Finance

Nisha Gopalan is a Bloomberg Gadfly columnist covering deals and banking. She previously worked for the Wall Street Journal and Dow Jones as an editor and a reporter.

Banks in China, like their embattled counterparts in Europe, may soon have to tap the market for capital as bad loans rise at an alarming rate. New advances soared to a record 2.51 trillion yuan ($384 billion) in January and the specter of soured debt is looming large:

Credit Binge
Chinese bank loans have surged in recent months
Source: National Bureau of Statistics of China

While at first glance Chinese banks' capital buffers may seem strong -- the Tier 1 capital ratio of the nation's biggest bank, ICBC, is 12.7 percent, more than the 9.5 percent minimum requirement for large state-owned financial institutions -- it's not as simple as all that.

Beefed Up
Capital adequacy ratios at China's biggest banks as of Sept. 30, 2015
Sources: Bernstein, company reports

The increase in lending comes at a time economic growth is stagnating. Authorities also lowered interest rates five times last year, squeezing banks' net interest margins as hundreds of new, non-bank lenders, such as peer-to-peer online operators, were vying for a slice of the pie.

Teamed with a commodities rout that's hurt steel and coal companies' ability to pay back their debts, bad loans are spiking on even the numbers China reports. Official data as of Sept. 30 put nonperforming loans at 1.59 percent compared with 1.25 percent at the end of 2014.

There are many who say the real level of soured debt in China's banking system is much higher. BNP Paribas puts the figure at about 8.4 percent, at the upper end. If true, that would rival the early years of last decade, before China cleaned up its banks so they could sell shares publicly in Hong Kong and created asset management companies like Cinda and Huarong to deal with the mess.

Who to Trust?
Chinese banks say nonperforming loans as a percentage of assets have been falling since their peak in 1999 at 33 percent
Source: CBRC, PBOC, CEIC, Bernstein

So if you accept that Chinese banks need to at least start thinking seriously about raising more capital, the question then becomes, how exactly?

One option would be subordinated perpetuals. These securities count toward Tier 1 capital and in Europe, go by the more infamous moniker contingent convertible notes, or CoCos. Chinese banks have been selling a truckload of them, including a record $91.5 billion in 2014, according to data compiled by Bloomberg.

But as the world's biggest issuers of CoCos, lenders may find investor appetite for any more relatively muted.

That leaves plain vanilla equity. Yet here again -- on the surface at least -- there's a stumbling block.

Outside of a few smaller financial institutions, the majority of China's banks are trading at an average of about 0.7 times book value, roughly in line with much-battered European banks. Rules in China, however, state that banks can't sell stock below one times book value.

Investors shouldn't worry too much. When China Citic Bank announced it was raising $2 billion last year to bolster its capital, another state-owned enterprise -- China National Tobacco -- stepped up to the plate, subscribing for 2.46 billion shares in a private placement. Citic's shares were trading at around 0.8 times book value at the time.

What that episode shows is that whether nonperforming loans are high or low, it's a safe bet that the government will find solutions akin to a cigarette monopoly to keep its banks afloat.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nisha Gopalan in Hong Kong at ngopalan3@bloomberg.net

To contact the editor responsible for this story:
Katrina Nicholas at knicholas2@bloomberg.net