Shadow Lending Crackdown Seen Forcing China Banks to Sell Bonds

Updated on
  • S&P predicts `significant capital pressure in the short term'
  • Lenders need 1 trillion yuan in fundraising: Sanford Bernstein

A crackdown on banks hiding bad loans in China looks set to trigger a flood of capital raising just as global investors warn of risks to the financial system.

New rules require lenders to make full provisions for loan rights they have transferred to other financial institutions, people familiar with the matter said last week. Banks will need to raise up to 1 trillion yuan ($154 billion) in capital over a number of years if the rules are applied to their total shadow lending exposure of about 12 trillion yuan, according to estimates from Sanford C. Bernstein & Co.

QuickTake Shadow Lending

China’s banks have been channeling lending through asset-management plans or trusts, making it harder for authorities to contain debt that’s ballooning amid the slowest economic growth in 25 years. Billionaire investor George Soros said on April 20 China resembles the U.S. before the 2008 financial crisis, while hedge fund manager Kyle Bass told a conference in California on Wednesday that the Chinese financial system is in a "precarious" state.

“Chinese banks may face significant capital pressure in the short term,” said Liao Qiang, an analyst at S&P Global Ratings in Beijing. “The greater capital pressure may drive banks to sell hybrid capital instruments.”

Chinese banks, the largest issuers of instruments that comply with Basel III standards with $194 billion outstanding, have been slowing down such offerings this year after two years of record-breaking sales. So far in 2016, they have sold $15.5 billion of hybrid securities counted as capital, compared to $19 billion in the same period last year, according to Bloomberg-compiled data.

Banks channeling loans via asset-management plans record them as receivables rather than as loans, allowing them to dodge capital requirements. Soured loans jumped 51 percent last year to a decade-high of 1.27 trillion yuan and banks are struggling to keep up with provisioning needs. While the new rules apply only to loan-beneficiary rights, not to trust beneficiary rights and designated asset management plans, Sanford Bernstein said the scope may be extended.

“With the new rule in place, it’s harder for banks to understate their non-performing loans and cut provisions,” said Wei Hou, a Hong Kong-based analyst at Sanford Bernstein. “While the outstanding amount of banks’ loan-beneficiary rights is not too big, this is just a start for the regulators to get to know Chinese banks’ true risk profile.”

Hou estimates banks have 30 billion yuan of transferred loan-beneficiary rights. Two calls to the China Banking Regulatory Commission’s press office went unanswered and the regulator hasn’t responded to faxed questions.

China introduced stricter capital requirements to meet Basel III standards in January 2013, adding to challenges for an industry facing slower profit growth. Bank of China Ltd. was the first Chinese bank to sell preferred shares with a $6.5 billion issuance in 2014.

CLSA Asia-Pacific Markets estimated in a May 4 report that the non-performing loan ratio in China’s banking sector is 15 percent to 19 percent. That compares to the official figure of 1.67 percent at the end of 2015, which was at the highest since 2009.

Sanford Bernstein, S&P and CreditSights Inc. forecast smaller banks will be under more pressure to raise capital because they have higher shadow-lending exposure.

Second-tier lender Industrial Bank Co. would have more than doubled its non-performing loans to 55 billion yuan at the end of 2015 if applying its corporate NPL ratio of 1.8 percent to its receivables book, according to Matthew Phan, credit analyst at CreditSights in Singapore. The bank currently has a loan-loss provision coverage ratio of 210 percent. But if the receivables were counted as loans, it would fall to 118 percent, below the regulatory threshold of 150 percent, Phan said. Two calls to the general office and one call to the media department of Industrial Bank went unanswered.

“The new rules apparently target the ways banks avoid capital usage," said Xuanlai He, credit analyst at Commerzbank AG in Singapore. "We might see more measures to come.’’

Natixis Asia Ltd. sees the big five lenders needing more capital as they take part in debt-to-equity swaps with delinquent borrowers.

"The rumor is that the plan for debt-equity swaps will be 1 trillion yuan and only the big five banks have the capital buffer to absorb this," Iris Pang, senior economist for greater China, told a press conference on Friday. "We guess they will need to recapitalize in 2016 in advance of the debt-equity swap, otherwise they will be short of capital."

— With assistance by Lianting Tu, and Judy Chen

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