Chinese banks are rushing to test a new way of pricing corporate loans against short-term market funding costs, a move that analysts say could make borrowing rates more responsive to monetary conditions but also test lenders’ risk management capabilities. The shift to the overnight or seven-day depository-institutions repo rate (DR) from the monthly-released loan prime rate (LPR) follows Beijing’s June decision to change lending benchmarks to better reflect market conditions. Bank of China, one of the nation’s biggest state-controlled lenders, has rolled out DR-linked corporate loans in Shanghai, Ningbo in eastern China’s Zhejiang province, and in the provinces of Fujian, Hebei and Henan, according to an online statement from the bank. Unlike LPR, which is based on quotations from designated banks and used to price corporate and household loans, DR is derived from actual short-term interbank transactions and more directly reflects banks’ funding costs and liquidity. “DR makes loan pricing more sensitive to short-term funding conditions, but it also exposes banks to greater interest-rate volatility,” said Zhang Lin, chief macro researcher at the Beijing-headquartered Far East Credit Research Institute. “That will raise the bar for pricing and risk management.” The shift points to an emerging “LPR plus DR” framework, giving banks a broader set of benchmarks to price loans for different borrowers and financing needs. Other commercial banks have moved quickly to test the mechanism. China Merchants Bank’s Wuhan branch extended a 20 million yuan (US$2.9 million) one-year working-capital loan to a private technology company using the average DR over the previous three months plus 0.87 percentage points, with the rate reset every three months. Bank of Shanghai later issued a 50 million yuan DR-linked working-capital loan to a chemical manufacturer, while Industrial and Commercial Bank of China’s Shenzhen branch launched a 50 million yuan floating-rate facility to a private company in a strategic emerging industry. Borrowers will also need greater capacity to manage rate volatility Zhang Lin, Far East Credit Research Institute China Minsheng Bank joined the push on August 3, launching the first DR-benchmarked loan under a free-trade account in Shanghai. The 10 million yuan working-capital facility went to an industrial-gas supplier in the Shanghai Free Trade Zone, broadening DR pricing into cross-border and offshore financing. Bank of China has gone further in Shanghai, launching the market’s first DR-linked loan with daily repricing. Unlike conventional monthly or quarterly resets, the rate changes each day in response to market conditions, creating a tighter link between corporate borrowing costs and short-term money-market rates. Beijing has been pushing to lower corporate borrowing costs in recent years. “Banks will need to strengthen the transmission from DR to internal funding costs and loan pricing, while improving hedging and repricing-gap management,” said Zhang of the Far East Credit Research Institute. “Borrowers will also need greater capacity to manage rate volatility.” In its second-quarter monetary policy report released on Wednesday, the People’s Bank of China said it would continue to steadily and orderly improve its monetary policy operating framework, conduct operations in a flexible and targeted manner, maintain an appropriate level of overall liquidity and better guide short-term money-market rates to remain stable. PBOC governor Pan Gongsheng told the Lujiazui Forum in June that the central bank would further refine its short-term interest-rate framework as monetary policy became more price-based. The move is in line with international practice. The US has shifted floating-rate loans to the secured overnight financing rate, commonly known as SOFR, which is calculated from overnight Treasury repo transactions. The UK uses the sterling overnight index average, or Sonia, an overnight benchmark based on actual unsecured sterling borrowing transactions. Like DR, it reflects money-market transactions rather than bank quotations and is widely used in derivatives and floating-rate products.