China’s banks are on the hunt for capital, despite the country having the highest number of representatives in the 2019 Top 1000 World Banks ranking. The 'big five' state-owned banks – Industrial and Commercial Bank of China (ICBC), China Construction Bank (CCB), Agricultural Bank of China (ABC), Bank of China (BoC) and Bank of Communications – are the highest ranked in China in terms of Tier 1 capital, but they are all facing a range of pressures on their liquidity.
As it looks to boost gross domestic product (GDP) growth, the government is leaning on banks to increase lending, particularly to smaller and medium-sized companies. But the spectre of shadow banking continues to have an impact on balance sheets, as steps by the regulator to curb the sector have resulted in smaller companies suffering from a lack of credit. Their slowdown has, in turn, had an impact on Chinese GDP growth.
So on the one hand, the banks are being encouraged to increase their risk profile and widen the range of companies they lend to – potentially raising the risk of more non-performing loans (NPLs) in the future. On the other hand, banks are being told to reduce their exposure to risky customers in order to cut NPLs.
Additionally, amid rising concerns around the asset quality and debt levels of city and rural banks, regulators in China are looking to the larger banks to provide support. Yet at the same time, the banks are expected to build up their capital, under requirements to increase capital buffers that come from beyond the Chinese regulators, as the country aligns itself with Basel III requirements. These pressures have pushed the banks into exploring new ways of boosting capital to meet the demands placed on them.
An NPL response
The impact of NPLs continues to undermine China’s growth. While the China Banking Regulatory Commission (CBRC) has been focusing attention on cleaning up the balance sheets of the large banks, the smaller banks have continued to suffer. Banks are now required to categorise loans as NPLs after 60 days of non-payment, shorter than the European standard of 90 days.
In some cases, the level of NPLs has proven too much to ignore. The regulator has had to intervene in extreme circumstances; for example, stepping in to take over Baoshang Bank in May 2019 – the first such intervention in the country in 20 years. Although Baoshang Bank’s reported NPL ratio was in line with the national average of 1.8% when it last reported in December 2016, the real figure was understood to be much higher, and the bank had not released a 2018 annual statement.
The authorities appointed CCB, the second largest state-owned bank in China, to run Baoshang Bank for one year. In a note on the takeover, Fitch Ratings noted: “The state banks' balance sheets are superior to the rest of the system, but their health could be undermined if they are ultimately relied upon to prop up a significant number of weaker banks, although it is not yet clear how Baoshang may impact upon CCB in this case.”
Banks throughout the country are taking different approaches to tackling NPLs. The 'big five' state banks increased their write-offs by 74% in 2018, and joint-stock banks increased their disposals by 38%. ICBC’s NPL rate was 1.52% in 2018, and the bank says it has sufficient provisions to cover this. Meanwhile, Bank of Beijing chairman Zhang Dongning says the bank has introduced stringent controls to reduce NPLs, while also actively looking to dispose of them and activate non-performing assets.
Driving down the risk of bad loans has now become a priority as Beijing watches GDP growth stutter. Moody’s has warned NPLs could increase if China's GDP growth falls below 6% in 2019. In addition to recognised NPLs, China also categorises bad loans into special mention loans. These loans are most at risk of falling into the NPL category, and are estimated to represent 4% of total loans. Overall, almost 6% of loans in China could be considered bad.
While many banks are choosing to sell off bad loans, others are taking another approach. Hu Yuefei, president of Ping An Bank, says rather than dispose of NPLs, the bank has chosen to create a separate pool for them away from its balance sheet. He says: “The bank has set up a team of 360 members of legacy talent and experts to recover the loans. We made the decision to recover NPLs rather than sell them off. The bank saw good results in 2018 as it was able to recover Rmb9.4bn [$1.3bn] of NPLs.”
In order to meet regulatory requirements, banks have also been restructuring internally. Fang Heying, president of China Citic Bank, says: “We carried out risk culture building measures, and credit restructuring. We moved to dispose of bad assets while increasing internal controls and compliance management to increase NPL write-offs. Through those efforts our ability to avoid risk was improved, and laid a solid foundation for the bank.”
Chasing the capital markets
If and when banks bring their NPLs under control, they can turn their attention towards other regulatory requirements. To meet the demands on their capital reserves, banks are looking at new ways of boosting their coffers, with the blessing of Beijing.
Yu Lingqu, deputy director of Shenzhen-based think tank the China Development Institute (CDI), believes the change to capital raising opportunities is overdue. “Over the past 30 years of development, Chinese banks have seen little change in the capital markets space," he says. "But now banks are not seeing the same levels of growth, with the possibility of negative growth. Even with the associated risk, the capital markets are looking attractive as a source of direct financing from the market.”
While the larger banks went through initial public offerings (IPOs) in the mid-2000s, some smaller banks are only now embarking on them. Shanghai Rural Commercial Bank (SRCB) kicked off its IPO process in 2018, and Gu Jianzhong, president of SRCB, says: “The bank will primarily list in Shanghai, and then, depending on business conditions, further supplement the core capital by a secondary listing in Hong Kong and issuing perpetual bonds. Other new tools will be used to support the flow of second and third tier capital.”
China is further exploring how the capital markets can boost funding, and is more open to looking for overseas opportunities. The European Central Bank holds renminbi assets, along with the Bank of England and the Swiss National Bank. This increased confidence has encouraged a trend of global asset mangers increasing their allocation of renminbi-denominated equity and bond assets. Xu Zaiyue, CEO of the Cross-Border Interbank Payment System, which is used to facilitate cross-border connectivity in renminbi, says: “Up to now, more than 60 central banks have increased their holding of renminbi reserves, which encouraged equity and bond managers’ investment in renminbi-denominated assets.”
This environment of opening up is demonstrated in the creation of Shanghai-London Stock Connect by the stock exchanges. This development creates direct investment and listing opportunities between the two exchanges. The China Securities Regulatory Commission (CSRC) is hoping that opening up to international investors will help to bring new funds into China’s stock markets. Mr Xu says: “The development will create an investment link between the Shanghai Stock Exchange and the London Stock Exchange. Companies will be able to raise capital on both of these exchanges for the first time.”
Building capital in perpetuity
The China Banking and Insurance Regulatory Commission (CBIRC) has also been open to allowing banks to explore new methods of raising capital. Banks are keen to explore perpetual bonds, which were sanctioned by the Financial Stability and Development Committee for the first time at the end of 2018. Perpetual bonds do not have a fixed maturity date, and can make interest payments to investors indefinitely.
The first mover in this field was BOC, which issued its perpetual bonds in January 2019 and garnered interest from 140 institutional investors. Although there had been concerns over the level of appetite for the bonds, the issuance also gained interest from offshore companies. The bank’s Rmb40bn issuance with a 4.5% coupon was seen as the benchmark as other banks move towards their own maiden offering.
In May 2019, the CBIRC approved China Minsheng Bank’s plans to issue a perpetual bond, making it the first joint-stock bank to issue. Zheng Wanchun, president of China Minsheng Bank, says: “The bank has issued Rmb40bn in perpetual bonds to date.”
Smaller banks are also looking into how perpetual bonds can help them. Guangzhou Rural Commercial Bank’s plans to issue $1.43bn in non-cumulative perpetual offshore preference shares should help to support the bank’s capitalisation and growth, according to a note from S&P Global Ratings. The agency estimates the additional Tier 1 capital will improve the bank’s risk adjusted capital ratio by about 1 percentage point to between 6% and 7% over the next 24 months. Beijing-based Huaxia Bank has also received approval to issue Rmb40bn.
Beijing has pledged to support the banks in issuing perpetual bonds by working with government agencies to adapt policy accordingly. The central bank has stated it will allow high-net-worth individuals to invest in the bonds. ICBC is looking to offer perpetual bonds and preferred stocks, in the hope this will attract new investors and institutional investors. Bank of Shanghai has offered preferred stock since 2007 to supply capital. The bank is currently assessing several tools, including perpetual bonds, to boost its coffers. It is estimated there will be as much as Rmb520bn of bonds on offer across China’s banking sector in 2019.
Caution urged
But issuing perpetual bonds alone may not be the panacea that China's banks are hoping for. Commenting on China Minsheng’s plan to issue a perpetual bond, S&P said in a note that the Rmb40bn issuance may not be enough to support the bank’s growth plans and provisioning requirements.
Some fear that supply could outstrip demand. Charles Su, global market research and sales managing director at China Industrial Bank, says: “While the bonds will increase the ability to raise capital, it does not necessarily mean there will be significant take-up among investors. Banks might [opt] to issue perpetual bonds, but they also need to go to the equity market for capital.”
The decision to adopt perpetual bonds comes with a foreign influence. Under the Basel III rules, the instrument qualifies as Tier 1 capital. Grace Wu, head of greater China banks at Fitch, says: “At present [China's] banks only have enough funds to meet domestic capital ratio requirements. The 'big four' state banks [ICBC, CCB, ABC, BoC], which are also global systemically important banks, either need to raise capital or reduce their balance sheets to meet global requirements.”
Under the requirements for systemically important banks, as defined by the G20’s Financial Stability Board, as China is an emerging market its banks will have to meet loss-absorbing requirements by the beginning of 2025. A second, higher requirement will be implemented in 2028. Moody’s forecasts that China’s 'big four' will have to raise an additional Rmb28,000bn in capital to meet these requirements.
Paul McSheaffrey, partner and head of banking at KPMG in Hong Kong, believes the perpetual bond reforms will bring China’s bond market into line with what is found in Europe and the US. “At present, the Chinese market is not as well defined. China wants to be seen as a strong member of the Basel Committee that complies with the capital requirement rules,” he says.
Ms Wu agrees, adding: “The country wants to demonstrate its compliance with Basel rules.”
Although finding further capital will place additional pressure on the banks, it should also build a buffer against future shocks. Mr McSheaffrey says: “The challenge for China is complying with the Basel rules that were created for counties that see 3% economic growth rates, when [in China] they are consistently at 6% or above. Making the changes will help China to build in resilience.”
The impact of US tariffs
As China’s banks work to meet new regulatory demands, the economy overall is facing downward pressure from the ongoing trade conflict with the US. At present, the back and forth in the US-China trade negotiations is not causing too much concern for China’s banks, thanks in part to the relatively low exposure their corporates have to US trade flows.
Even the largest bank in China is not overly concerned about the impact of an increase in tariffs. Gu Shu, president of ICBC, says: “Of our corporate loan clients, only about 5% have export business to the US. And only a small portion of their trade business is connected with the US, so trade tariffs are not a primary worry. The concern is from the indirect impact on the capital market and the foreign exchange market.”
China Industrial Bank’s Mr Su says the trade disputes with the US will have limited impact on China’s economy in the short term. “However, in the medium to long term, the tariffs will have substantial drag on growth,” he adds.
It is the long-term impact, and how wide the ripples could spread, that the banks are keeping a watch on. The CBRC has warned speculators that shorting the renminbi will cause them greater losses overall. Even in the face of volatility, the CBRC does not expect to see long-term currency depreciation. However, the renminbi has suffered in the face of trade tensions, and other Asian currencies close to the renminbi, such as the New Zealand and Australian dollars, have also been hit.
China has also been trying to talk down the possibility of any shocks hitting its stock markets, with the CSRC saying the markets have already absorbed the impact of a wave of tariffs imposed in May 2019. For Postal Savings Bank of China (PSBC), it has been business as usual, with chairman Zhang Jinliang saying the bank’s foreign currency assets and exposure to export-oriented companies is low.
However, Mr Zhang at PSBC says a trade war could cause changes to the Chinese banking sector as a whole, if lenders rethink their development strategies due to the restructuring of the global value chain. He adds that this could also transform China’s economic structure. “In this regard, commercial banks need to further strengthen the construction of their risk control systems, innovate their business models, and rationally adjust the structure of their assets and liabilities. They need to properly respond to the new situation,” says Mr Zhang.
Alternatively, some banks have a positive view of the trade conflict with the US. Jin Yu, chairman of Bank of Shanghai, says: “There is a possibility it will create a climate to improve future trade between the two countries.”
A 5G force
China’s ongoing complex relationship with the US extends down to the company level, seen most publicly with Huawei. Due to the company's alleged close ties to the Chinese government and rumours over spying, the US has banned Huawei's equipment from being used in US communications networks. Even as the US moves to distance itself from the company, Chinese banks are looking to work with Huawei, particularly with the evolution of 5G technology. BoC, ABC, CCB and ICBC have all collaborated with Huawei on developing their online banking propositions. Now banks are exploring what could take their business to the next level.
With the country's banks looking to streamline their back-office technology, Jason Cao, president of the financial services sector at Huawei's enterprise business group, recommends they set up intelligent data products that give a more comprehensive oversight of the data they hold on their customers. He suggests that banks should move towards an open banking architecture that can enable them to access tech platforms that will modernise their operations without having to build all of the component parts themselves. While open banking has taken off in Europe, it has yet to become widely used among Chinese banks.
In addition, Mr Cao says: “The implementation of 5G will dramatically increase what can be done. Low latency and high bandwidth are basic features of the technology. China's banks have begun looking into what the technology can do for them, and are opening 5G experience centres to carry out investigations in a test environment.”
CCB has established its own fintech unit, and the bank says it spent 2.2% of its total operating income on fintech in 2018. This follows similar moves from the likes of Ping An and China Minsheng Bank, which have developed a strong reputation for their tech developments. Meanwhile, PSBC estimates that its annual technology investment will account for 3% of total operating income each year.
Indeed, updating systems can bring quantifiable gain. After China Minsheng Bank updated its internal operating systems, it reported a reduction in the cost of data management, with the annual cost of account management declining from Rmb2 to Rmb0.1.
Mobile banking and beyond
Meanwhile, the financial strength of the challenger banks in China is growing, with Ant Financial’s MYbank breaking into the Top 1000 World Banks ranking in 2019. The online-only bank lies in 881st position in the global ranking and 146th of the 152 Chinese banks listed, with Tier 1 capital of $685bn in 2018.
However, while noting mobile-only neobanks’ success among Chinese consumers, many of the country's banks argue that they hold a different position in the market. PSBC’s Mr Zhang says: “In most rural areas, people still recognise the importance of physical channels.” At PSBC deposits account for 95% of its total liabilities, and personal deposits represent 87% of total deposits.
There is a widespread acknowledgement that the relationship between the banks and fintechs is reciprocal and provides a revenue stream for the traditional banks – as China Everbright Bank CEO Ge Haijiao points out: “The fee payment services in the utilities panel of the WeChat app are provided by China Everbright Bank.”
Overall, banks are showing few concerns about any threat fintechs might pose. Mr Yu of CDI says: “Despite their rate of growth, there is a huge disparity between what is offered by the established banks and what is offered by the likes of WeBank. It has been likened to a grown-up fighting with a child. There is an inherent strength to the established banks.”
But even if banks feel little threat to their dominance at present from the fintech companies, Mr Yu believes the established lenders would benefit from moving faster when it comes to matters such as blockchain and artificial intelligence. “There is a huge need to test these before they are used or they could bring big risks to the financial markets. However, some banks seem to expect others to do this testing for them,” he says.
While developing technology may be another strain on Chinese banks’ resources, the alternative of not fully embracing change could be building up another level of risk that banks will have to manage further down the line.
