supply and demand—enhancing both perceived accuracy and operational relevance of the LPR.

Industry professionals have acknowledged an intrinsic alignment of the LPR formation mechanism and the MLF ratesThis alignment requires quoting banks to base their loan interest rates for top-quality clients on the MLF rate plus an additional spreadNonetheless, as influencing factors continue to evolve, experts suggest that the focus should remain on enhancing the pricing capabilities of smaller banks in this context.

Despite the significant achievements of the LPR reforms, there remains room for improvementExperts indicate that there are still challenges that need addressing to further advance the marketization process, particularly in refining the LPR framework

Scrutiny over quoting institutions should be reinforced while ensuring alignment of responsibilities and establishing criteria for effective performance, focusing on genuine loan rate quotes for top-tier customers to enhance LPR integrity.

Moreover, a prevalent issue is the misalignment between MLF operational targets and LPR quoting institutionsThe PBOC designates primary dealers in open market operations without necessarily reflecting LPR institutes within the same categoryThis disconnect implies that banks not listed as primary dealers cannot align their funding cost movements with the liquidity provided through MLF operations, ultimately undermining the LPR's quote quality.

Wang also advocates that apart from ongoing optimization of the quoting institutions, facilitating timely and effective adjustments between bank lending rates, PBOC’s benchmark rates, and market rates remains paramount

This ideally involves ensuring banks predominantly utilize LPR as a pricing reference for new loan issuances while promoting a competitive landscape for deposit ratesA comprehensive mechanism for adjusting deposit rates—anchored to LPR quotes and yields from long-term government bonds—has proven influential in curbing excessive deposit rates, thereby ensuring a smoother financial environment.

Nonetheless, the existing transmission mechanism is currently oriented toward the LPR influencing deposit rates rather than the reverse, indicating substantial room for negotiation and reformThe continuing marketization journey will progressively establish a robust linkage from the PBOC’s policy rates to deposit rates and then to lending rates, ultimately enhancing the responsiveness between market interest rates and loan pricing practices.

Li Peijia further asserts that the ongoing LPR reforms have substantially improved monetary policy transmission efficiency but highlight critical aspects of LPR that need addressing, such as a lack of term structure diversity and comprehensive pricing benchmarks across different loan categories.

Therefore, suggestions put forward include enriching the LPR's term matrix beyond the current one- and five-year structures, potentially incorporating additional options like six months, two years, and three years