Chinese banks are suddenly being frank about the non-performing loans mystery

Under pressure to pay out a steady flow of dividends, some state-owned banks are ‘smoothing’ quarterly earnings

PUBLISHED : Monday, 07 November, 2016, 3:10pm
UPDATED : Monday, 07 November, 2016, 10:52pm

Here’s something you don’t hear often from companies: “We’d like to apply tougher accounting standards, but our government won’t let us.”

This is the odd but interesting spin that many Chinese banks are putting on their latest set of results, in which most major financial institutions lowered their coverage ratios for bad loans; they did this not because levels of credit stress have improved, but rather as an easy accounting tweak to boost results after a tough third quarter.

We believe the reported results highlight that the largest state-owned banks may have obtained consent from the banking regulator to operate on lower levels of bad loan coverage
Bernstein Research

We know this not only because it is obvious, but because bank executives and spin doctors said so.

In an odd way, it is a sign of sophistication that banks did not even try to defend the smaller coverage ratio as a reflection of increasingly safe fundamentals.

Rather, they told analysts that as much as they would like to be more conservative in their treatment of non-performing loans (NPLs), Beijing insists they protect profits and dividends.

“While top line pressure is expected to continue, banks still face pressure from the government to maintain flat earnings growth, which is unlikely to be achieved without further lowering NPL coverage ratio,” Citigroup explained in a note to clients.

Bernstein Research analysts seemed to hear a similar narrative: “We believe the reported results highlight that the largest state-owned banks may have obtained consent from the banking regulator to operate on lower levels of bad loan coverage…. This should help the institutions to produce smoother earnings trend in the near term.”

Banks’ net interest margins – or the difference between what banks pay on deposits and receive for loans – were squeezed slightly in the July to September quarter, and the fees business took a hit.

But rather than issue reports that reflect this deteriorating profitability, nearly all the banks lowered the amounts of reserves they have to set aside for bad loans. Both ICBC and China Construction Bank even reported coverage ratio’s below the 150 per cent regulatory minimum.

Banks’ net interest margins – or the difference between what banks pay on deposits and receive for loans – were squeezed slightly in the July to September quarter, and the fees business took a hit.

But rather than issue reports that reflect this deteriorating profitability, nearly all the banks lowered the amounts of reserves they have to set aside for bad loans. Both ICBC and China Construction Bank even reported coverage ratio’s below the 150 per cent regulatory minimum.

Analysts say that Chinese regulators have encouraged the sector to take higher charges for bad loans in good quarters, and lower charges in tough times, thus smoothing the ride downhill and avoiding major jolts. If this “soft landing” approach rings a bell, it is because the same trend has occurred on the macro-economic front: China’s gross domestic product has been gradually declining in an orderly manner over recent years.

“The third quarter results of Chinese banks remind us again of the crude reality that earnings declines can’t be tolerated,” Patricia Cheng, lead analyst of a CLSA report, said. “This artificial outcome won’t please investors. But it’s a reminder of the crude reality that no profit decline will be tolerated (yet).”

Why would banks be so honest about their financial engineering of bottom-line trends? Part of it is because they have no choice – Chinese banks meet international reporting standards, which means they have to reveal enough information for analysts to identify underlying profitability trends. But their frankness on this issue is also a way of hinting of a “Beijing put” – the message we get is that one way or another, the state will keep these institutions in tact.

And this narrative is working. CLSA, for instance, has an outperform rating on the sector.

“Banks … are able to keep engineering a stable profit and dividend. The impact from low rates and corporate default gets smoothed,” CLSA said in a note to clients.

Moreover, these institutions pay dividends not just to private-sector investors, but to various state-owned institutions, adding another incentive, in CLSA’s view, to prop them up. “Chinese banks are the biggest contributors of dividends to the Ministry of Finance and among the biggest taxpayers. An earnings drop has more than just a market impact,” the broker said.

Though few brokers mentioned it, another artificial backstop for share-price performance is the large ownership of bank shares by Chinese pensions and other financial interests. This year we have seen surprisingly strong inflows into bank shares, leading to speculation of “national team” buying.

To paraphrase John Maynard Keynes – the banks are saying their results can stay irrational longer than bears can stay solvent.

This is my last regular column in this space. Thanks for reading, and thanks to SCMP for the forum.

Cathy Holcombe is a Hong Kong-based financial writer

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