Risks rising for China’s city commercial banks

City commercial banks across China are increasingly relying on interbank funding and wealth management products as deposit substitutes– but growing investment holdings, waning liquidity and weakened capital buffers have rendered them more vulnerable to financial disruption, according to analysts at Fitch Ratings.

The group of lenders have grown rapidly in the last few years, says a latest study from the ratings agency, with their market share doubling to 12 per cent of system assets at the end of 2016, from around 6 per cent at the end of 2006.

Nonetheless, “their rising systemic importance implies any excessive risk build-up in this sector could lead to higher overall systemic risk”, said Fitch analysts Katie Chen and Grace Wu.

Much like mid-tier lenders, city commercial banks have shifted more assets into less-liquid, non-loan financial products, to enhance yield.

“There is a strong desire to seek higher investment yields, as loan yields have declined given the interest rate cuts,” Chen and Wu said.

The local banks also rely on those products to “bypass regulatory lending restrictions”, in their efforts to support local economic growth and enhance employment.

However, large holdings in non-loan financial products, most of which are from non-bank financial institutions, increases their exposure to spillover and contagion risks, they said.

And given their greater exposure to micro and small enterprises (MSEs) and cyclical sectors, these banks’ financial performance is also susceptible to local economic fluctuations.

“The risk profiles of city commercial banks are generally weaker than those of state banks, given their more limited franchises, relative cost inefficiencies, and concentration on higher risk sectors, including cyclical sectors such as manufacturing, wholesale and retail, real estate, and construction,” the analysts said.

Their liquidity levels and funding profile is also a weak spot.

Compared with larger banks, city commercial lenders have limited access to the monetary tools offered by the People’s Bank of China.

The central bank can inject capital through its Open Market Operation to larger banks, which subsequently channel that liquidity to smaller banks through interbank lending. However, only around 20 city commercial banks are currently eligible to participate in the scheme.

The others have grown increasingly dependent on interbank funding and selling wealth management products.

Nevertheless, when liquidity is tight those with a weaker profile or lack of qualified pledged assets may not be able to access sufficient liquidity from the interbank market.

Almost all city commercial banks have varying levels of local government ownership, too, directly or indirectly through local state-owned enterprises, and this exposes them to strong implicit and explicit local government influence.

As a result, their business strategies are often closely aligned with local government development strategies.

“Supporting a local economy’s funding needs may run contrary to sound governance and prudent risk management, and weigh on their standalone credit profiles,” say the Fitch analysts.

“Sustaining local economic growth and employment is their key priority.”

The ratings agency adds in the report that local governments have a strong propensity to support city commercial banks during times of need – but their ability to do so may be restricted by their own limited financial capacity, and China’s fiscal system.

“Local authorities may leverage local SOEs and other institutions to provide ordinary support to the banks,” they said, “but their ability to provide timely and sufficient extraordinary capital support under stress is considered limited.”