* China banks face crackdown on fee charges
* Rising funding costs seen hurting smaller banks most
By Lawrence White and Kelvin Soh
HONG KONG, April 27 (Reuters) - Bank of China's weaker-than-expected first-quarter earnings sets a muted tone for its three peers that report on Friday, with banks facing growing pressure as more borrowers struggle to repay loans in the face of a slowing economy.
The world's second-biggest economy grew at its slowest pace in nearly three years in the first quarter at 8.1 percent after slowing exports and curtailed state investment crimped overall activity.
Bank of China, the country's No.3 lender by market value, posted on Thursday a near 10 percent rise in January-March net profit, but the figure fell below expectations as flat net interest margins offset a rise in fee income.
"For the large banks, margins should all come under pressure because of rising funding costs," said Stanley Li, an analyst at Mirae Asset Management in Hong Kong.
"Depositors are looking for higher-yielding places to put their money, and that means funds cost more for banks while demand for loans continue to grow."
The sheer size that China's banks have grown to is astonishing, when factoring in that the Big Four - Bank of China, ICBC, China Construction Bank and Agricultural Bank of China - were technically insolvent institutions less than a decade ago.
ICBC's market capitalisation of $240 billion is slightly less than the combined value of Goldman Sachs, Morgan Stanley, Citigroup and Bank of America. ICBC's 2011 net profit alone is nearly equal to Morgan Stanley's entire market worth.
The Big 4 reported a combined 14 percent rise in total assets, to 51.3 trillion yuan last year, roughly the size of the German, French and British economies combined, the New York Times pointed out earlier this week.
The huge growth spurt for the Big Four may be set for a down shift.
Analysts are divided on whether China has seen its worst for the year, but they are confident its economy will pull through with growth of at least 7.5 percent, if not over 8 percent, as Beijing relaxes monetary policy to foster activity.
And in a sign that Beijing is loosening policy reins to support the economy, Chinese banks lent a whopping 1.01 trillion yuan in March in their biggest lending surge in 14 months as the government relaxed credit restrictions.
The spike in loans underlined easier credit conditions in China this year, with lending rates in the grey market pulling back from sky-high levels of as steep as over 80 percent last year when Beijing was still tightening policy.
But the costs of the loans are beginning to eat into the banks' bottom line with greater force.
Bernstein Research senior analyst Mike Werner said in a research note this week the brokerage forecasts the group will report net income growth of 13-14 percent, 2 percent below consensus estimates on the back of higher credit costs.
"MONOPOLY"
Following a widely publicised visit to the entrepreneurial hotspot of the eastern coastal city Wenzhou on October 5, premier Wen Jiabao spoke about the need for financial support for the small- and medium-sized businesses that were being strangled by a liquidity squeeze. A spate of suicides by small business owners in the city threw the issue into sharp relief.
As part of its response, the government has been cracking down on the fees that banks can charge these businesses, including the so-called 'consulting fee' banks were able to levy just for maintaining a lending relationship with a company.
"It was encouraging to see Bank of China growing fee income," said Alexander Lee, an analyst at DBS Vickers. "There were expectations that fees might decline due to the increasing controls that regulators have put in place."
This move can be seen in the broader context of increasingly direct public comments by senior party officials both within and outside the banking system, aimed at shaking up the big banks' cosy monopoly and appeasing growing public dismay over their big profits.
Some delegates attending China's annual parliamentary meetings in Beijing in March openly criticised rising bank profits, taking a public stand that is rare for the country's normally docile legislature.
These comments foreshadowed a speech in early April when premier Wen said the country's state banks act as a monopoly that make money "far too easily".
Jiang Jianqing, chairman of ICBC, the world's biggest bank by market value, said in a taped CNBC interview on Thursday he wanted to see "a healthier, more diversified and more multi-ownership financial system" including more "anti-monopoly enforcement."
He also said profit growth at Chinese banks will come down to reasonable levels starting this year as the economy slows.
FUNDING COSTS RISE
The concerted nature of these public remarks hint at possible reform of China's interest rate policy, which puts a ceiling on the interest rates banks can pay to attract deposits and sets a floor on lending rates, ensuring a healthy interest rate spread that is currently hovering around 270 basis points.
Liberalising these rates would almost certainly narrow that spread by pushing up the rate paid on deposits as banks compete more freely with each other.
This reform is unlikely to take place too quickly, however, and in the short term analysts see the smaller banks which have the highest loan-to-deposit ratios hit harder by rising funding costs affecting the whole sector.
For the entire sector, though, the expectation is for a slowdown in fee growth, as Bernstein's Werner points out.
"We forecast that fee income growth will decelerate further... due to the continued government restrictions on the type of fees the banks can charge to small enterprises," he said in the note. (Additional reporting by Twinnie Su and Vikram Subhedar in Hong Kong, Koh Gui Qing in Beijing; Editing by Murali Anantharaman, Michael Flaherty and John Mair)
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