PBOC Crusade Against Leverage Seen Curbing Bank Debt Spree

  • NCD sales fell 33% in January as China interbank rates surged
  • China Securities Co. says tighter controls "totally possible"

China’s battle on leverage is extending to short-term debt that smaller lenders have used to supercharge growth.

Chinese banks, excluding policy and state lenders, sold 1 trillion yuan ($145 billion) of negotiable certificates of deposit, or NCDs, in January, down 33 percent from December. The People’s Bank of China has pushed up money market rates in the past three months and China Securities Co. said it’s “totally possible” regulators will force lenders to add NCDs to their measures of interbank borrowing, prompting them to further rein in issuance.

Difficulty selling the securities is fueling concern that weaker smaller lenders could face cash crunches and even miss payments. Higher borrowing costs have cut into the profitability of trades in which small banks sell interbank paper and invest the proceeds into other lenders’ wealth-management products, which in turn channel the money into the bond market. Regulators already started trying to unwind these circular arrangements when the PBOC included off-balance sheet WMPs when measuring credit growth.

"It’s a crusade against unfettered leverage," said Zhou Hao, a Singapore-based economist at Commerzbank AG. "Small banks have expanded their assets much faster than big banks thanks to the funding from the interbank market. PBOC tightening is now making it very painful for them."

China allowed sales of NCDs in December 2013 as a fresh fundraising avenue for smaller lenders, which have difficulty competing for savings with multi-branch state banks. Between 2014 and 2016, issuance surged 15-fold to 13.6 trillion yuan, with sales by city commercial banks and rural banks jumping 23 times, according to data compiled by Bloomberg.

There was no immediate reply to questions faxed to the PBOC.

Adding NCDs to credit calculations would boost listed city banks’ ratio of interbank borrowing to total liabilities from 20 percent to 34 percent as of Sept. 30, higher than the regulatory cap of 33.3 percent, according to China International Capital Corp., which warned that there could be a chain reaction of asset sales.

Surging borrowing costs have already made carry trades using NCDs unattractive.
The average five-year AAA corporate bond yield is now 4.44 percent, 3 basis points lower than the three-month rate on AA+ NCDs. On June 30, it was 34 basis points higher.

“Growth in Chinese smaller banks’ NCD sales may decline this year due to rising interbank borrowing costs, although banks still have incentives to issue NCD to support their asset growth,” said Yulia Wan, a Shanghai-based banking analyst at Moody’s Investors Service. “The slowdown in NCD sales will likely slow their asset expansion and rising costs hurt their profitability.”

S&P Global Ratings said last month that growing interbank exposure is a weak spot for smaller banks, stretching their capital and creating significant counter-party risk.

Industrial Bank Co. was the leading issuer of NCDs, offering 979 billion yuan of such notes in 2016. The Fuzhou-based lender had 1.7 trillion yuan of interbank borrowing on its balance sheet as of Sept. 30, 31 percent of total liabilities. Adding NCDs, the ratio reached 37 percent, according to a Bloomberg calculation using company data. Industrial Bank said in an e-mailed reply to questions that "as of now, we have not received related notification" on any regulation changes. The five-largest state lenders, which control over 40 percent of China’s total deposits, accounted for just 1 percent of offerings.

"Smaller banks took advantage of a shortcut," said Wei Hou, a Hong Kong-based analyst at Sanford C. Bernstein. "The best-case scenario to unwind risks would be seeing them adjust their growth model and slow the pace of expansion voluntarily. In the worst case, we could see technical defaults as one or two smaller banks may have trouble accessing liquidity."

Falling profits may force some lenders to raise capital, Hou said.

The capital-adequacy ratio at smaller banks averaged 12 percent as of Sept. 30, compared with 14 percent at large lenders, according to the banking regulator.

"On the one hand you have high leverage that hasn’t been accounted for in the risk-weighted assets at those banks, and on the other you have low capital buffers," said Commerzbank’s Zhou. "This is not comforting."

— With assistance by Yuling Yang, Jun Luo, and Judy Chen

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