China Banks' Risk Profile

The bulk of market capitalisation in Asian equity is in bank stocks. China has been leading the way, and the banks' health should be monitored closely. We know of the rampant bank lending that has been on going for the past 12 months. Now we need to know the extent of the potential bad debts and how that would play out in 2010. We already know that bad debts for credit cards have already doubled year on year and that is an ominous sign.

China's banks posted strong profit growth in Q3 2009 as new lending continued to surge. The jump in new lending meant that non-performing loans decreased as a percentage of assets. Regulators started to tighten lending standards in Q3, which along with the need to meet new capital adequacy requirements, could eat into profits. However, a shift toward longer-term loans and of savers into demand deposits may increase the net-interest margin for banks, which fell through Q3 2009 due to lower interest rates.

Capital Adequacy Ratios

Fitch warned that due to "major ongoing weaknesses in loan classification and disclosure of off-balance-sheet exposures" China's banks' capital positions are probably worse than they appear. The banks have used an increasing amount of off-balance-sheet transactions to bundle loans and sell them to investors, which represents a "growing pool of hidden credit risk." These transactions free up space on the banks' balance sheets so that they can increase their lending without lowering their capital adequacy ratios.

China’s Banking Regulatory Commission denied reports that it would raise the minimum capital ratios to 13% in 2010 from 10-11% now, but it said that banks would need to develop “medium-to-long-term plans” to replenish capital after the lending binge of 2009. As of September, all of the largest banks except the Bank of China had capital ratios over 12%. The shift toward longer-term loans from Q2 2009 has boosted the net interest margins of China’s banks, but the loans also come with higher risk weightings, pushing down their capital ratios. In order to maintain their 12% capital adequacy ratios, China’s 11 largest listed banks would need to raise an additional RMB368 billion (US$43 billion) in capital, according to calculations by BNP. Core capital adequacy ratios at the banks fell to 8.9% at the end of September 2009, from over 10% at the end of 2008.

In August 2009, the WSJ reported that the China Banking Regulatory Commission was considering a ruling that subordinated debt held by other banks would no longer count as supplementary capital. Estimates suggested that as much as 51% of subordinated debt issued by banks (RMB210.0 billion in H1 2009, three times the total amount for 2008) was held by other banks. In October, regulators issued a ruling that was significantly easier for banks to meet: Only subordinated debt acquired after July 1, 2009 would need to be deducted from Tier-2 capital. This will make it more difficult to replenish capital by issuing subordinated debt but does not require significant changes as a result of the ruling.

When the government recapitalized the banks in the late 1990s, it formed asset management companies (AMCs) to purchase non-performing loans from the banks, which were funded through bonds held by the banks. The AMCs have had very low recovery rates on the NPLs, and their bonds may have to be rolled over or written off. The government opted to allow at least one of the recapitalization bonds that allowed China's banks to become commercial enterprises to be rolled over for another decade. A US$36.2 billion bond held by Cinda Asset Management was to come due at the end of September, but was rolled over for another ten years. Writing off the principle due would have cost CCB more than half of its net assets, and the remaining bonds, which come due in 2009/10, are expected to be rolled over as well.

From October 2009, insurance companies will be allowed to invest in the property market. This will allow state-owned banks to transfer underperforming commercial property holdings to insurers at book value, and insurance companies will not have to write down the property values because they will be booked as long-term assets. This lets insurance companies diversify their assets to better match the duration of their liabilities but also protects banks' balance sheets.

Central Huijin, a division of China's sovereign wealth fund, said that it would continue to buy shares in China's three largest banks to reassure investors and stabilize their share prices.

How Much Will Non-Performing Loans Increase?

The increase in NPLs may come in mid to late 2010 given that they tend to peak 12-18 months after a credit boom. However, the revival in property markets and increase in mid- to longer-term loans may limit the deterioration of assets.

The surge in NPLs would be limited to RMB400 billion (US$58.5 billion) in 2010, but another RMB250 billion (US$36.6 billion) in NPLs could emerge in 2011. If credit is tightened more in 2010, NPLs would jump higher.

The Banking Regulatory Committee is raising minimum capital adequacy requirements from 8% in 2008 to 11% by 2010, but the PBoC controls the reserve requirements, blunting the regulators’ ability to control loan growth.

FT Dragon Beat: If 1/6 of the RMB20 trillion in bank lending to be issued from 2008 to 2010 goes sour, then the government's liability would be RMB3.3 trillion, which is about the same as all the nonperforming loans recognized so far.


p/s photo: Freida Pinto