Investors lucky enough to have received a decent allocation in any of China's big bank flotations probably are feeling pretty pleased with themselves. Despite dire risk warnings before each offering, every large mainland bank stock has performed handsomely since its Hong Kong listing. Bank of China has risen 28 per cent since its May debut, China Construction Bank has gained 84 per cent following its listing in November last year and Industrial and Commercial Bank of China has leapt 35 per cent in eight short weeks. More, given the relatively rosy outlook for China's economy in 2007 and global investors' continued willingness to accept diminished risk premiums and pour money into anything linked to the mainland, holders of Chinese bank stocks can look forward to another good year. Perhaps investors should not be too pleased. In a new report, Jonathan Anderson, UBS's highly rated chief economist, highlights two medium-term risks. These are not the hoary old chestnuts of increased foreign competition or a rise in non-performing loans should the economy slow. Every investor in Chinese bank stocks should already be aware of those. Mr Anderson is not especially bothered by either of those dangers. Even with this month's full opening of China's banking market, the expansion of wholly owned foreign banks will be gradual. According to UBS's analysis, over the next five years foreign banks' market share is likely to grow to just 5 per cent, from 1.7 per cent today. And the gains are likely to come in niche areas such as wealth management. Nor is Mr Anderson unduly worried about the prospect of a blowout in non-performing loans. Chinese banks have become a lot more professional in recent years, he argues. And following government efforts to get bad assets off their balance sheets, the banks could cope with even double or triple the current official level of non-performing loans. What really bothers Mr Anderson is the continued development of China's financial markets. As the mainland moves more towards a market-led economy, at some point Beijing is going to deregulate interest rates. At the moment China's banks make nearly all their money from the spread they earn between the interest rates they pay on deposits and what they charge on loans. Thanks to government regulations, they earn nearly 2? times from one-year loans what they pay out on equivalent deposits - one of the largest spreads in the region. With eventual liberalisation, increased competition inevitably will cause that to narrow, severely denting banks' profitability. According to Mr Anderson, a one percentage point increase in the deposit rate would have been sufficient to wipe out all state bank profits last year. The second danger he sees is the expected growth of China's capital markets. China's savers now have little option but to keep the bulk of their money - almost 80 per cent - in bank deposits, a far higher proportion than other Asian economies (see chart). As China's stock and bond markets are deregulated and develop, banks inevitably will lose market share to less intermediated forms of savings. Assuming a constant rate of economic expansion, Mr Anderson estimates that the growth of banks' balance sheets will slow to an annual rate of between 6 and 7 per cent from about 22 per cent currently. 'The Chinese banking system will be gradually moving from a high-growth, high-margin environment to a low-growth, low-margin business model, with accompanying pressures for shakeout and consolidation,' warns Mr Anderson. Of course, the news is not all bad. More nimble banks will be able to profit from a move into fee-based businesses and away from interest income alone. But whether those will include the listed state behemoths that have served investors so well in recent months remains to be seen.