How bad is bad? A look at 30 small banks in China

An anxious China has rescued three banks this year. At least 25 more share some of their worst traits

  • In a rare government takeover, the Baoshang Bank was seized in May, drawing attention to weaker rural lenders in struggling regions of China. Over the next three months, state-owned entities stepped in to acquire big portions of two more such lenders.
  • looked through the financials of 30 regional and national joint-stock banks that exhibit worrying financials, some of them flagrant. The study found 25 of them had at least one of the salient negatives that characterised the three rescued banks – large amounts of shadow loans, sparse liquidity, and late or no financial reports.
  • Despite China’s moves to rescue banks, there are also signs it is letting big creditors take losses – upending the assumption that the government will always tide them over. That would be a sea change for the country, and may be just the beginning in giving the market a bigger role in cleaning house.
  • Still, observers say China will try for orderly resolutions for banks beyond saving, and for others, the country’s biggest banks – the state-owned behemoths – will be forced to step in with either partial or full takeovers.

Over four months this year, China’s government swooped in to shore up three rural banks.

In May, it seized the Baoshang Bank outright, something it had not done in nearly 20 years. Next, in July, one of the ‘Big Four’ state-owned banks suddenly became the largest stakeholder in the troubled Bank of Jinzhou. Then in August, the HengFeng Bank – about twice the size of the other two banks – was infused with cash by China’s sovereign wealth fund.

The inadequacies at the three banks varied, but all overlapped in one big way: shadow banking, where assets are kept out of daylight through helpful accounting. Such opaque investments represented more than one-quarter of total assets at Baoshang, rising to nearly one-third at HengFeng, and at Jinzhou, to almost 40%.

Despite the very high proportions at those banks, elsewhere they are lofty, too. A study by of 30 other banks found six others with proportions above one-fifth, two of them grazing 29%.

But there were other signs of frailty. Over the last two months, pored over financial data of a sampling of 30 mostly small and mid-sized regional lenders that, like the rescued banks, show some disquieting indicators. The review found 25 of them shared at least one of three red flags with the three banks that blew up: a heavy shadow banking book; sparse liquidity, as measured by the adjusted loan-to-deposit ratio (LDR), which includes the shadow lending proxies; or late or missing financial reports.

But China’s anxiety over these far-flung banks – Baoshang is in Inner Mongolia – masks a greater effort to cordon off the larger banks that fund them from any contagion. As its economy slows, China may be trying to head off bigger, chaotic spasms of deleveraging.

Its effort comes at a tenuous time. A raging trade war with the US is biting into the country’s export juggernaut. The adoption of international accounting standards, as well as slowly tightening domestic regulations – both would purge banks of shadow loans – is exacerbating stress on smaller banks whose balance sheets have come alive with the murky investments. China may be slowly ending the implicit guarantees on the wealth management products that shelter shadow loans and that have enriched banks and asset managers. As well, a broader definition of what constitutes a non-performing loan (NPL) will also translate into higher provisions and capital charges.

In a sign of alarm, in April, the National Audit Office said a few banks in Henan, a province in the country’s eastern mid-section, had NPL ratios above 40% at the end of last year. The disclosure of such explosive rates of toxic assets was the first in decades.

Last but not least, economic growth in China’s hinterlands has slowed sharply, hurting the loan books of banks in those regions. Coupled with a vice of stricter rules, it is unclear how the mid-sized and smaller banks on the periphery of the major metropolitan centres will adjust.

Liang Yu, a director at S&P Global Ratings in Hong Kong, said in an August research note that more difficulties will likely surface in the next year, and some banks will be absorbed or cease to exist completely.

“Credit divergence will intensify, in our view, because some small and mid-sized banks are less equipped to deal with a slowing and rebalancing economy and tightening financial regulations,” she wrote.

Four banks flush with shadow loans examined the 30 banks through many lenses: the NPL ratio, the special-mention loan (SML) ratio, core Tier 1 capital ratio, capital adequacy ratio and when a bank last reported results.

But crucially, the study looked at exposure to shadow banking products, such as trust beneficiary rights (TBRs) and directed asset management plans (Damps) and the attendant adjusted loan-to-deposit ratio (LDR). Damps channel funds to a corporate borrower by buying investment products from a third party like a brokerage or special-purpose vehicle. Along with TBRs – loans extended via trust companies – the two products make up a quarter of shadow banking assets in China, according to UBS estimates, and are thought to be among the worst credits in the market. Smaller banks use these under-the-radar instruments to extend loans to racier borrowers like property developers and local companies.

In’s sample, Zhengzhou Bank in Henan province led the pack with the highest percentage of shadow loans to assets at 28.7% of its 466 billion yuan ($65.4 billion) loan book. Next came Huishang Bank in Anhui province, with 28.6% of its 1.1 trillion yuan assets, followed by Shengjing Bank in troubled Liaoning province, with 22.2% of its 985 billion yuan book, and the Bank of Tianjin, also in a struggling region, with 22% of its 659 billion yuan assets.

“It’s not that all TBRs and Damps are going to be non-performing,” notes one analyst in Hong Kong who used to work for a global bank. “But it is fair to say a lot of them in China are regulatory arbitrages that aim to avoid provisioning for risky lending.”

Some of those banks also scored high in their adjusted LDR, a metric that reflects a bank’s ability to cover loan losses and withdrawals by customers – and that does include shadow assets in its calculation. The Chinese government scrapped a 75% goal in 2015 to encourage lending. Today, analysts generally recommend 80–90% to keep deposits and cash ahead of loan losses.

The Bank of Tianjin had the highest LDR in the review at 123% last year, followed by the Huishang Bank, which is listed in Hong Kong, at 118.8%. Of the banks that did disclose shadow loans, nine had adjusted LDRs over 100%.

Another flashing red light is the ‘special-mention’ loan category, a rung just above non-performing, and generally used as a holding cell for faltering loans – that segregation can keep a bank’s profits looking healthier than they are. The loans are at least 30 days past due, but no more than 90. The category also encompasses any borrower that has lost money for the past two quarters, or a company that has defaulted on a loan or bond at another lender.

In this arena, two banks in lagging Shandong province, Shandong Zouping and Shandong Guangrao, both rural commercial banks, had startling special-mention loan ratios of 31.2% and 27.6% respectively in 2017. They were followed by Tangshan Bank in Hebei province, with 19.9% in 2018.

Apart from the standouts, as many as 15 other banks had an SML ratio of 3% or more. Three percent is the average of all banks in China.

A lack of timely financial reporting was also a warning sign. Four banks in the study did not put out an annual report last year: Shandong Zouping; Shandong Guangrao; Chengdu Rural Commercial Bank; and Zaozhuang City Commercial Bank, which has not issued one since 2016.

Capital adequacy ratios were another hurdle examined. Six banks fell below the regulatory requirement of 10.5%, with as little as 2.28% at Anhui Tongcheng Rural Community Bank.

On core Tier 1 capital, most of the banks exceeded the 7.5% minimum ratio, with a handful of laggards, most notably Anshan Bank, straggling at 3.25%, and, again, Anhui Tongcheng at a mere 0.23%.

Three different stories of government redemption

On May 24, the Chinese government announced it would take possession of Baoshang Bank for one year. Baoshang, which last issued an annual report in 2016, had shadow assets at the time that were one-quarter of its loan book, plus an LDR of 137.2%. (Excluding the TBRs and Damps, its LDR was a respectable 80.8%.) State-owned China Construction Bank has taken over its day-to-day operations.

Besides the financials, two things stood out in the Baoshang takeover. The first was its ties to Xiao Jianhua, a financier accused of bribery and stock manipulation who has not been seen in public since 2017. His Tomorrow Group reportedly owns almost 90% of Baoshang, and the government later accused the group of misappropriating money from the bank.

The second is the bank’s depressed location, in Inner Mongolia. Weaker banks tend to be concentrated in areas where local economies are faltering, analysts have noted. Besides Inner Mongolia, an S&P report listed Gansu, Guizhou, Hainan, Heilongjiang, Jilin, Liaoning, Ningxia Hui, Qinghai, Shaanxi, Shandong, Tianjin, Tibet and Xinjiang as other trailing regions.

“Banks are more vulnerable to asset quality problems if they operate in regions with economic growth that is slower than the national average, or experienced a relatively sharp slowdown in the past few years,” said S&P’s Yu in a research note.

I believe there’s a commercial solution for the troubled banks, provided their assets are still valuable and can be used to recapitalise and restructure
Hong Kong-based former analyst at a global bank

The Baoshang takeover was the government’s first in almost two decades, but it was unusual in another way: in a departure from past practice, the government said it would negotiate with creditors holding more than 50 million yuan in loans on how much they would recover – instead of covering their losses outright. The shift in tone left observers wondering how far the government will ultimately go in letting the market absorb its own losses.

In July, the next domino fell. Bank of Jinzhou had missed its April 30 deadline for its 2018 financial report; its auditor, Ernst & Young Hua Ming, quit when it discovered some of the bank’s loans were not used by institutional clients for their stated purpose. Jinzhou said it was unable to reach agreement on the documentation required to address the issues in question.

The bank did ultimately release its annual report on September 8, showing some arresting figures: a loan book 37.2% made up of shadow loans, an adjusted LDR of 153.8% and an SML ratio of 16.7%. Jinzhou is headquartered in Liaoning, one of the areas with slackening growth.

Instead of a takeover, this time the Industrial and Commercial Bank of China (ICBC) – the country’s (and the world’s) largest bank – stepped in, paying 3 billion yuan for an 11% stake. It was joined by China Cinda Asset Management, which bought a 6.5% stake, and China Great Wall Asset Management, which did not disclose the size of its purchase. The two are half of China’s ‘Big Four’ asset management companies.

“The inconsistency of the approach is making the market nervous,” says the financial research analyst, contrasting the cases of Baoshang and Jinzhou, and adding that the two may be just the start in novel approaches to bank rescues. “I believe there’s a commercial solution for the troubled banks, provided their assets are still valuable and can be used to recapitalise and restructure.”

He gave as an example Guangfa Bank, which needed capital and managed to raise 13 billion yuan from its biggest shareholder, state-owned China Life Insurance Company. The transaction involved no government intrusion.

chinese renminbi

In August came a slightly different approach in the deliverance of the HengFeng Bank, previously called the Evergrowing Bank. Like Baoshang, it, too, had ties to Xiao and its call-out might be part of an attempt by the government to further break apart his holdings.

But HengFeng, based in Shandong, also seemed to have somewhat sketchy financials. Its TBRs and Damps were 31.8% in 2016, the last year it reported results. And asset-wise, it is far larger than the other two banks: 1.2 trillion yuan.

In this case, it was China’s sovereign wealth fund, Central Huijin Investment, that emerged to buy a stake in the bank. Huijin is a subsidiary of the China Investment Corporation, which acts as the Chinese government’s shareholder in the country’s four biggest banks.

The three interventions have crackled through China’s financial megacosm, and with no dearth of problematic lenders, the question now is: who’s next?

When worse might actually mean better

On the face of it, the average bad-debt piles at China’s banks show little cause for concern. According to official data, the rural commercial banks had an NPL ratio of nearly 4%, the highest of any of China’s six types of banks. At the immense ICBC, for instance, the NPL ratio stands at 1.52%.

“There are rising bad debt problems at most of the banks,” says David Marshall, co-head of Asian financials research at CreditSights in Singapore. “But they look manageable for the large banks we are tracking, and more serious at some of the city commercial banks, especially given their stretched balance sheets with low capital and heavy reliance on market funding.”

But the NPL metric in China is not entirely straightforward. Profits and losses on shadow wares are accounted for as investment receivables – not as loans. So a shadow loan that went sour wouldn’t show up in a bank’s NPL ratio.

Even so, six banks in the overview had NPL ratios exceeding the government maximum of 5% – by a lot. Leading the list was Shandong Guangrao, with 13.9%, followed by Anshan Bank with 13.3%, Anhui Tongcheng Rural Commercial Bank at 12.3%, Guiyang Rural Commercial Bank with 9.9%, Shandong Zouping at 8.7% and Benxi City Commercial Bank with 7.4%.

But, at times, the NPLs might be conveying budding improvement, too. For instance, at Anshan Bank, TBRs and Damps went down to 10.5% of its loan book in 2018 from 21.4% the previous year; its NPL ratio leapt to 13.3% – showing the bank may be recognising these assets in a more realistic part of its balance sheet.

On paper, its financial state appears parlous, though in fact it may be reporting more accurately. Its loan-loss provisioning soared to 4 billion yuan in 2018 from 2.67 billion yuan the previous year, but its ballooning NPLs meant that its ratio of allowances for loan-impairment losses to NPLs swooned to 44.54% from 281.27%. The regulatory requirement minimum is 120%.

So what will happen to China’s vulnerable banks? Analysts say many weaker lenders are actively trying to improve their credit management, recapitalise and find new investors. After Baoshang, where the government for the first time put a question mark over the largesse generally extended to creditors, analysts wonder how much more discipline the government plans to instil.

Analysts say Chinese authorities still do not want to let even a small bank collapse, preferring an orderly exit. But in letting large creditors – possibly even depositors – take some losses, a better risk management system might take root.

“What the Baoshang takeover did is it introduced the concept of counterparty risk within the system,” says the financial research analyst.

Banks used to think that funding smaller banks riddled with shadow loans in a tottering part of the country was a “golden” opportunity because China would never allow their creditors to take losses on the chin.

He adds: “Not any more.

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