Bad Loans Bite Back In China

The takeover of a commercial bank for the first time in nearly two decades highlights the urgency of banking reform in China.

China’s Banking and Insurance Regulatory Commission (CBIRC) took control of Mongolia’s Baoshang Bank in May, citing “serious credit risks.” The move unnerved domestic markets and forced the People’s Bank of China (PBoC) to deliver an infusion of cash to the banking system.

The takeover of Baoshang, which had RMB576 billion ($83.9 billion) in assets as of the third quarter of 2017 (the bank’s most recent financial disclosure), is the first such move in 18 years. While Chinese officials characterized Baoshang as a unique case, the public takeover comes in the midst of Beijing’s push for more bank lending to mitigate the country’s economic slowdown, exacerbating worries about the stability of smaller lenders amid rising debt and bad loans.

“At present, small and mid-sized banks are operating smoothly, liquidity is relatively ample and overall risks are fully manageable,” the CBIRC said in Financial News, an official publication of the PBoC.

But in June, for the first time ever, the PBoC issued a new financing-support tool, officially called an interbank negotiable certificate of deposit (IBNCD), to help the Bank of Jinzhou raise liquidity. Some call it a credit-risk mitigation warrant (CRMW)—a kind of Chinese version of credit-default swaps, or insurance against loan defaults.

The two events have the market worried that the authorities are trying to project confidence in hopes of calming jittery interbank lenders. Some small banks rely heavily on short-term loans from the interbank market. A Reuters analysis revealed that at least 18 smaller institutions have not published up-to-date financial reports, suggesting they may be under pressure.

Addressing Moral Hazard

More broadly, the Baoshang bailout and Bank of Jinzhou’s CRMW highlight a persistent problem with the structure of banking in China. On one hand, says Maximilian Rech, program director and assistant professor of international affairs at the Ecole Superieure des Sciences Commerciales d’Angers in Shanghai, the state banks are too big to fail; on the other, their balance sheets are not attractive. “These state banks hold liabilities that are very dangerous,” he says.

The last government rescue of a bank in China was in 2001, when bad loans placed a severe burden on Chinese bank balance sheets. The government bailed out the banks, writing down the bad loans through inflation.

Since then, the market has assumed that the state will guarantee deposits, says Michael Pettis, professor of finance at Peking University: “As long as people trust the government guarantee, there won’t be bank runs, which is why I don’t think we’ll have a banking crisis.”

The takeover of Baoshang Bank, however, is a signal that the government is now addressing the moral hazard fostered by the implicit guarantee. The National Audit Office said in April that some banks in central China had nonperforming loan ratios of higher than 40% at the end of 2018, the first official disclosure in decades of such high rates of toxic assets.

“In our view, the state takeover of Baoshang Bank suggests China will have to face the consequences of years of rapid debt accumulation,” Ting Lu, chief China economist at Tokyo-based Nomura Holdings, wrote in a May note to investors. “But the impact of this particular case should not be exaggerated.”

Leilei Wang, a fintech expert at consulting firm Kapronasia, argues that China’s banking industry is still in “a stable state” despite lower net interest margins due to the economic slowdown; the Baoshang takeover “is not necessarily indicative of systemic risk.” On the other hand, Wang says, regulators are trying to provide guidance on alternative operating models, in line with a national deleveraging campaign that requires Chinese banks to set aside greater amounts of capital to hedge off-balance-sheet assets.

In January, for example, the PBoC announced a new tool to encourage banks to replenish capital via perpetual bonds: bonds with no maturity date. The Bank of China promptly sold RMB40 billion of perpetual bonds with a coupon of 4.5%. The issue attracted more than 140 institutional investors. As of the end of April, 10 major Chinese banks plan to sell as much as RMB 520 billion of perpetual bonds.