Taming Wild Banking Risks Banking regulator keeps a watchful eye on Chinese banks to fend off threats as their credit ratings come into question

By LAN XINZHEN

Taming Wild Banking Risks Banking regulator keeps a watchful eye on Chinese banks to fend off threats as their credit ratings come into question

By LAN XINZHEN

GONG LEI

International credit rating agency Fitch Ratings warned 16 Chinese banks of possible downgrades due to risks to their medium-term assets quality outlook and liquidity strains. The announcement came in its latest report, the Viability Ratings for Global Financial Institutions, released on July 21.

Viability Ratings, which features a more detailed assessment of fnancial institutions’intrinsic financial strength with a 20-notch long-term rating scale from aaa to f, is a substitute for Fitch’s long-established Individual Ratings that use a 10-notch A-to-F scale.

The 16 Chinese banks were graded between bb and b, of which the Industrial and Commercial Bank of China, China Construction Bank and Bank of China were graded bb and Agricultural Bank of China bb-. Another 11 banks such as Bank of Communications, China Merchants Bank, China Citic Bank and Shanghai Pudong Development Bank were graded b+, while Hua Xia Bank received a b.

The latest grading caused a panic to seize foreign institutional investors, forcing many to sell off stocks from Chinese banks in anticipation of the downgrade. But the People’s Bank of China, China’s central bank, has tried to clear up these misgivings and prove the security of China’s banking sector by providing concrete statistics.

Quality assets

Three ratios are typically used to measure a bank’s fnancial health: asset-to-liability, capital adequacy and non-performing loans (NPL).

By the end of June, China’s banking sector had reported assets of 104.14 trillion yuan ($16 trillion), increasing 19.4 percent from the previous year, and total liabilities of 97.81 trillion yuan ($15.05 trillion), up 18.8 percent year on year, according to statistics released by the China Banking Regulatory Commission (CBRC) on July 25.

The capital adequacy ratio of commercial banks in the first quarter stood at 11.8 percent, higher than the required 11.5 percent and 10.5 percent for systematically important banks and non-systematically important banks, said the CBRC.

The NPL ratio of China’s commercial banks for the first quarter was 1.1 percent, much lower than the internationally recognized security line of 5-8 percent. In total, they had 433.3 billion yuan ($66.66 billion) worth of NPL, 300 million yuan ($46.15 million) less than the end of 2010, according to the CBRC statistics.

Statistics aside, international rating agencies and investment institutions still expressed concerns about China’s banking sector.

Fitch highlighted risks to the medium-term asset quality outlook for China’s banking sector given the rapid growth of credit since 2008, a large amount of which has been extended to local governments and property-related borrowers, which have questionable repayment capacities in the medium term.

“This risk is further underscored by elevated property prices in numerous Chinese locales, and the banking sector’s meager capital and burgeoning size,” said the report.

Loans secured by local government fnancing platforms are usually less than 30 percent of total loans, said the central bank’s statistics. Local government debts totaled 10.7 trillion yuan ($1.65 trillion) in 2010, while China’s GDP that year was about 39.8 trillion yuan ($6.12 trillion), creating a debtto-GDP ratio of 26.88 percent, much lower than the international standard of 60 percent, said statistics from the National Audit Offce of China.

“Overall, we believe the risks behind loans to local governments’ financing platforms are controllable,” said the central bank.

Local government investment in recent years has targeted large self-liquidating projects that provide economic and social benefits. Industrialization and urbanization have accelerated in China, making it possible for a large number of these projects to have steady and sufficient cash flows to offset debts and their ensuing interests, said the central bank. Some projects, while developed along with peripheral industries, can reap diversifed revenues to pay off their debts, and only a small number of them need fscal support to cover their debts.

Chinese banks tend to have low NPL rates, according to these banks’ regularly released fnancial reports. These rates were audited by accounting companies before their release, verifying their accountability. Most of the 16 banks are already listed, and only a few are seeking approval from the China Securities Regulatory Commission for a public listing, said the central bank.

In addition, commercial banks themselves value the quality of loans and have reinforced risk-control efforts over their loans.

Problems remain

Banks must also conform to new supervision standards for China’s banking sector announced by the CBRC in May, said Zhou Xiaohe, a researcher with the Hong Kongbased fnancial news agency ETNet.

CBRC’s new supervision standards will have stricter capital adequacy, leverage, liquidity and loan loss reserves requirements, and hence it is considered as China’s counterpart to Basel III, or the third of the Basel Accords agreed by members of the Basel Committee on Banking Supervision. Basel III was developed in response to the deficiencies in financial regulation revealed by the global fnancial turmoil in 2008. Its introduction as a global regulatory standard on bank capital and liquidity marked the beginning of the global reform of banking supervision.

The CBRC will revise and release supplementary rules and standards like that on commercial banks’ capital adequacy by the end of 2011 to ensure the new supervision standards be implemented in early 2011. All banks will have to meet the capital adequacy requirements frst—no less than 11.5 percent for systematically important banks and no less than 10 percent for nonsystematically important ones, said the CBRC guideline.

The stricter requirements will put additional pressures on capital for bank managers. Chinese commercial banks will have to pursue diversified businesses and services in the next five years, but it will still be difficult to find a replacement for loans as their major source of capital, said Zhou Kunping, Deputy Manager of the Development Research Center under the Bank of Communications.

Commercial banks have to raise funds to meet the capital adequacy requirements set in the guideline, particularly because the central bank has raised the deposit reserve requirement ratio several times to a record high of 21.5 percent in the first half of this year, which has made the financial market thirsty for liquidity.

A total of 903.55 billion yuan ($139 billion) was raised in the banking sector last year, making up 27 percent of the total fundraising in the financial market, said a report inWind Information, a publication on financial data, information technology and software services. Banks raised 62.21 billion yuan ($9.57 billion) in the frst half of 2011, or 30.3 percent of the total and 68.85 percent of last year’s total, said the publication.

To some extent, it’s irrational for banks to grow through ceaseless fundraising, said Zhou. Shareholders’ stakes in these banks will be diluted when banks raise too much money through equity fnancing, he said.

Even if banks raise funds through issuing bonds, this could cause increases in their accounting costs and trim their return on the capital ratio in case of a slowdown in growth, he said.

In addition, while competing for funds with companies in other industries, banks seeking large amounts of capital will hinder the effective capital deployment within the financial market, and make it even more diffcult for poorly capitalized small and medium-sized enterprises to survive on direct fnancing.

Anticipating bad debts

Zuo Xiaolei, chief economist of the Beijing-based China Galaxy Securities Co., advised banks to dispel fears of local government debts turning into bad debts on their balance sheets in order to clear up international doubts about the health of China’s banking sector.

“It’s imperative to have solutions addressing local government’s debts in the short run, and introduce standards and rules for local governments to abide by in issuing local debts, so as to prevent a crisis from breaking out in the long run,” Zuo said.

Zuo proposed several solutions: turn local debts into national debts; assess economic and social benefts of infrastructure projects; privatize some local state-owned enterprises (SOEs) to pay back loans; and require a certain ratio of bad debt reserves for local governments’ debts as a risk control device.

In principle, increases in Central Government revenues don’t necessarily ensure the payment of loans secured by local governments through their fundraising platforms, and that is why loans to local governments have to be classified and treated differently, she said.

Loans have been granted for local governments either to fulfill their functions or to implement public welfare projects. Loans that were part of China’s counter-crisis stimulus package should be included as national debts and paid off from the Central Government’s coffers, like a certain proportion of increases in annual fscal revenue, she said.

As most loans to local governments were invested in infrastructure projects, assessing such benefits will help strike a balance between debts and revenues of public fnance, she said.

While local governments are advised to sell part of their state-owned assets by privatizing SOEs to pay their debts, banks are advised to have a certain ratio of bad debt reserves for loans to local governments.

In the long term, measures should be taken to contain local governments’ impulse to propel GDP growth through launching as many projects as possible, which is the root cause of huge accumulated local government debts, she said.

Zuo also advised banks to have an accountability system and a budget constraint mechanism for granting loans to local governments, as few Chinese banks operate independently from governmental interference, which is especially true with loans.

It will only increase their risks of having more NPLs if banks fail to practice discretion and manage loans to local governments in line with basic principles, she said.