Small Regional Banks Are the Achille’s Heel for China’s Financial System

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A new analysis point to China’s smaller regional lenders as being the chief source of vulnerability and risk for the country’s debt-laden financial system.

China kicked off a concerted deleveraging campaign over a year ago, in order to reduce the mountain of debt accumulated by stimulus measures launched in the wake of the Great Financial Crisis.

The deleveraging campaign has focused on China’s immense and heavily leveraged state-owned enterprise sector, to which the country’s bank-dominated financial sector is highly beholden.

While the health of large-scale financial institutions are a perennial concern, some observers believe that it’s smaller banks out in the provinces that pose the greatest threat to China’s financial stability.

Writing for The Financial Times Brandon Emmerich, Principal at Granite Peak Advisory, and Alex Campbell, Chief Investment Officer for Black Snow Capital, point to roaring growth in the assets of China’s weakest and most risk-fraught banks in recent years.

According to their analysis China’s weakest banks have seen average compound annual asset growth of more than double that of healthier lenders. Weak banks now account for 20% of all assets in the Chinese banking sector.

These banks are far more vulnerable than their larger peers due to their enthusiasm for regulatory arbitrage, their high liquidity risks as well as the dubious quality of their assets.

This heightened vulnerability is embodied by the official reading for their share of loans to total assets, which stands at only 35% for China’s weakest banks.

According to Emmerich and Campbell the remainder of the assets of these weaker banks are actually risky loans concealed as investments in order to dodge loan-to-deposit ratio requirements.

This means that the actual risk levels of these banks are far higher than what conventional metrics would otherwise indicate.

“The non-performing loan data for China’s banks is notoriously optimistic,” they write. “A new rule from the banking regulator is designed to incentivise banks to more aggressively recognise past due loans – a tacit admission of past cover-ups.”

Further compounding the vulnerability of these banks is their dependence upon the fickle interbank market for funding.

China’s weakest banks have a deposit-to-liabilities ratio of only 57%, as compared to 80% for their healthier peers.

This means that they are heavily dependent upon the short-term interbank credit for funds, making them highly vulnerable to any liquidity-related contingencies.

Smaller regional banks are the most fragile of all lenders, given that the distribution of risk in China’s financial sector is highly skewed in geographic terms, and far more concentrated in the western, northeastern and rust belt regions.

The western provinces of Gansu, Qinghai and Ninxia have a combined local government fiscal deficit of 26% and a debt-to-GDP ratio of 96%, as compared to figures of 5% and 41% respectively for the affluent eastern coast.

For this reason the geographic distribution of loans by banks can serve as reasonable predictor of their future losses.

“More branches means more lending,” write Emmerich and Campbell. “Banks with the highest risk for unrecognised non-performing loans will be those with highest exposure to China’s weakest regional economies…the weakest are the small, regional banks with heavy exposure to China’s northeast and west.

“Should China face a deleveraging of the banking system, this set of smaller regional banks will probably be the first to face problems.”

 

 

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