Customers fill out forms at a branch of China Merchants Bank in Haikou, Hainan province. [Photo by Zhang Mao/China Daily]

Improved net profit margin and asset quality will brighten prospects for China's banks in the second half of this year, and smaller urban commercial banks will likely grow the fastest, said analysts.

Average net profit of banks in the first half may see year-on-year growth, and it may grow further in the second half, they said.

China has 37 banks listed in Shanghai, Shenzhen and Hong Kong. They will start to release financial results for the first half from Friday.

According to Shenwan Hongyuan Securities, average net profit of 27 A-share banks in the first half is expected to grow 3.3 percent year-on-year, versus 2.5 percent year-on-year growth in the same period last year. The overall profit is expected to reach 700 billion yuan ($103 billion).

China Merchants Bank, among the first ones to issue first-half forecasts, said its net profit is expected to reach 39.26 billion yuan, up 11 percent year-on-year. Its non-performing loans or NPL rate at June-end is expected to be 1.71 percent, down from 1.87 percent at the end of 2016.

Banks' fundamentals are recovering. Lending is up amid strong demand for infrastructure development. Policymakers are encouraging mass entrepreneurship, said a research note from CITIC Securities.

Efforts to reduce the leverage ratio in the entire financial market to prevent bubbles and irrational lending have helped to recover asset quality and reduce NPL risks, CITIC Securities said in its note.

Meanwhile, ratings agency Moody's has upgraded its outlook for China's banking sector from "negative" to "stable", suggesting it is positive about Chinese banks' NPLs.

Wan Ying, an analyst with Moody's Investors Service, said policymakers are taking a consistent approach to curb shadow banking. This will help reduce financial risks and restore balance to the lending system.

Zhang Shuaishuai, an analyst with China International Capital Corporation, said net interest margin is expected to widen in the second half of this year, giving more room for net profit growth.

"Short-term lending continues to grow, which should expand banks' net profit margin. Short-term lending was on the lower side sometime back. This will give banks more room for flexible pricing," said Zhang.

As for retail banking, pressure may remain as individual small investors' deposit growth has slowed. Some banks have seen net outflow of deposits from individual clients.

"For many banks, the retail banking sector is not profitable because operational cost is high, and good assets are limited. Clients' loyalty is hard to maintain, and products are not diversified enough to meet various demands," said Zhao Jiancheng, an analyst with Bank of Qingdao.

A recent report by McKinsey & Company said the retail banking sector in China needs to improve efficiency and management of customer experience.

Under the current model, one wealth manager on average looks after more than 1,200 accounts. Consequently, customer feedback is not given a priority. Customer preferences are very often not acted upon by key departments.