China's five major state-owned banks all reported better-than-expected quarterly profits this week, buoyed by higher fee income. But the outlook remains grim for the rest of the year as the banking industry faces slower profit growth, narrower interest-rate margins and rising bad loans.

Chinese banks have been used to fat margins between lending and deposit rates, but the government has been narrowing the difference. The China Banking Association said last month it expects net profit growth for China's 17 listed banks to slow to 8 percent in 2013, from 19 percent in 2012.

As the world’s second-largest economy heads toward its slowest pace of expansion in 23 years, credit demand is weakening and nonperforming loans are rising. Beijing is targeting a 7.5 percent gross domestic product growth rate for this year and scrapped the lower limit on the lending rates bank can charge customers on July 20, a move that will hurt lenders’ pricing power on corporate loans.

The average net interest margin rose to 2.59 percent in the second quarter from 2.57 percent in the first quarter, according to China's banking regulator. But that's still lower than the 2.75 percent margin recorded in the fourth quarter.

The “Big Five” -- Industrial and Commercial Bank of China, China Construction Bank, Agricultural Bank of China, Bank of China and Bank of Communications -- reported combined first-half earnings growth of more than 12 percent. Agricultural Bank of China led the pack with an earnings growth rate of 14.7 percent.

Industrial and Commercial Bank of China (HKG: 1398), the world's largest bank by total assets, posted net profit of 69.6 billion yuan ($11.4 billion) for the April-June period, up 12.5 percent from a year earlier. That topped expectations for 67.1 billion yuan in a Thomson Reuters poll of analysts.

ICBC was able to reduce some of its reliance on interest income. Income from fee-based services such as credit cards and sales of wealth-management products rose 23 percent to 67.4 billion yuan in the January-June period, faster than the 5.8 percent rise in interest income. In the first half, ICBC's net interest margin, a measure of lending profitability, narrowed to 2.57 percent from 2.66 percent.

The lender said its nonperforming loans rose to 81.8 billion yuan as of June 30 from 80.24 billion yuan three months earlier. The ratio of bad debt to total credit was unchanged at 0.87 percent. But in a sign that more loans may turn sour later this year, ICBC reported overdue loans not designated as nonperforming rose to 69.2 billion yuan, or 0.73 percent of all loans, from 0.71 percent at the end of last year.

ICBC set aside 9.8 billion yuan in loan-loss provisions in the second quarter, up from 9.1 billion in the same period last year.

China Construction Bank Corporation (HKG: 0939), the nation’s second-largest lender, posted the smallest profit increase in five quarters. Net income in the second quarter increased 9.7 percent from a year earlier to 60.1 billion yuan. Its net interest income climbed 11 percent to 187.7 billion yuan and the net interest margin was unchanged at 2.71 percent. Fee-based income gained 13 percent to 55.5 billion yuan.

China Construction Bank set aside 16.1 billion yuan for potential bad loans in the first half, compared with 14.7 billion yuan a year earlier.

Agricultural Bank Of China Limited (HKG: 1288), the nation’s third-largest lender, said it recorded a 22 percent increase in second-quarter profit as it set aside less money for soured loans, while lending and fee income rose.

For the first half of the year, the bank said it recorded a 15 percent increase in net profit to 92.4 billion yuan, up from 80.50 billion yuan a year earlier.. Interest income rose 7.1 percent and fee income jumped 22 percent. China's largest rural lender said its net interest margin narrowed to 2.74 percent from 2.85 percent a year ago. Agricultural Bank of China reported nonperforming loan ratio of 1.25 percent at the end of June, down from 1.33 percent at the end of 2012.

Bank of China (HKG: 3988), the country's fourth-largest lender, reported quarter net profit of 40.9 billion yuan, up 17 percent and topping analysts' expectations of 38.0 billion yuan.

Its first-half net profit was up 12.9 percent. Net profit for the six months ended June 30 was 80.72 billion yuan, up from 71.6 billion.

Net interest income rose 10.7 percent to 137.29 billion yuan and net fee and commission income rose 24 percent to 68.96 billion yuan. Net interest margin for the first six months of the year was 2.23 percent.

Bank of Communications Corp. (HK: 3328), China's fifth-largest lender by assets, said profits rose 12.02 percent year-on-year in the first six months of 2013 to 34.83 billion yuan. It wrote off 4.8 billion yuan of soured debt in the first half, Bloomberg reports, citing Citigroup Inc. analyst Simon Ho. The write-off helped limit the increase in bad loans to 3 percent in the second quarter.

Net interest income rose 11.3 percent to 65 billion yuan while net fee and commission income increased 27 percent to 13.9 billion yuan.