Shadow Finance Expansion by Chinese Banks Deepens Credit Mystery

  • Banks are booking more assets as 'receivables' this year
  • Rating agencies say it's hard to assess their credit quality

China’s riskier banks are investing more customer funds in financing that is kept off their loan books, making it harder for rating companies to gauge their asset quality.

There has been a surge in a balance-sheet item known as receivables, which often includes shadow funding such as trusts and wealth products, said Moody’s Investors Service. Fitch Ratings said it is hard to analyze this escalation in activity. Listed banks excluding the Big Four saw short-term investments and other assets -- which include receivables -- jump 25 percent in the first half, compared with total asset growth of 12 percent, data compiled by Bloomberg show.

Slower growth in the world’s second-largest economy coupled with "still significant" credit expansion prompted Standard & Poor’s to cut its view of the banking industry’s economic risk to negative from stable this week. Shadow-finance assets, estimated at 41 trillion yuan ($6.4 trillion) by Moody’s at the end of 2014, have become more attractive as five interest-rate cuts by the central bank since November curbed profits from lending.

"Our concern with some of these investment positions is banks are using them as a way to bypass lending restrictions," said Grace Wu, a senior director at Fitch in Hong Kong. "Unlike bank loans, they don’t get reported into loan provisions, so it’s more difficult for us to ascertain the asset quality."

The opacity of Chinese banks’ credit exposure helps explain why they are priced as if investors are expecting a nonperforming loan ratio of 10 to 12 percent next year, which would mark a "sizeable credit crisis" in other countries, according to Wei Hou, a banking analyst at Sanford C. Bernstein & Co. The reported ratio is 1.5 percent, according to the China Banking Regulatory Commission.

The nation’s shadow-banking industry emerged as a way for creditors to circumvent lending restrictions and for savers to attain yields higher than the legally capped deposit rate. It includes trusts, asset-management plans and wealth-management products, which package loans into products for buyers.

Shanghai Pudong Development Bank Co.’s receivables made up about a quarter of assets as of June 30, according to its semi-annual financial statement. Out of 1.1 trillion yuan of receivables, 82 percent were trusts and asset-management plans that purchase trust loans, while 11 percent were other lenders’ wealth management products.

The receivables climbed in the first half because the bank invested more in other lenders’ guaranteed WMPs as well as in asset-management products derived from bills issued by large banks, Shanghai Pudong said in an e-mail. It added that its credit and liquidity risks are both manageable.

Less Liquid

Adding loan investments and receivables to banks’ loan-to-deposit ratios pushes the figure close to or even over 100 percent for some commercial lenders, such as Shanghai Pudong and China Citic Bank Corp. Ltd., according to Moody’s analysis.

"Though they’re called investments, they’re less liquid than most investments," Christine Kuo, a senior vice president at Moody’s, said at a briefing in Taipei. "So the funding you’re relying on isn’t steady deposits but more sensitive wholesale money. When the market is tighter, the banks’ liquidity management will be more difficult."

Chinese banks are already facing slowing deposit growth amid competition from higher-yielding investments. Deposits climbed an average 12 percent each month in 2015 from a year ago, compared with 15 percent in the five previous years. While interbank rates have become steadier in the past year amid monetary easing, they are still more volatile than in other markets. The three-month Shanghai Interbank Offered Rate moved in a range of 2.3 percentage points over the past year, compared with 0.12 percentage point for the London interbank offered rate of the same tenor.

Banks are also binging on the riskiest class of debt, with lenders other than the biggest five issuing 85 billion yuan of Tier 2 securities in the third quarter after raising 91.7 billion yuan in the three months to June 30. That’s the highest two quarters on record, according to data compiled by Bloomberg. The yield premium investors demand to own Bank of Beijing Co.’s 4.9 percent 2026 bonds over similar-maturity government debt has widened four basis points since June 30 to 168.2 basis points.

Yield Driven

Investments in loans and receivables are more popular with mid-tier banks, which face higher funding costs and are more driven by yields, said Wu at Fitch. Chinese lenders’ net interest margin narrowed to 2.51 percent in the second quarter from 2.73 percent three years ago, CBRC data show. The regulator didn’t respond to a fax seeking comment.

Investors are paying more to hedge their exposure to Chinese credit as growth slows and a plunge in equities since June heightens financial risks. The nation’s credit-default swaps, which pay buyers in the case of a sovereign payment failure, have risen 28 basis points this quarter to a two-year high of 122 on Wednesday. The yuan has declined 2.7 percent since the day before a shock devaluation on Aug. 11.

Manufacturing Contracts

The preliminary Purchasing Managers’ Index from Caixin Media and Markit Economics was at 47.0 for September, missing the median estimate of 47.5 in a Bloomberg survey and below the final reading of 47.3 in the previous month. Readings have remained below 50 since March, indicating contraction.

Shadow financing thrived in China partly to help banks bypass a two-decade-old 75 percent cap on their loan-to-deposit ratios. Now with the rule set to be scrapped on Oct. 1, lenders may be more likely to record credit on their loan books, said Wei at Sanford C. Bernstein.

"If they can lend more with the same amount of deposits, they may not need to hide their loan exposure in other parts of their balance sheet," he said. "The debt receivables is another platform for banks to continue to channel credit into the shadow banking sector. Sooner or later I think regulators will catch up and close the loophole as well."

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