Chinese regulators have tightened their grip on the banking sector in an effort to control financial risk, the country’s ballooning shadow banking sector and excessive debt load. Which banks stand a better chance of meeting these tougher requirements? Stefania Palma reports.

PBOC

In 2017, Chinese regulators have escalated a clampdown on the financial sector in an attempt to control the country’s bulging debt load, which accounted for 257% of gross domestic product (GDP) in 2016.

The reforms’ key objectives are to deleverage China’s economy and financial system by eliminating regulatory arbitrage, slowing the pace of wealth management product issuance and investigating malpractice in the banking sector.

So far, banking regulators the China Banking Regulatory Commission (CBRC) and the People’s Bank of China (PBOC, the central bank) have been actively issuing tougher directives. Smaller Chinese lenders, with their weak profitability, capitalisation and funding profile, are likely to be hit hardest by the tighter requirements.

Short, sharp shock

The regulators’ crackdown is notable for its quick build-up and severity. To the market’s shock, the Central Commission for Discipline Inspection (CCDI) – the watchdog that has been rolling out president Xi Jinping’s anti-corruption drive within the Communist Party – began targeting senior financial officials in 2017.

So far, the CCDI has opened investigations on CBRC assistant chairman Yang Jiacai, and China Insurance Regulatory Commission (CIRC) chairman Xiang Junbo for suspected “disciplinary violations”.

More broadly, the three financial regulators – the CBRC, the CIRC and the China Securities Regulatory Commission – want to increase policy coordination to avoid regulatory arbitrage. According to Michael Taylor, managing director and chief credit officer at rating agency Moody’s Investor Services: “[China] had different financial regulators taking different actions on shadow banking at different times. As a result, there have been regulatory arbitrage opportunities.”

Lengthening shadows

As a result, China’s shadow banking sector has ballooned. Incumbent banks that have historically prioritised large corporate clients while under-serving small and medium-sized enterprises and individual customers left a gap for shadow banking to fill. “We have recently witnessed the development of semi-financial institutions that have had a negative impact on the real economy,” says Yi Huiman, chairman of the Industrial and Commercial Bank of China (ICBC). 

Shadow banking assets in China have more than doubled since 2012, growing to Rmb64,500bn ($9342bn) by 2016, equivalent to 87% of GDP, according to Moody’s. Assets funded by wealth management products have grown particularly quickly, accounting for 47% of shadow banking finance in 2016 – up from 16% in 2012.

These wealth management products are instruments sold to Chinese retail investors that offer higher yields versus bank deposits and are backed by bonds, interbank placements, bank loans and trust loans. Since these instruments do not guarantee principal repayment, banks risk having their investors ask for compensation if the products do not perform.

Additionally, wealth management products are kept off banks’ balance sheets to avoid capital regulations, making them difficult to monitor. The bulk of these instruments also have tenors between one and three months, meaning there is a maturity mismatch with their underlying assets.

To slow the growth in wealth management products, in 2017 the PBOC included non-cash wealth management products in its definition of credit, which is used by banks to complete quarterly macroprudential assessments for the central bank. This means, for example, that non-cash wealth management products will now be part of banks’ calculations of capital adequacy ratios. “It will be very difficult to have a complying capital adequacy ratio when you have high asset growth that includes wealth management products,” says one market participant.

China’s largest banks are unlikely to struggle with the PBOC’s new regulation. “The big four [ICBC, Bank of China, Agricultural Bank of China and China Construction Bank] have some involvement in [wealth management products], but they are less involved overall relative to their size,” says Sonny Hsu, senior credit officer at Moody’s.

Shibor concerns

However, China’s smaller banks will probably be hit hardest as they are heavily exposed to wealth management products, have poorer asset quality and weaker profitability. They also rely on wholesale rather than deposit funding.

This is problematic now that interbank rates are on the rise. The one-year Shanghai interbank overnight rate (Shibor) jumped from 3% at the end of 2016 to 4.43% as of June 22. “The central bank has had a neutral bias towards tightening rates since last autumn. But with the deleveraging in the real economy and now deleveraging in the financial sector, interest rates have been inching up as supply of liquidity is tightening,” says Nicholas Zhu, senior analyst at Moody’s.

On the other hand, China’s larger banks are confident the Shibor jump is not going to hurt them. “We are a conservative bank; interbank lending accounts for less than 6% of our total lending,” says ICBC’s Mr Yi.

And Xu Li, president at Shanghai Rural Commercial Bank, says: “Total interbank debt accounts for below 30% of our total debt. Most of our funding comes from corporate and individual deposits. This will be more of a challenge for small and mid-sized banks.”

Malpractice target

Tackling malpractice more generally is another part of China’s focus on the banking sector. “We have witnessed malpractice in China's financial sector. Risk control of financial innovation is critical,” says Mr Yi.

Under new chairman Guo Shuqing, the CBRC has issued directives on controlling risk, nicknamed ‘334’ in Chinese. They aim to clamp down on the three issues of regulatory arbitrage, violations by related parties in financial transactions, and for-profit product restructuring. The initiatives also condemn three violations (of law, rules and regulation) and four excesses (in transactions, compensation, fee charges and disingenuous innovation).   

China credit growth

The CBRC has asked all Chinese banks to complete inspections based on these guidelines, with an original deadline of the end of June. But market participants and local media say the deadline has been postponed. The CBRC has not publicly announced the extension, but at financial forums such as June’s Lujiazui conference, CBRC officials did not confirm or deny this postponement, according to one attendee.   

If banks fall short of the ‘334’ guidelines, they will have four to six months to meet the criteria – a short timeframe, highlighting the urgency with which the CBRC is assessing domestic banks. It is not certain whether the inspection and banks’ amendments can be done before the end of 2017, especially as the country gears up for the 19th National Congress of the Communist Party in late 2017.

The latest news in regulatory reform before The Banker went to press involved the CBRC asking domestic banks to probe “‘systemic risk’ presented by ‘some large enterprises’ involved in overseas buying sprees”, as reported by the Financial Times. These reportedly include the conglomerates Dalian Wanda and HNA, consumer group Fosun International and insurer Anbang.

Chinese authorities detained Anbang chairman Wu Xiaohui in June, according to financial magazine Caijing, although his detention has not been officially confirmed.  Anbang said in a statement that Mr Wu was “unable to perform his duties”. 

Balancing act

The challenge for Chinese authorities lies in implementing tougher regulation as much as in avoiding unintended consequences. For instance, the PBOC’s crackdown on wealth management products and low corporate bond issuance in the first quarter of 2017 means other shadow banking activity – entrusted loans, trust loans and undiscounted bankers’ acceptances – have grown at their fastest pace in two years.

“It is a game of whack-a-mole. You try to clamp down on one type of product, but because [corporates have a] maturity mismatch and need constant refinancing… [products that had been clamped down on previously make a comeback],” said Stephen Long, managing director, financial institutions, at Moody’s, at the Institute of International Finance spring meetings.

For this crackdown to yield results, it needs to be sustained for the long term, according to many market participants. But in the past, China has relaxed regulation as soon as it dented economic growth. “We have already begun to see a bit of a pullback from some of [these new] measures. Liquidity injections by the PBOC have offset some of the tightening caused by the crackdown. There seems to be a clear pattern; regulatory tightening will always be subject to other policy objectives,” says Moody’s Mr Taylor.

What is more, addressing China’s leverage problem purely through tougher regulations is unlikely to be successful, he adds. “[These] measures address credit supply but not underlying demand for credit. As long as demand stays strong, there will be credit providers out there willing to meet this demand,” he says.

Industries suffering from overcapacity, such as small property developers, or local government financing vehicles, which have been banned from issuing bonds, still turn to shadow banking in absence of other funding solutions.

The clampdown in 2017 on irregularities and risk in the financial sector to reduce China’s leverage has been significant in its rapidity and intensity. But this crackdown can only be effective if it is sustained – and coupled with a close look at where the demand for shadow banking originates.

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