By Alicia García-Herrero, Chief Economist for the Asia Pacific at NATIXIS, an adjunct professor at City University of Hong Kong and Hong Kong University of Science and Technology (HKUST) and visiting faculty at China-Europe International Business School (CEIBS). Originally published at Bruegel
China bank risk is on the rise. The unwavering focus by both markets and regulators – ranging from individual banks to financial system stability as a whole – reflects a sense of urgency that actions are needed to contain the risk. This is no easy job. And at least in the government’s mind, it requires not only a trade-off between short-run profitability and long-term system risk of commercial banks, but also balancing the interest between different players in the financial industry, for example, insurers and asset management corporations (AMCs).
This also explains the creativity on risk shifting through repeated tightening and loosening of policies, and the ultimate outcome favors banks the most. In fact, both markets and regulators have come up with different ways to survive in front of challenges. The usage of investment receivables and wealth management products (WMPs) are initiated by banks, but these channels are likely to be further restricted. The government has encouraged debt-to-equity (D/E) swap, adjusted from banks holding equities to shifting risks to other market players.
Whilst different institutions are interlaced in the financial system, let’s focus specifically on the impact on banks on four aspects, i.e. asset quality, liquidity, profitability, and solvency.
Asset quality: Deterioration to continue although cushioned by D/E swaps. The latest development shows that banks have won the tug-of-war with regulators, i.e. banks are no longer allowed to hold equities from D/E swaps, which would weigh heavily on capital requirement as time goes on. Since the first D/E swap, an equivalent of 8% special-mention loans is already offloaded. Although offloading of stressed assets through D/E swaps could help improving asset quality, we expect deterioration in asset quality to continue due to slower GDP growth and the still weak global demand. A huge pick-up in corporate performance to service debts remains unlikely.
Liquidity: Signs of stress increasing with JSCBs and CCBs particularly at risk. The understated loan-to-deposit ratio and the high proportion of overnight funding together raise the risk for a shortfall in funding when liquidity squeezes. The recent spikes in SHIBOR pointing to more pressure in 2017, and this is especially true for JSCBs and CCBs.
Profitability: Less cushioning from fee income as banks will find it more difficult/costly to issue WMPs. Chinese banks have expanded business in fee income in response to interest rate liberalisation, which has resulted in lower rate and net interest margin. The key factor of future profitability is regulation. PBoC will include assets behind WMPs in its Macro-Prudential Assessment (MPA) from 2017 Q1, whilst CBRC will tighten rules on WMPs such as requiring banks to set aside capital for provisioning. This poses restrictions on banks in the ability to issue further. In particular, funds and securities firms have already overtaken banks as the larger drivers for the WMP issuance in S1 2016.
Solvency: Although capital buffers look sufficient for regulatory standards, three key weaknesses are masked. Firstly, with special-mention loans included, NPL coverage ratio would fall below regulatory limit (150%) to 53%, indicating provision may not be sufficient. Secondly, if off balance sheet WMPs are included, asset-to-equity ratio would increase by 15%, meaning that the leverage is higher than it appears. Thirdly, no organic capital is created. Therefore, 2017 might prove more difficult in terms of solvency for Chinese banks than it appears on paper.
No Rebound in Sight
All in all, the likelihood of a rebound of the Chinese banking sector in 2017 or a big crisis remains low. The operating environment for banks would remain challenging, especially with weak macro environment and more regulatory requirements. Having said that, although other channels in investment receivables and WMPs will be more restricted, banks appear to benefit the most from debt-to-equity swap. This should offer a helping hand to asset quality but the deterioration will continue.
The four aspects (asset quality, liquidity, profitability, and solvency) are definitely not pointing to a positive outlook. Whilst SOCBs will remain stable, smaller banks (JSCBs and CCBs) will face increasing pressure due to the reliance on overnight funding, strong linkage to WMPs, and the overstated capital buffers.
I am jaded, I guess. All I see above is that the fire sector in China is getting squeezed out…..Good riddance as they mainly represent an overhead expense that gets paid by the consumer.
In the USA, imho, we would do well to bring back Glass Stegal complete and not mess around with easily gamed multi thousand page pleas to play nice.
Then comes the hard part..pu^ING in place a just revenue system and realize that taxes are use to deter activity. If you want less speculation…tax it.
What goes around comes around: Saving the banks by resolving corporate bankruptcies with D/E swaps is best for banks? But expensive because then they have to put their money where their mouth is and run those corps. in a prolonged economic downturn… This analysis sounds like boilerplate; it could be referring to the US or the EU, both of which are still on life support. The truth is it is very expensive for central banksters to prevent a minsky moment from becoming a complete collapse in the aftermath of a free-for-all frenzy where there is a massive lack of liquidity and zero profits. The new catch phrase for all kinds of equilibrium can apply to economics too. There is a balance to all things that seems to be part of a universal constant, no? “The economic policy going forward will respond to information and be driven by entropy.” I can almost hear Yellen saying this.
Your last three sentences reminded me of Herman Daly’s view of a steady-state economy, STO:
Following the 2008 finance collapse in the West and Japan we’ve seen central banks pursue a very liberal monetary policy over a period of many years, labeled “Quantitative Easing” or “Zero Interest Rate Policy”. The money created pursuant to this policy has been largely channeled into large banks and shadow banks, used to boost prices of financial assets, by large corporations for massive stock purchases, and by the MIC for their purposes. There has been no quid pro quo required from the recipients of these funds in terms of debt-equity swaps, no state ownership positions taken by the government in the recipients, nor even any material regulatory restrictions imposed on enormous financial derivatives speculations by large banks and shadow banks in the wake of the financial crisis. In sum, it has been an interesting interpretation of capitalism and “free markets” by all involved.
Setting aside potential issues similar to those that triggered the transition of 1949, I see no particular reason why China cannot adopt this template. There is presently little consumer price inflation, and the money under discussion here has already been destroyed. It is merely the forms that recognition of that destruction and remediation will take that is now under consideration IMO.