China banks risk Lehman moment as wholesale borrowing rises

Posted on November 23, 2016

Chinese banks are increasingly reliant on funding sources that western peers used before the financial crisis, leading investors and analysts to warn that China’s financial system could be vulnerable to a Lehman Brothers-style collapse.

Their use of volatile wholesale borrowing to fund balance sheets has particularly worried analysts, who warn that banks could be left without the stability of a broad retail deposit base and unable to raise cash when most needed.

Concern over China’s rising debt has already become widespread among investors and policymakers. These concerns have focused on banks’ declining asset quality as defaults rise but many analysts believe the bigger risk comes from the liabilities carried on bank balance sheets. 

“The real issue isn’t the volume of debt but rather the liability-side ‘plumbing’ that underlies the debt boom,” says Jonathan Anderson, principal at Emerging Advisors Group and longtime China-watcher. “If there’s going to be financial crisis in China, this is where it will come from.”

Chinese lenders have traditionally relied on deposits from households and corporations to fund loans and other investments, providing a buffer against market turmoil. Retail deposits are “stickier” than funding from other financial institutions because retail customers rarely switch banks, while wage payments and corporate revenues provide a steady inflow of new deposits. 

That is now changing, as swift growth in loans and other debt assets outstrips growth of deposits. China’s ratio of private sector credit outstanding to standard commercial bank deposits rose to 117 per cent at the end of March from 84 per cent at the end of 2008, according to an FT analysis.

While this ratio is still below the ratio in developed markets such as the US at 181 per cent and the EU at 178 per cent, the rapid upward trend is worrying, analysts say. 

“Exposures are not nearly big enough today to talk about real crisis risks yet. But fast forward a few more years at the current pace and those risks will start to loom a good bit larger,” says Mr Anderson. 

The widening gap between assets and deposit liabilities is being filled by less stable funding sources. One of these sources is interbank lending. Big banks, whose broad retail branch networks allow them to draw in plentiful deposits, lend to smaller banks with less access to deposit funding. 

But beyond the traditional lending between banks, another newer funding source from so-called “wealth management products” (WMPs) is causing concern. These are structured notes offering investors higher yields than those available on traditional bank deposits. Banks create WMPs in partnership with nonbank institutions such as trusts, securities companies and fund management companies. 

Some WMP proceeds flow directly to corporate borrowers such as real estate developers, mines and factories, but most are invested in money-market assets. These assets are essentially loans to banks, mostly in the form of repurchase agreements or interbank “placements”.

“Since 2009 and 2010, we’ve seen a significant shift. Particularly with smaller banks, we’ve seen a greater reliance on borrowing from other financial institutions to fund their business,” says Charlene Chu, senior partner and head of China banks at Autonomous Research in New York. “That can be a source of volatility and problems when a financial sector starts to come under stress.”

The nightmare scenario is a WMP default, according to analysts, which could spark a broader run in which customers abruptly stop buying WMPs or even demand immediate redemption of products already purchased.

In this scenario, money-market liquidity would evaporate and banks that rely heavily on wholesale funding could find themselves unable to meet deposit outflows or payouts on their own WMPs. 

The scenario could be reminiscent of 2008, when the Primary Reserve Fund, a popular US money-market mutual fund, suffered losses on short-term commercial paper issued by Lehman.

When Primary Reserve “broke the buck”, marking down its shares to below the normal $1-per-share baseline, investors in other money market funds confronted the possibility of losses on products previously considered risk-free. As money-market investors withdrew en masse, these funds were forced to pull loans abruptly from banks and corporates. 

Mr Anderson warns of a situation in which “isolated seizures among nonbank financials start to paralyse parts of the banking system as well. At that point, fears of counterparty risk grow, setting off a wave of liquidity hoarding”.

Even in the absence of a system-wide run on money-market funding, reports of problems at a specific institution could cause wholesale lenders to cut funding, much as Northern Rock in the UK found itself abandoned when counterparties began to doubt its solvency. 

“Banks are becoming more sensitive to the risk of potential counterparty failure, which could magnify any collective reaction to negative news and trigger a sharp tightening in system liquidity,” says Christine Kuo, senior vice-president at rating agency Moody’s in Hong Kong, where she covers financial institutions. 

China launched deposit insurance beginning last year that covers most bank deposits. Most WMPs, by contrast, provide no explicit guarantee. Yet much like US money-market funds before 2008, most Chinese investors consider WMPs “money-good” and pay little attention to fine-print disclosures about underlying assets, relying instead on the reputation of the state-owned banks that sell them. 

Chinese banks have struggled to extricate themselves from implicit guarantees. In 2013, Industrial and Commercial Bank of China used its own funds to ensure payouts on a WMP that it had sold through its branches but for which it bore no legal responsibility.

The moves echoed bailouts of off-balance-sheet vehicles by bank sponsors like HSBC and Citibank during the financial crisis. These institutions faced pressure to shield clients from losses in order to prevent reputational damage, even though they had no legal obligation.

In theory, new banking regulations under the global Basel III framework should prevent Chinese banks from relying too heavily on short-term funding. The “net stable funding ratio” was added to Basel III specifically to address this vulnerability. A separate “liquidity coverage ratio” is meant to ensure banks hold enough easy-to-sell assets to survive a 30-day stress period when money-market funding is unavailable.

China’s banking regulator has published draft regulations to implement Basel III, but the rules do not come into full effect until 2018 at the earliest.

“Net stable funding ratio is still years away. Today, no Chinese bank publishes their ratio. They’re calculating it internally but they don’t publish any ratio, so we really don’t know what it’s like,” says Ms Kuo.

China’s “Big 4” state-owned commercial banks, which remain largely deposit-funding, once dominated China’s financial system, but that has changed in recent years.

Total assets at Chinese banks outside the “Big 4” increased only modestly from 96 per cent of gross domestic product to 109 per cent by the end of June 2016, according to Jonathan Anderson, principal at Emerging Advisors Group.

Meanwhile, assets at smaller banks rose from 100 per cent of GDP to 185 per cent. The biggest rise has come from nonbank financials, which have increased assets from 52 per cent of GDP to 147 per cent of GDP.

Bank of Jinzhou, based in northeastern Liaoning province, is an example of a small bank that relies on wholesale funding. Customer deposits account for only 51 per cent of total liabilities, compared to 80 per cent at Industrial and Commercial Bank of China.

Worryingly, smaller banks are also where the greatest credit risk is lurking, analysts say.

At Bank of Jinzhou, “debt securities classified as receivables” account for 51 per cent of total assets. This is a category frequently used for exotic credit assets like “trust beneficiary rights” and “directional asset management plans” that are often used to disguise risky loans. At ICBC, comparable assets account for about a fifth of the bank’s total.

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