The scene is just as you would expect in any bank on any normal workday, customers going about their business while staff and security guards share the occasional joke as warm July afternoon sunlight fills the lobby. Just over two months earlier, the scene inside the bank in the Inner Mongolian city of Baotou was completely different. On May 24, financial regulators unexpectedly took over Baoshang Bank, the first bank failure in China in more than 20 years. It set off a chain reaction that created significant stress in China’s money market, weakening small banks and eroding the government’s ability to control the economy. Government-directed investment in the Bank of Jinzhou last week further underscored the problems facing the Chinese banking sector. On one side of bank lobby in Baotou there is also still a stark reminder of Baoshang’s demise, with three posters hanging on a whiteboard giving the full statement from the People’s Bank of China (PBOC) and the China Banking and Insurance Regulatory Commission (CBIRC) describing the takeover, citing “serious credit risks”. “We have almost forgotten the incident,” said a customer inside the Anshan Road branch, who gave his surname as Xie. “Right after the takeover, I saw many elderly people holding their passbooks and swarming into the branch. Now everything seems to have calmed down.” Under the posters, “Baoshang Bank is trustworthy” has been written in green ink, supplemented with a smiley face in an attempt to reassure customers. While bank depositors may be able to look past the closure, government regulators, other financial institutions and financial market traders have not. The regulators’ move to take charge of Baoshang immediately triggered a crisis of confidence over the potential credit risk posed at hundreds of similar smaller local banks. That, in turn, threatened a liquidity crisis in China’s interbank market, where banks come to lend to and borrow from each other, as no one wanted to lend to an institution that might fail. Baoshang marked a watershed moment for the banking industry. That’s called counterparty risk – something the Chinese financial system hasn’t known much about in recent years Trivium China analysts The crisis of confidence was a result of Chinese financial regulators having built up their credibility over decades on the expectation that they would always come to the rescue if they were in trouble, leading to the widespread belief that financial institutions were effectively guaranteed. This created a problem of “moral hazard”, where financial institutions felt they were protected from risks, allowing them to place ever riskier bets. But that changed with the takeover of Baoshang because Chinese regulators chose not to guarantee all deposits and investments in the bank. Corporate and interbank customers suffered heavy losses, but personal and small business accounts, for example, were fully guaranteed. For the first time, the risk that a large bank could lose all or part of its investment in a smaller financial institution was introduced into the market. “Baoshang marked a watershed moment for the banking industry,” analysts at advisory firm Trivium China said. “That’s called counterparty risk – something the Chinese financial system hasn’t known much about in recent years.” This was a necessary reform for China’s financial system, requiring that investors properly gauge the risks of their investments. Given China’s goal is to become a global financial centre, its financial institutions needed to learn to properly price their investments to take account of the risks, according to Trivium China which described it as a “pivotal moment”. But for a system accustomed to being able to largely ignore the risk of not being repaid, it was a shock. Larger banks were suddenly unwilling to lend to smaller banks through the interbank market, fearing that, like Baoshang, their balance sheets hid large amount of bad loans. Baoshang “was an important trading node” for negotiable certificate of deposits (NCD), a security sold by small banks to other banks, and which can be re-sold to other financial institutions, to help them acquire the liquidity they needed for their daily operations, like granting loans to individuals, local businesses as well as supporting local government infrastructure projects. NCDs had long been treated as risk-free, although they are not backed by collateral, but according to said Zhang Ping, deputy director general of the National Institution for Finance and Development, a think tank which is part of the Chinese Academy of Social Sciences: “Baoshang was a blister that had to be squeezed. However, that action risked leading to a chain reaction of credit contraction.” In the week after Baoshang’s takeover was announced, the volume of NCDs issued plunged by nearly 90 per cent. Small banks were only able to sell 20-50 per cent of their NCDs, down from 65-75 per cent before the Baoshang takeover. “Cleaning up [Baoshang] damaged faith in NCDs,” added Zhang. Because smaller banks depend on borrowing from the interbank market for their liquidity, the situation threatened to cause the entire banking system to seize up. To ease the funding stress, the PBOC immediately injected around 2 trillion yuan (US$291 billion) into the interbank market. But tensions in the money market remain high, with other banks watching closely for any signs that other small banks may fail. Given easy comparisons with Baoshang’s situation, the PBOC was forced to step in at the end of May to effectively guarantee the NCDs from the Bank of Jinzhou, a city commercial bank listed in Hong Kong with roughly US$100 billion in asset, after its external auditors resigned. The Bank of Jinzhou, whose shares were suspended from trading earlier this year, said on July 25 that it was in talks with multiple parties for possible strategic investment. But the troubles of Jinzhou and other regional banks have only just started. The Industrial and Commercial Bank of China, the country’s largest lender by assets, said in filings with the Shanghai Stock Exchange that it would inject up to 3 billion yuan (US$435 million) to purchase a 10.82 per cent stake in the Bank of Jinzhou. In addition, China Cinda Asset Management and China Great Wall Asset Management, two of China’s four largest state-controlled distressed debt managers, said on Sunday that they would also take stakes cent in the troubled bank. The CBIRC has also ordered the distressed debt management companies to prepare contingency plans to invest in high-risk small banks, Reuters reported on Friday. Deprived of new funding, smaller banks have started to liquidate investments with brokerages and other nonbank financial institutions, putting them at risk, according to PBOC data for June. Small bank balance sheets are contracting and [nonbank financial institutions] are forced to react to the sudden withdrawal of funding, possibly by liquidating assets such as government and policy bank bonds Logan Wright “This means that small bank balance sheets are contracting and [nonbank financial institutions] are forced to react to the sudden withdrawal of funding, possibly by liquidating assets such as government and policy bank bonds,” according to Logan Wright, who leads Rhodium Group China Markets Research. In response, the PBOC directed large state-owned banks to lend short-term cash to troubled brokers and other nonbank financial institutions to ensure a broad credit crunch did not develop. But the results of the episode, and the likelihood that another bank failure will occur in the not too distant future, has eroded the government’s ability to ensure that its economic stimulus policies are implemented with the intended effect. “Interbank market tensions will not be confined to the dark corners of China’s financial system: they have significant effects on the real economy when smaller bank balance sheets contract, because those are the risk-taking institutions in China,” Wright added. “This also impacts the fiscal policies essential to supporting growth today, because weaker local banks starved of funding are unable to lend for local government infrastructure projects. “China’s financial system depends upon large banks lending to small banks, because the PBOC only transacts with larger banks. Break the liquidity chain and Beijing’s control over the entire economy weakens.” Zhou Liang, vice-chairman of the CBIRC, the country’s banking regulator, said earlier this month that because small and medium-sized banks were irreplaceable in China’s financial system, the central government would continue to support them to better serve their local communities. But even two months after the Baoshang seizure, small banks continue to struggle to acquire the liquidity they need to make new loans. Small banks with credit ratings below AA+ are still only able to sell 20 per cent of their NCDs and daily NCD volume in the interbank market are half of what they were a year earlier. Baoshang, whose business operations were taken over by China Construction Bank, China’s second largest lender, might have been the unlucky institution used as an example to warn others, argued a person close to the local Baotao government, who only gave his surname as Zhang. “Such an operation with the style of ‘do it right the first time’ might have a broader consideration behind it,” he suggested China’s central bank confirmed the takeover was due to the improper and illegal use of bank funds by the Tomorrow Group, which held 89 per cent of Baoshang’s shares. The ownership structure, though, was unclear based on the financial reports posted on its website. Baoshang was part of the Tomorrow Group empire owned by billionaire Xiao Jianhua, with the CBIRC saying in a statement in early June that Tomorrow Group had sold its holdings in more than 10 financial institutions as part of a state-mandated process of divesting assets to reduce financial risks. The Baoshang crisis added to the concerns of local residents about the sustainability of the city’s treasury, given the bank ranked as the largest taxpayer in Baotou, with an annual payment of 2.7 billion yuan (US$392 million) in 2017.