Three recent bank failures show that China can take the short-term pain of financial clean-up and clear the way for more financial reform.
- The defaults of three Chinese banks raised fears over a systemic collapse, prompting speculators to bet on a banking crisis
- But the events were not what they looked like
- The incidents may mark a turning point
- Beijing showed its resolve to attack the incentive problem; ending the implicit guarantee should be structurally positive for credit pricing.
The government’s takeover of Baoshang Bank in May marked China’s most high-profile bank failure in two decades. The subsequent bailouts of Bank of Jinzhou and Heng Feng Bank by state-owned banks and the Central Huijin sovereign wealth fund in July and August fanned any talk of further bank failures.
No systemic risk in China
Baoshan Bank and Heng Feng Bank failed in the wake of a corruption investigation, while Bank of Jinzhou was punished for regulatory violations. The banks’ problems had been known for a while as they had omitted to publish financial statements for two years.
The central bank responded resolutely, injecting liquidity to keep the failures from triggering systemic risk. Interbank rates spiked only briefly and generally remained low throughout the failures.
The government used different forms of bailout: Baoshan Bank and Heng Feng Bank were nationalised and the Bank of Jinzhou was rescued by state-owned strategic investors, including ICBC, China Cinda Asset Management and China Great Wall Asset Management.
Kicking the implicit guarantee habit
The Baoshang and Heng Feng takeovers may mark a turning point for China’s banking system by breaking the implicit guarantee policy. This could go a long way to dealing with moral hazard: investors do not exercise prudence in investment decisions because they believe that the government will always come to the rescue.
The central bank offered some guarantees, but did not bail out all Baoshang creditors, setting a precedent for subsequent bank rescues. Its decision was a carefully calibrated compromise between preventing financial contagion by preserving public confidence and avoiding moral hazard by injecting market discipline into the system.
Already in 2017, Beijing allowed state-owned Dongbei Special Steel Group to default on the principal of its debt. Bond investors with holdings over RMB 500,000 had to take a haircut of 78%, although small investors were repaid in full. Subsequent bond defaults have followed this precedent.
I have long argued that China’s excess capacity problem was due to capital misallocation stemming from the implicit guarantee policy. Ending this is structurally positive for China’s fixed income market as it addresses moral hazard and improves credit pricing.
Unregulated small bank growth in China is over
Crucially, these bank failures suggest the era of unregulated rapid growth for small banks is over. Since the early 2000s, the assets of small and regional banks have grown rapidly at the expense of the large banks. Many of these small institutions engaged in regulatory arbitrage through opaque and complex financial activities funded in the wholesale market: interbank borrowing by small and regional banks rose from 12% of total funding in 2015 to 13% in mid-2019. This compares to a steady average of 2% by the large commercial banks and the Big Four.
This rapid growth helped meet the policy goals of financing local infrastructure and improving the private sector’s access to funding. However, financial risk at the small and regional banks rose rapidly, including the shadow banks and non-bank financial institutions (NBFIs), risking a systemic shock.
In response, under Beijing’s deleveraging campaign, large banks' funding for the NBFIs was cut off (see Exhibit 1).
Exhibit 1: Bank loans to corporates and NBFIs in China have dropped sharply since deleveraging started in 2017
Source: CEIC, BNPP AM (Asia); August 2019
The harder it becomes for small banks to use rapid growth to cover poor lending decisions, the more likely it is that they will have to be restructured or absorbed by larger and stronger institutions. The examples of Baoshang, Jinzhou and Heng Feng show that China has the capacity to handle the short-term pain of financial clean-up adequately and pave the way for more financial reform.
 See “Chi Flash: China Sets Precedent for Debt-Default Resolution”, 5 September 2017
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