China’s smaller banks vulnerable to shocks as policy makers tighten rules

Smaller Chinese banks have made risky investments using volatile wholesale funding streams.

Now, as policy makers tighten liquidity and strengthen the rules governing banks’ involvement in shadow banking, analysts warn that the chance of a liquidity shock is increasing.

It was a liquidity shock that struck foreign institutions like Lehman Brothers and Fannie Mae in the US, and RBS group in the UK in 2008, when they found themselves without the cash available to meet their obligations.

Chinese policy makers, therefore, have a new tightrope to walk as they look to curb financial risks in the system without sparking a run on a smaller bank, or worse.

Life is not always easy for smaller Chinese lenders.

Larger banks can employ economies of scale to achieve cost savings that they cannot. Rules governing cross-regional business mean that Chinese regional banks are restricted to offering services in their own locations and, by and large, Chinese savers prefer to entrust their cash to the larger players, not least because the big banks have been in existence for longer.

As a result, the smaller banks have had to find new ways to boost their profits, and have had to raise the cash to do so from sources other than deposits.

These often involve the shadow banking sector, with banks selling, investing in and lending to wealth management products to boost their fee income.

This is particularly the case for rural and city commercial banks, small banks that operate in just one city or region, and for smaller joint stock commercial banks, which operate nationally, but are dwarfed by the four giant state-owned lenders.

In recent years China ’s smaller banks have aggressively grown their assets. According to figures published by Katherine Lei, a banking analyst at JP Morgan, in a recent report, between 2012 and 2015 assets at China’s big four banks increased by 9 per cent, while those at joint stock commercial banks grew by 18 per cent, and those at city and rural commercial banks grew by 22 per cent.

During this period China ’s total leverage was increasing rapidly, suggesting that even normal loans at this time were vulnerable to default.

Furthermore, this increase was mainly driven by investing in non-standardised assets, which Lei defines as “loans lent to borrowers through the structure of special-purpose vehicles,” and can include trust products or asset management plans.

What made this more risky was that smaller banks had to rely on unstable sources of funding from the interbank market to fund such expansion.

“Interbank activity has increasingly served to help banks pursue profits and expand assets, rather than being a tool for liquidity management,” said analysts at Moody’s.

This inter bank funding, which normally entails borrowing from deposit-rich state owned banks, is often short in duration, where as the investments made by the banks using that money is generally longer in duration.

“The duration mismatch makes the lending vulnerable to changes in liquidity. Plainly, higher funding costs have the potential to trigger disorderly deleveraging.” said Nathan Chow, a DBS economist.

This is a particular concern now interest rates are rising.

Earlier this month, the People’s Bank of China (PBOC) surprised the market by increasing the seven-day repo rate, a key interest rate between the central bank and commercial banks in the interbank market, as well as the 14-day and 28-day repo rates.

“The liquidity concern for joint stock commercial banks is certainly rising, especially when rates increase,” said Alicia Garcia-Hererro, chief economist at Natixis.

As of the first half of 2016, the total loans issued by joint stock commercial banks added to their non-standardised asset investments (effectively shadow banking loans) were equivalent to 117 per cent of their total deposit base.

“The cost of lending more beyond the loan book will be higher,” said Garcia-Hererro.

As well as raising rates, Chinese authorities are also tightening the rules about shadow banking products. The banking regulator, the CBRC, the securities regulator, the CSRC, and the PBOC have all recently issued proposals that would restrict banks’ activities in the shadow banking sector, and include these activities when measuring their total risk appetite.

JP Morgan’s Lei describes such tightening as “The right step, in our view,” but adds “it could lead to rising liquidity risk and default risk in the system in the near term.”

“Transparency into shadow banking cash flow or transactions is very low. There may not be written contracts to state the risks and rewards of some transactions. This means that financial deleveraging may lead to unintended consequences in system liquidity,” said Lei.

Banks may be obliged by regulators to hold greater capital, at a time when their access to funds from the interbank market is becoming more expensive. Should there be a problem with asset quality, and this is always possible given smaller banks’ risky lending and investment habits, then all this could come to a head at once.

In an extreme case, Lei says, sizable defaults in shadow-banking products could lead to liquidity events such as bank runs and there is even a possibility, albeit a remote one, of bankruptcies among smaller banks.

Technical defaults are not impossible if banks have trouble accessing liquidity when fears of counterparty risk loom. Plainly, the PBOC must walk a fine line between tightening too much and too little,” wrote Chow.