Shadow Banking Crackdown Could Further Hamper Capital Adequacy Ratios

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China’s commercial lenders will find it a challenge to raise their perilously low capital adequacy ratios amidst Beijing’s ongoing shadow banking crackdown, according to Christopher Balding, associate professor of political economics at Peking University.

In an opinion piece published by Bloomberg, Balding points out that Beijing’s “war on financial risk” and its efforts to contain debt and the shadow banking sector could have an adverse impact on the capital adequacy ratios of banks.

“The government is committed to reducing off-balance sheet banking activity…[yet] moving trillions in wealth-management products and other risky instruments onto balance sheets will cause capital-adequacy ratios to drop,” writes Balding, citing a UBS estimate that capital could fall to just 6.3% of assets in the wake of such shadow banking reforms.

According to Balding many of China’s small and medium-sized banks are now shoring up their capital levels by raising funds via private offerings of convertible debt, with some regions boosting share capital by in excess of 65%.

This method averts a shock dilution of value at the outset, with staggered conversions across the medium-term helping to maintain stability.

While Balding views this as a sign of real process, the 220 billion yuan in convertible debt issued last year is dwarfed by the 2.8 trillion yuan “still needed to raise overall capital to acceptable levels.”

The quandary of Chinese banks is further compounded by exposure to growth risks and the persistence of non-performing loans, which some analyst estimate could be as high as 25%.

In order to safely improve the health of Chinese banking sector, Balding still advocates that lenders continue to gradually bring shadow assets back onto their balance sheets.

In order to prevent any shocks caused by this process, Balding says Beijing should coordinate the timely provision of capital injections as risky assets are reclassified.

While the Chinese central bank’s provision of $273 billion to banks in 2017 signals its keen awareness of the need for such measures, Balding says a change in mentality is still urgently needed amongst lenders themselves.

“Banks…need to avoid seeing these injections as free money,” writes Balding. “They must use the infusions to build up acceptable capital buffers and reduce bad-loan ratios, not as an excuse to resume profligate lending.”

Balding also points to the need for regulators to institute more effective internal controls, as exemplified by a recent fraud cause involving the Shanghai Pudong Development Bank, which saw its Chengdu branch extend over $12 billion in loans to shell companies in order to conceal bad debts.

In addition to improving the ability of regulators to scrutinise the Chinese banking sector, higher levels of transparency would raise the ability of banks themselves to raise much-needed funds.

“One reason banks have difficulty raising capital is that they’re prohibited from selling new shares below book value,” writes Balding. “Investors price their stocks well beneath this floor because they don’t trust official financial data.

“More reliable controls would help restore that trust, thereby boosting share prices and making it easier to address all the other problems banks are facing.”

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