Connectivity within the Chinese banking system is growing, a new report has warned, increasing financial contagion risk across the sector as a whole, if any companies were to suffer serious distress. The study, by top Chinese securities company Everbright Securities, released on Wednesday, highlighted national joint-stock commercial banks, as well as some city commercial banks, as accounting for 40 per cent of such “interrelated assets”, which grew at a compound annualised pace of 23 per cent through 2014-16 to reach a value of 40 trillion yuan (US$5.88 trillion). At the same time, many of these banks are operating from a weak capital base and have high leverage, the report said. Industry observers have long been concerned about the true level of capital buffers at many of China’s smaller banks. Everbright now suggests that including interbank and off-balance-sheet lending, the tier 1 capital adequacy ratio dropped to 9.33 per cent, by the end of 2016, down from the official 11.25 per cent and that banks now need about 2.3 trillion yuan of additional funding to cement their capital bases. It names particularly national banks such as Industrial Bank, China Minsheng Bank, SPDB, Citic Bank, and city commercial banks such as Shanghai Bank, Nanjing Bank, Hangzhou Bank, Ningbo Bank and Beijing Bank. The Tier 1 capital ratio – the comparison between a bank’s core equity capital and its total risk-weighted assets – at some of these banks has now hit the type of levels “reached by western institutions, in the run-up to global financial crisis”, the report says. China’s banking sector is facing new headwinds as asset growth cools “The ratio rose before 2014 due to implementation of Basel III accord. But since then it declined to 5.31 per cent by the end of 2016. “Factoring in sizable off-balance-sheet assets, the ratio was 4.59 per cent, below the recommendable level of 5 per cent,” the report noted. The findings echo a working paper published by the People’s Bank of China a month ago, which, which said national joint-stock banks now play a bigger role than the country’s “Big Four” state-owned banks in having the ability to cause serious shock waves across the financial system. The paper suggests that due to their impact, banks such as Huaxia Bank, China Merchants Bank, Industrial Bank should be classified as “systemically important banks”, and be subject to higher regulatory requirements, as a result. Listed joint-stock banks and city banks have expanded their assets ferociously in the past few years, mainly through interbank investment, which has eventually flowed into the bond and money markets, and infrastructure and real estate companies that otherwise would find it hard to obtain loans. Such investments enable the banks to skirt loan quota limits, and bypass capital base requirements, as interbank assets carry low risk-weighting at only 20 per cent, while loans carry risk-weighting at 75-100 per cent. McKinsey warns of China’s ‘looming interest rate storm’ An earlier Morgan Stanley report has estimated that risk-weighted assets are understated by around 7.4 per cent if proper risk weights were applied to 28 trillion yuan of non-standardised assets. China Chengxin International Credit Rating, which is 30 per cent owned by Moody’s, has noted that by the end of 2016 securities investment exceeded traditional credit assets as the largest profit generator for smaller and medium sized banks, representing around 40 per cent of their total assets. “Traditional metrics such as non-performing loans and overdue loans are increasingly irrelevant in gauging Chinese banking asset quality….In terms of the quality of their securities investment, there is a transparency problem,” said Bai Yan, an analyst with Chengxin. She doesn’t see a replay yet of the liquidity crunch of June 2013, as many banks have taken pre-emptive measures, but added that risk is slowly growing.