BOCHK may have broken no laws but its risky lending practices make investors nervous Bank of China's Hong Kong (BOCHK) subsidiary may not have broken any laws when it provided $2.2 billion to now detained Shanghai tycoon Chau Ching-ngai, but the loan violated standard international lending practices and will make it more difficult for the mainland's other state banks to list overseas. BOCHK accepted risky shares as collateral and appeared to turn a blind eye to Chau's investment strategy, which essentially was to liquidate profitable Hong Kong property assets and invest the proceeds in speculative Shanghai real estate projects. The facts available suggest that politics or personal relationships drove the banks' loans despite its establishment of internal controls. 'The question is, did the bank make bad loans or was somebody at the top saying I am going to make loans to my buddies?' one analyst asked.If it turns out the bank did not go by the book in Chau's case, investors are not likely to leap at the initial public offerings proposed by the other state banks - including Bank of China's mainland operations - ahead of 2007, when China's banking sector is thrown open to foreign investors. Those listings are central to the government's plan to recapitalise the banking system through an infusion of money from foreign sources. The recapitalisation is also part of a delicate dance involving the banks, the social welfare network and the government that is supposed to lead to a more efficient capital allocation system shorn of politics. A scandal at the first key bank listing overseas call these goals into question. 'The fact that the loan to New Nongkai [Chau's privately held flagship] became problematic in less than a year raises questions about the adequacy of BOCHK's loan approval controls,' said Standard & Poor's, which lowered its ratings on the bank's debt last Wednesday. Some say the bigger question is the long-term viability of China's banking system. How can the banks clean up their bad loans when there is no national - let alone local - data about the financial status of borrowers? How can a bank distinguish between good and bad borrowers when there is no credit rating system? On June 9, BOCHK issued a statement exonerating itself of wrongdoing. According to the bank, the loan to Chau 'was conducted in compliance with the internal credit risk management policies and procedures of BOCHK and was properly approved by the Credit Committee of BOCHK'. The bank said it granted a one-year $2.1 billion 'bridge' loan in June last year to New Nongkai Global Investments for the purchase of a controlling stake in imGO, which Chau subsequently renamed Shanghai Land Holdings. In return for the loan, Chau put up as collateral his 100 per cent shareholding in New Nongkai and New Nongkai's 75 per cent shareholding in Shanghai Land. He also signed a personal guarantee. As a further safeguard, BOCHK said it wrote into the contract a number of other smaller codicils, including board appointments on New Nongkai and signature control over some of Chau's bank accounts. But analysts say these provisions still did not go far enough for a loan of this size. First, accepting shares as collateral for a loan is generally not a smart way to run a bank. Shares fluctuate in value, particularly shares in companies involved in speculative property deals. In addition, the shares were not in a company unrelated to the borrower - they were in the borrower itself. If anything was to go wrong, both the loan and the shares were likely to go south. Even worse, as an equity holder, the bank is last in line for any assets if the borrower goes bankrupt, after the taxman, employees and major lenders smart enough not to accept shares as collateral. 'Banks in the West don't tend to make too many loans secured on shares,' Fitch Ratings Asia-Pacific banking analyst David Marshall said. Nor is it clear exactly where those shares were. In rare instances where banks in the West accept shares as collateral, they usually lock them up in their vaults and make sure they are easily convertible into cash. Banks can get caught when the shares are in somebody else's hands or have 'lock-up' provisions that prevents their sale. This latter scenario happened repeatedly towards the tail end of the technology boom, as shares value plummeted before they could be sold. The shares were also accepted in exchange for a 'bridge' loan. Bridge loans became popular in the US when investment banks, eager for business, began making loans to corporate customers with the expectation they would soon go public and pay the money back. First Boston learned that such loans can be a bridge too far after it was stuck with US$1.1 billion in rickety loans - including $450 million to Ohio Mattress - that eventually led to the bank's sale to Credit Suisse. It is not clear whether BOCHK took a close look at the property deals Shanghai Land became involved in. A loan of this size backed by shares in a company that transformed from a Hong Kong asset-holder into a speculative property investor in Shanghai certainly would have drawn the attention of western auditors. Another troubling aspect is how much BOCHK relied on loans to a select group of clients. According to the bank's prospectus, HK$28.5 billion - or 13.2 per cent of its $216 billion in 2001 corporate loans - went to just 16 companies. That is an average of $1.8 billion each. Another 13.6 per cent of loans were granted to just 46 companies, which means a quarter of BOCHK's loan book was allocated to a handful of top borrowers. While BOCHK's large overall property portfolio is in line with its Hong Kong competitors, the biggest loans were heavily concentrated in property. Seven of the bank's top 10 outstanding loans were granted to property companies, raising red flags about over-concentration in one industry. 'If you have a lot of big loans, you first make sure one group is not too big,' Moody's banking analyst Deborah Schuler said. The percentage of loans to equity is another concern. The $2.1 billion loan was 4 per cent of the bank's $52 billion equity - higher than some analysts would like. The full story has yet to be told. But the initial facts suggest a troublesome lack of attention to the important details of how to run a bank and do not bode well for China's bid to reform its banking sector.