Christopher Langner is a markets columnist for Bloomberg Gadfly. He previously covered corporate finance for Bloomberg News, and has written for Reuters/IFR, Forbes, the Wall Street Journal and Mergermarket.

China is setting the stage for a major bank bailout, potentially accompanied by a round of industry consolidation. On Saturday, Bloomberg News reported that the China Banking Regulatory Commission closed a loophole through which some nonperforming loans may have been leaving balance sheets. 

The regulator sent a notice last week requiring lenders to make full provision for any loan rights transferred to other financial institutions, which in many cases included their own wealth-management products. Yes, that's right. Banks created funds that went on to buy the right to receive payments for loans the lenders had made. Those advances then conveniently disappeared from the banks' books. If they soured, too bad.

The regulator's action means lenders can no longer evade responsibility for such loans.

It's unclear how much bad debt may have gone unaccounted for through that method but if the CBRC took notice it must be significant. Another form of off-balance-sheet lending -- the practice of using trusts or asset management plans to extend credit -- could result in losses of as much as 1 trillion yuan ($154 billion), Commerzbank estimated in February.

The bottom line is that Chinese banks will have to increase provisions. By the time of their next quarterly earnings reports, investors may be surprised by an even steeper jump in nonperforming loans. That will eat into profits and further pressure the provision coverage ratio, which for some banks has already fallen below the 150 percent required by the CBRC.

Industrial and Commercial Bank of China, the world's biggest lender by assets, already avoided reporting a large drop in first-quarter profit by letting provisions fall to 141 percent of existing nonperforming credit. The ratio for fellow state-owned behemoth Bank of China also dropped below the regulatory level. The CBRC has been considering changing the threshold, which is relatively high among large global banks.

Watch Them Grow
Provisions for loan losses at ICBC, the world's largest lender, continue to grow
Source: Company filings
* First-quarter numbers.

China's trend toward off-balance-sheet lending mirrors what many Western banks did before the 2008 crisis. Lenders created trusts that bought mortgages, which were then sliced and diced into tradable securities before being sold to investors. Moving the loans off their books enabled the banks to continue lending.

The subprime crisis pushed the Financial Accounting Standards Board to review the rules and effectively force banks to bring all that debt back on to their balance sheets. The result was an 88 percent surge in nonperforming loans at the world's 20 biggest lenders (excluding the Chinese) in the first year of the revised regulations.

The Value of Discipline
NPLs grew 88 percent after banks were required again to account for debt sold to trusts
Source: Bloomberg
* Data excludes Chinese banks.

If China follows a similar trajectory, the likely spike in provisions and nonperforming loans at the nation's banks may require more than just tinkering with regulatory coverage requirements. While a few quarters of writedowns and no dividends may shore up the balance sheets of the biggest banks, smaller institutions may not be able to make it through without state intervention, whether through a capital injection or an engineered merger with a bigger lender. Acquirers may need some government equity to cope with the mess they're taking on. 

Buffering Up
The 2009 accounting change prompted a 45 percent jump in loss provisions at the biggest banks
Source: Bloomberg
* Data refers to aggregate of world's biggest 20 lenders by assets, excluding Chinese banks.

It's always hard to read the real intentions of Chinese regulators, but they look to be paving the way for a major bailout and overhaul of the banking system. Whether intentional or not, they may find their hand forced in any case. Banking troubles have a habit of feeding on themselves.

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

To contact the author of this story:
Christopher Langner in Singapore at

To contact the editor responsible for this story:
Matthew Brooker at