Chinese banks have made impressive strides and have significantly improved the sector’s risk profile, says Fitch Ratings in a new report. However, the agency also cautioned that despite this improvement, Chinese banks continue to face serious challenges and banking industry risk remains one of the largest vulnerabilities facing the economy.

“Key weaknesses include widespread corruption and ineffectual corporate governance, and underdeveloped risk management and internal control systems,” said Charlene Chu, director in Fitch’s Financial Institutions team in Beijing. In the report Chu added that other weaknesses include China’s weak accounting and legal frameworks, as well as poor (albeit gradually improving) profitability, asset quality, and capital.

According to the report, although the financial performance of Chinese banks has generally improved, the Chinese banking system remains one of the weakest in the world. All Chinese banks, to varying degrees, continue to demonstrate thin profit margins, relatively low capital, weak asset quality, and underdeveloped risk management systems.

The report states that the results of recent reform measures have been mixed, with China’s larger, premier banks clearly benefiting from reforms, while weaknesses at other institutions remain largely unaddressed. “Deeper and more comprehensive reforms – including improvements in the supporting financial infrastructure and a resolution of the government and Communist Party’s role in the financial system – will be necessary to improve overall systemic risk,” Chu added.

Fitch is of the view that the medium-term outlook for economic growth in China remains strong. “However we continue to be concerned that less productive investment could give rise to new bad debts, particularly if the economy decelerates. Such a turn of events could undo some of the hard-earned progress in bank reforms over the last decade,” warned Chu.

The report notes that while managing credit risk remains the principal challenge for Chinese banks, the agency is also concerned about rising market risk as Chinese authorities pursue further exchange rate and interest rate liberalisation, begin to relax long-standing controls on capital outflows, and introduce new trading activities.