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Asia-PacificJuly 3 2020

China’s small banks face the regulators

Covid-19 has exacerbated the gap between China’s largest banks and small rural lenders so regulators have stepped in. How will these changes impact the country’s banking sector? 
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Hengfeng

At the top end of China’s banking sector, there seems to be little fluctuation in business over the past few years. The state-owned banks have dominated the Top 1000 World Banks ranking for several years, and despite slowdowns in their Tier 1 capital growth, they remain comfortably the best capitalised in the world. A look at the smaller end of China’s 4000-strong banking industry reveals a different story, however.

China’s big four banks, namely ICBC, Bank of China, Agricultural Bank of China and China Construction Bank, hold Rmb72,000bn ($10,200bn) between them, representing almost 40% of China’s total deposits. While they can use their substantial coffers to protect themselves from the current economic downturn, the same cannot be said for their smaller, and much more exposed, rural and commercial counterparts. 

There have been several moves from the regulators in recent years to make the smaller banks stronger, through greater regulatory oversight, curbs on shadow banking and an improvement in the recognition of non-performing loans (NPLs). 

Grace Wu, senior director of financial institutions at Fitch Ratings, says these changes have focused on removing the deficiencies in the smaller banks. “The build-up of excessive risks, particularly at smaller city and rural banks, was threatening system stability. Fitch views samples of reported operational deficiencies at smaller banks since 2019 as a sign of regulatory commitment towards containing financial sector risks. Reporting and exposing vulnerabilities will heighten risk awareness and would benefit longer-term financial sector development,” she says.

Smaller bank problems 

Even with these changes, the smaller banks have remained a cause for concern, with worries about their levels of funding and poorer management.  

“Smaller banks generally have poor franchises as well as weak capitalisation due to low profitability and excessive growth,” Ms Wu says. “Strong local government influence and related-party lending raises governance concerns, while their narrower geographical focus and large exposure to non-loan investments, such as wealth management products, increases concentration risks.” 

The limited pool of resources available to these smaller banks can also cause problems. “Compared with larger banks, small city and rural banks have limited risk buffers and they typically have larger exposures to consumer loans, credit card receivables and small business lending – sectors that are most vulnerable to a coronavirus economic shock. This could lead to large capital erosion for some small banks,” Ms Wu adds. 

The risk of contagion is also high on the list of reasons for concern. Any limit on smaller banks’ ability to lend will spread into the local economy. This is creating anxiety during the coronavirus pandemic, since providing support for small and medium-sized enterprises (SMEs) has never been more important than now. 

Harry Hu, senior director, financial institutions ratings, at S&P Global Ratings, says: “The smaller banks are needed to support the economy. They are vital for the support of SMEs, which has become a priority of the government.” 

The scramble for deposits has also intensified. “There are real problems for smaller banks in building up deposits. Demand for loans has increased, thereby intensifying competition for deposits,” Mr Hu says. “Smaller banks are making slower digital progress, so are losing out, as more people want to bank digitally. They need to find a way to develop or innovate, perhaps by offering new products to attract clients.” 

Lender issues 

These concerns about smaller banks experiencing problems is not just hypothetical. There have already been situations where banks have needed assistance this year. 

The risk is these banks falling into financial trouble, causing a run on the bank. Yulia Wan, vice-president senior analyst, financial institutions group at Moody’s Investors Service, says: “Bank of Gansu is an example of where the regulator has stepped in to provide stronger government support to the bank, rather than allowing it to fail.” 

In this case, the Bank of Gansu held total assets of Rmb335bn and a deposit share of 12.7% in Gansu province at the end of 2019, but the warning signs were already there. The bank’s NPL ratio of personal business loans had risen to 14.08% from 4.77% the previous year, despite reducing the number of loans of this type it issued by 7.7%. The bank’s overall NPL ratio for 2019 was 2.45%, up from 2.29% in 2018. 

Bank of Gansu’s struggles came to light in early April when depositors rushed to withdraw their funds after the share price plummeted by 43.5%, following the announcement that several shareholders had pledged their shares as collateral in order to raise funds.  

As part of the restructuring plan, the bank will receive capital injections from enterprises related to the local government, and special loans from the People’s Bank of China (PBOC), the central bank. Later that month, Bank of Gansu appeared to have seen some return to strength as it was reported it would be providing Rbm30bn in loans to the State-owned Assets Supervision and Administration Commission, and several companies owned by the provincial government. 

However, Bank of Gansu is not the only bank to see this form of intervention. Bank of Jinzhou and Hengfeng Bank have both received cash injections from larger banks and funds linked to the government since the end of 2019. 

The risk of NPLs is likely to put pressure on more banks. In a note, Moody’s stated NPLs among city commercial banks increased by 53 basis points (bps) in 2019, significantly higher than the 3bps increase seen overall in the banking system. 

Ms Wan at Moody’s Investors Service says these problems have accelerated during Covid-19: “Asset risks are rising for Chinese banks. The sector-wide NPL ratio rose to 1.91% at the end of March from 1.86% at the end of the fourth quarter of 2019.” 

The problem becomes even starker when comparing banks of different sizes. “In addition, the divergence in NPL ratios widened among different types of banks, with the NPL ratio for state-owned banks remaining almost flat in the first quarter, while that of city commercial banks increasing by 13bps,” Ms Wan says. “Rural banks have been hit the hardest, with their ratio increasing by 19bps. This is largely because smaller banks have the greatest exposure to SMEs and high risk sectors like manufacturing and wholesale and retail, which have been the hardest hit by the pandemic.”

Regulators step in 

To stabilise the sector, the China Banking and Insurance Regulatory Commission (CBIRC) announced reforms that would bring in tougher oversight in order to forestall distress. These changes included stricter checks on the qualifications of shareholders and equity restructuring. The PBOC has also moved to provide additional support. 

Geoffrey Choi, EY Asia-Pacific financial services assurance leader, says: “The central bank has been supportive of banks throughout the pandemic. The reserve ratio has been decreased a couple of times, freeing up more capital in the market. This means the banks will be able to lend more.” 

After years of struggling with NPLs and increased regulations, the coronavirus has been a burden that some banks have found too much to bear. Regulations are putting pressure on banks to have strong cash reserves. “Under the banking regulation, every $1 of NPL typically needs 150% provisions, although this could be lower for some small banks,” says S&P’s Mr Hu. 

The PBOC has said it will implement further reforms and bank consolidations in 2020 aimed at small and medium-sized banks, which will focus on accelerating capital replenishments, raising funds through additional channels, including insurers, and improving corporate governance. 

Higher standards 

Moving early to shore up these banks could help prevent greater problems further down the line. While CBIRC’s financial stability report classifies just 13.5% of financial institutions in the high-risk category, issues with small bank distress have the risk of spreading to other institutions and into the wider economy. 

Providing support may also be necessary for some banks to meet international standards. Mr Choi says: “China needed to have a good governance model, even before the coronavirus threat. But I think in the long term, the commercial and the rural commercial banks will be able to get through this. A very small fraction of the group might need some direct support, especially as they ready their operations to be Basel compliant.”  

During 2019, the PBOC encouraged banks to start issuing perpetual bonds as a way to generate additional Tier 1 capital to meet Basel III requirements. While this strategy may work for state-owned banks and the largest commercial banks, it might not be appropriate for rural commercial banks. 

Alternative methods of capital support have been explored. S&P’s Mr Hu says: “Some measures have been introduced to help with small bank capitalisation. For example, CBIRC has aimed to be more flexible with insurance companies investing in bank capital instruments. With more capital issuances, the funds raised can be used to increase small bank capital.” 

Consolidation possible 

If smaller banks are not able to meet the requirements, or obtain support from the government, the solution may be to consolidate. 

Mr Choi expects this to be the case. “Consolidation will become more common. If you look at the number of banks in China, there are already more than 140 commercial banks, and more than 1000 rural commercial banks. In order to build up stronger capital, consolidation may be a good option,” he says.

He cites what happened in Henan province as a good example of the type of intervention that may be seen. During early 2019, a run on the banks occurred after the National Audit Office stated that 42 banks in Henan had more than 5% bad loans, with some of them recording up to 40% bad loans on their books at the end of 2018. The PBOC and CBIRC stepped in after a rumour spread on messaging platform WeChat that Yichuan Rural Com­mer­cial Bank was at risk of bankruptcy, and saw depositors rush to the branches to withdraw cash. Following this incident, CBIRC announced in November 2019 that it would provide financial injections and support management reforms to support struggling banks. 

This may continue to be the preferred method of involvement from the regulators for now. “We are not seeing the regulators push hard for banks to merge; I think they would rather have it play out,” Mr Choi says. “However, we are starting to see some mergers taking place. The scale of consolidation depends on what the bank executives and shareholders are willing to do.”   

Finding banks that could work well together with a similar client base may be difficult. Ms Wu says: “Consolidation makes sense but there are operational hurdles, given these banks tend to have narrower business focus and are often quite closely tied to local governments.” 

She further cautions of the possible social impact if banks were to be pushed into mergers, especially while under the shadow of the coronavirus pandemic: “Their largest shareholders are typically tied to the local government, directly or indirectly through local state-owned enterprises. Industry consolidation and employee redundancy during a down cycle also has its own social and political challenges.” 

With so many factors at play, there is no easy solution to resolving the problems of China’s smaller banks. As the impact of the coronavirus rolls on, putting even greater pressure on banks, the regulator may find it needs to take drastic measures to prevent bank insolvencies and the social concerns that follow them. 

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Read more about:  Asia-Pacific , China , Regulations
Kimberley Long is the Asia editor at The Banker. She joined from Euromoney, where she spent four years as transaction services editor. She has a BA in English Language and Literature from the University of Liverpool, and an MA in Print Journalism from the University of Sheffield. Between degrees she spent a year teaching English in Japan as part of the JET Programme.
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