Bank of Communications (Bocom) has distinguished itself among China’s largest banks during the past year due to its conscientious efforts to bolster credit risk management, most notably for its efforts to secure collateral against loans to local government financing vehicles (LGFVs).
Bank loans to LGFVs are estimated to stand at around 7.66 trillion renminbi ($1.13 trillion), spurred by China’s four trillion renminbi fiscal stimulus response to the global financial crisis that was largely channelled via large, state-controlled banks. As a result, market participants believe the potential of widespread LGFV loan defaults represents one of the greatest risks to the Chinese economy. The government is so worried it launched a national audit of credit-extended LGFVs.
LGFVs can be viewed as a type of project financing, funded mostly by banks, for public utility and infrastructure build-out. Banks have traditionally extended credit based on a ‘letter of comfort’ issued by the various local people’s congresses – a form of local government issued ‘guarantee’. Ironically, this ‘guarantee’ does not bind the debtor to repay the creditor in the event of default.
“While Chinese generally honour contractual agreements it was not an uncommon banking practice to consider such letter of comfort as an important form of security and source of repayment,” says Yang Dongping, chief risk officer at Bocom, based in Shanghai. In China, the local governments are elected by the People’s Congress. “Such as letter of comfort is not legally enforceable in China, so Bocom decided to ease reliance on it. The cashflow and assets of the LGFVs should all be taken into account to form an intergral view of the credit,” Yang adds.
Bocom, which has a reputation for its prudent credit risk culture across all its 140 branches, made a decision in the second half of last year that it was time to put an end to giving credit based on an economically worthless ‘guarantee’. At that time, Yang banned staff from giving out loans to LGFVs based on a ‘letter of comfort’ alone.
Local government borrowers must now demonstrate how the public projects can expect to generate cashflow for loan repayment; or otherwise, post collateral. The bank’s integrated collateral management system conducts valuations on more than one million pieces of collateral gathered from the bank’s customers, of which 85% are real estate-related, at different frequencies ranging from daily to annually. The valuation model, co-developed with an accountancy firm, has enabled Bocom’s risk management division to mark-to-market the value of, for example, residential properties based on data from independent data suppliers that monitor property price changes across 110 cities in China. Meanwhile, the system also enables the team to monitor in real time the inflow and outflow of each form of collateral.
“From a financial disclosure perspective, the integrated collateral management system also enables us to calculate our loan provision more accurately in our quarterly financial report,” says Yang. “As we estimate loan provision based on a discounted cashflow model – and one of the most important sources of cashflow is from the collateral – being able to accurately value these collaterals will ensure accuracy of our loan provisioning.”
The investment in a collateral valuation system was instrumental when Bocom was reviewing a 120 million renminbi loan granted to an LGFV linked to the Hubei provincial government in July 2009. Deteriorating profitability of this Hubei LGFV, which borrowed the money for building toll roads, led Bocom’s risk management team to demand the provincial government to collateralise the loan in March 2010. After months of discussions with Hubei government officials, Bocom convinced the municipal’s financial bureau to inject land worth 160 million renminbi into the LGFV to collateralise the loan.
Today, Bocom’s uncollateralised lending to LGFVs stands at 15% of the Shanghai-headquartered bank’s total lending to LGFVs – a ratio that Yang says should be the lowest among peers. Its ratio of the uncollateralised corporate lending to total corporate loans is higher at 36%, says Yang.
In the national auditing exercise, banks are verifying the amount of loans granted to LGFVs in collaboration with various local governments; and all banks are due to report their audited figures to the China Banking Regulatory Commission by October. Yang is confident the regulator should have few concerns about Bocom’s position as its non-performing loans to LGFVs stands at just 0.07% of the group’s 1.22% total non-performing loan ratio, or 25.33 billion renminbi, as of June 2010.
For its efforts to improve risk management in a challenging environment, Bocom wins house of the year, China.