There has been a big migration in the way Chinese banks are channelling credit to debtors in the real economy. Historically, banks would make loans to corporates and households that they hold as assets and absorb deposits as the liabilities. In this world, the banks are the final dealer of money. If you want to buy money, they will sell it to you for one price (i.e. the interest on loan); if you want sell money they will buy it from you at a lower price (i.e. the interest on deposits); capturing the spread in the middle as profit.
However, since the Global Financial Crisis (GFC), the Chinese banks transformed from being the final dealer to one of many in a chain. Instead of directly lending to the final source of demand for money, banks are lending to other financial dealers. Moreover, in place of holding most of their interest-bearing assets as loans, increasingly banks are holding their assets in form of untraded debt securities known as investment receivables issued by financial dealers as a part of this new channel of financial intermediation.
This change in the way money and credit flows across the economy is what I call the evolution of the Chinese financial system and this evolution has serious consequences on how risk is priced and how losses will be transmitted in the event of a default. This piece is an attempt to explain this evolution; its causes and the implications for credit growth and the general economy in the near future.
To understand this evolution, we must first understand the evolving incentive structure of Chinese bankers. In the past eight years since the GFC, several convoluting trends merged to form the chimera of problems we are observing today.
Decentralization of Chinese banking: Introducing the cast
The first trend that has emerged is what I would described as the decentralization of Chinese banking. During the Maoist Era (1949-1978), the People’s Bank of China (PBC) was China’s central and only commercial bank. In the 1980s, as a part of ‘reform and opening up’, the Chinese government wanted to create a commercial banking sector that operated on a profit-making basis. Four banks , and later with Bank of Communications, were split off from the PBC and were instructed to operate on a commercial basis.
To further promote commercialization among these banking behemoths, all five of these banks listed their shares for trading in Hong Kong or Shanghai (or both) in the 2000s. However, because of their historic ties and strategic importance, the central government retains majority ownership of these banks through untraded shares. The Chairman of these banks are all appointed by the Party and has substantial power in the policy-making bodies of the government. I will henceforth refer to these five banks as the big-5. Throughout the 1990s and early 2000s, the big-5 dominated the banking sector and held most its banking assets.
In subsequent years, the government wanted to create greater competition in the sector and allowed a crop of what are now known as ‘joint-stock banks’ (JSBs) to be born. The JSBs are often joint investments by the Chinese central government and private investors. Compared to their big-5 counterparts, the central government’s investment in these banks are much smaller and is believed to receive less pressure and guidance. With a smaller stake from the government, these banks are believed to be more profit-driven and less policy-oriented. Also, like their big-5 counterparts, the JSBs tend to have national network of branches and are quite large by international standards. In March 2016, the largest JSB, China Merchant’s Bank, had 5.4T yuan ($US 806B) in assets and is of a comparable size to the largest banks in some of the smaller G20 countries such as Australia and Canada .
In addition to joint stock banks, another batch of city commercial banks (CCBs) has been aggressively expanding their assets. As their name indicates, city commercials are often established by municipal governments and local businesses to help bridge local funding requirements that outside banks may not be willing to finance. CCBs often have names that are tied to their home city such as ‘Bank of Tianjin’ or ‘Bank of Ningbo’. Some of the larger and more established CCBs are very ambitious and have gone public with their shares trading in Hong Kong and Shanghai. As of 2015, the CBRC indicates there are 133 banks in China that are classified as CCBs.
Lastly, rural commercial banks (RCBs) have also popped up and are among the fastest growing part of the Chinese banking system. Similar to their CCBs counterparts, RCBs are small financial institutions that are catered to serving their home jurisdiction. Individually, each RCB is quite small but there are hundreds of such banks across China. Collectively, as of September 2016, they hold 29T yuan (US$ 4.2T) of assets; as a group, they are larger than the CCBs. Data on RCBs are quite limited because very few of these banks currently trade either in Shanghai or Hong Kong. Due to data constraints, I will refrain from discussing about RCBs in this post.
With the main cast introduced we can dive into the heart of the issue. Throughout the 2000s, partly driven by very strong need for credit from a booming economy, the Chinese banking sector became increasingly crowded with new JSBs, CCBs and RCBs propping up to compete with the incumbent big-5. This competition led to the big-5 losing market share and shrinking their share of total banking assets. Prior to the GFC, the big-5 held 51.4%; by the latest quarter, they held 36.6% (see Chart 1).
The enforcement of the loan-to-deposit ratio (LDR) and loan quotas
Bad regulation leads to bad incentives. On paper the LDR was a requirement prior to the crisis. However, in the years prior to the GFC, bank asset growth was in line with the needs of the real economy and was not stressed by the CBRC. In the aftermath of the financial crisis, as a measure to control against excessive loan growth, the CBRC enforced the LDR as a binding regulatory metric. With their historical ties to the central government’s large state-owned enterprises and its established network of branches, the big-5 was in a much better position absorb and retain deposits. As payment goes, most of the money went into the coffers of the big-5 and they were not constrained by the LDR because of their ample deposit base.
However, for the newcomers to the market, the JSBs and CCBs have a thin roster of corporate and retail clients to absorb and retain deposits. With the enforcement of the LDR, a small deposit base means less loan growth and less profit to distribute to shareholders. With the central government passing a 4 trillion-yuan fiscal stimulus and subsequent financing needs, the JSBs and the CCBs had to find a way to cash in on this need for credit. One of the answers these smaller banks responded with was investing in securities instead of originating loans. There are several benefits for investing in securities as opposed to loans but in the years after the GFC, the leading motivation was circumventing the LDR. Investing into securities does not constitute as a loan and thus the smaller banks can expand their assets, cash in on the investment boom while meeting the regulatory metrics of the CBRC.
The CBRC classifies multiple classes of securities but for our purpose we will focus on a class of untraded securities known as ‘investment receivables’. For the rest of this piece the term securities will refer to these investment receivables.
As Chart 2 and Chart 3 clearly show, the movement away from loan generation to security investments only occurred for the JSBs and the CCBs; loans as a share total assets remained constant for the big-5 banks. Conversely, investment receivables did not rise among the big-5.
As a residual of the central planning days, in the years after the GFC, the PBC imposed loan quotas on banks to control the aggregate quantity of credit. In addition, the PBC also indicated where this credit should be allocated and used this quota system to prevent excess credit from piling into speculative asset classes such as real-estate and lending to local governments. Because of these constraints, banks once again have an incentive to report loans as something else to circumvent these rules to generate a respectful level of profit. Once several banks began marking loans as ‘securities’ to benefit from regulatory arbitrage, it is difficult for other banks not to follow suit as shareholders jealously look at the peer banks’ superior returns.
Security investments: a free lunch (for now)
In addition to bypassing the LDR, security investments have the added benefit of circumventing the CBRC’s other regulations, namely the capital adequacy ratio (CAR) and the provisions against credit loss.
On the CAR:
Near the peak of China’s credit boom in 2012, the CBRC began asking its banks for compliance with the internationally negotiated prudential requirements set by the Basel Committee. In the aftermath of the GFC, governments around the world pushed banking regulators for a better set of regulations to ensure a similar crisis cannot occur again. The new proposal was agreed upon in 2011 and is colloquially known as ‘Basel III’.
One of the solutions the Basel Committee mandated is a higher capital adequacy ratio, essentially increasing the amount of loss banks can internally absorb before its creditors begin to be impacted. On paper, the Chinese banking standard exceed that mandated by Basel III: CBRC mandates a minimum CET1 ratio of 7.5% compared to 7.0% required by Basel III . In addition, the CBRC imposed a strict time schedule to adhere to these new regulatory benchmarks. The minimum CAR was to be 9.5% in 2013 and would rise by 1% per year until 2015 leaving large banks to have a minimum CAR ratio of 11.5% and 10.5% for smaller banks; this is quite high compared to most other banking jurisdictions.
When pressured by shareholders for returns and squeezed by regulators to adhere to the newly established CAR requirements, Chinese bankers had to find ways to compromise and meet the needs of both parties. Caught in this bind, bankers turned once again to securities as their answer. The CBRC’s Capital Rules stipulates that interbank assets can be have a risk-weight as low as 25% while conventional loans would require a weight of 100% : this infers for every yuan of capital, banks can theoretically hold four yuan of securities for every one yuan of loan. The CBRC’s strict schedule to adhere to the CAR may have pushed many of the smaller bank to binge on securities in order be compliant for the new capital adequacy regime (see Chart 4). In form, a high CAR is reflective of strong solvency; however, in substance, this masked the risk in the sector and may have put the banking system in a more precarious position.
On provisioning against credit loss:
Another tangible short-term benefit for holding securities as opposed to loans is the benefit of provisioning against credit loss. Under the current accounting framework, Chinese banks forecast for credit loss based on a historical data; this is known as the incurred-loss model. This is a feature is that consistent with the international accounting standards. However, there is an issue with applying this standard to China. Unlike in developed markets where there are ample historical samples of credit loss, the Chinese capital market is quite young and since the early 2000s, China has been on the upside of a credit cycle. This implies the sample for credit loss captured in China will be bias because the data does not capture what credit loss would look like during a downturn in a credit cycle.
Additionally, the class of securities that most smaller banks are holding practically did not exist prior 2012 when the constraints from the Chinese regulators began to be imposed. On an incurred loss model, if there has been no previous episodes of loss, then no provisions will need to be set aside to cover for future losses. For this reason, JSBs and CCBs book almost zero impairment loss against these securities even when they comprise 20% of their total assets. The lack of provisioning against these asset is a big source of concern for the sector because any credit loss will be directly absorbed by shareholders without the traditional buffer that credit loss on convention loans offers.
The need for update regulatory metrics
Currently there are three regulatory metrics that the CBRC enforces to ensure prudential standards in the Chinese banking sector:
1. Non-performing loan (NPL) to provision ratio of 150%;
2. Total loan to provision ratio of 2.5%;
3. Minimum capital adequacy ratio as described above.
The rapid rise of securities assets among the JSBs and CCBs have in many ways gamed these prudential requirements and the sector has outgrown these regulatory metrics. With the majority of asset growth in the banking sector in the form of securities, measuring loans will not capture the new risk that is emerging on the banks’ balance sheet. Secondly, with provisions reflecting forecasts based on a past era during a credit upcycle, this underestimates the potential loss during a downcycle and places a false sense of security among bankers, investors and regulators. Lastly, with loan-like assets able to obtain a non-loan risk-weight, this games the CAR and potentially exaggerates the loss absorbing capacity of the sector. For these reasons, the CBRC should develop and enforce regulatory metrics that is consistent with the current reality of ‘investment receivables’ and not fight today’s battle with yesterday’s metrics and tools.
Going forward these are headwinds that the sector and the CBRC must address to prevent a rise in systematic risk. With the current credit cycle on a down-swing, many of the issues I have outlined is emerging or have already emerged. With profit growth for the sector weak and a deteriorating credit environment, many banks will be squeezed as their free lunch comes to an end and they will begin to pay for the cost of their past excesses.
Should the economy continue to deteriorate and liquidity conditions begin to tighten, this may push many JSBs and CCBs to the edge of solvency. In this scenario, we should not be surprised to see an emergency recapitalization program organized by the government or shot-gun marriages arranged with one of the large banks. Regardless of the outcome, the future for many JSBs and CCBs is not looking bright.
PS: In this piece, I have discussed the evolution of Chinese banking assets. In the near future, I will draft a piece covering the equally exciting evolution of the funding structure (liabilities) of the sector: stay-tuned!