China's Banks Are Improving (Sort Of)

Capital ratios are still too low. But there are signs of progress.

Gonna need some more.

Photographer: Fred Dufour/AFP

Among the most important questions facing China's economy is this: How stable are the banks?

The big picture is pretty well known, and ugly. Debt stands at nearly 300 percent of gross domestic product. Some analysts think the non-performing loan ratio -- officially at 1.74 percent -- may actually be as high as 25 percent. Even state media is promising a "war on financial risks" in 2018.

But there are some reasons for cautious optimism. A recent note from analysts at UBS Group AG offers one example. The analysts estimate that for China's banks to increase their net tier-one capital ratio to 12 percent, they will require an additional 2.8 trillion yuan, equivalent to about 3.4 percent of GDP.

Problematically, the government is committed to reducing off-balance-sheet banking activity, which will make improving that ratio much harder. Moving trillions of yuan in wealth-management products and other risky instruments onto balance sheets will cause capital-adequacy ratios to drop. By UBS's estimate, such a reform would reduce smaller lenders' capital to just 6.3 percent of assets -- a worryingly low number.

As it happens, small and mid-sized banks may have found a solution to this dilemma. Rather than raising new capital by issuing shares, they've been doing so primarily through private offerings of convertible debt. This avoids a big up-front dilution of value -- "sticker shock," as the analysts put it -- by spreading out conversions over the medium-term, thereby providing more stability. In some provinces, smaller lenders have used such sales to boost their share capital by more than 65 percent.

These are not insignificant sums. In fact, they amount to a quiet bailout underway -- and suggest some real progress.

Even so, the 220 billion yuan in convertible debt issued last year pales in comparison to the 2.8 trillion still needed to raise overall capital to acceptable levels. Making matters worse, China's banks remain exposed to growth risks. Even as economic activity has picked up over the past 18 months and industrial inflation has accelerated, bad-loan ratios haven't appreciably declined. Any slowdown in industrial price increases or economic growth will drive those ratios up and require yet more capital.

Given all this, what's the best path forward?

Bringing shadow assets onto banks' balance sheets remains the right thing to do, however challenging. But it must be done carefully: Capital injections should be timed to track the reclassification of risk assets to avoid a shock. The People's Bank of China -- which extended $273 billion to banks in 2017 -- at least seems to recognize the scale of the problem.

Banks, for their part, need to avoid seeing these injections as free money and simply returning to the practices that got them into trouble in the first place. They must use the infusions to build up acceptable capital buffers and reduce bad-loan ratios, not as an excuse to resume profligate lending.

Regulators should also be more aggressive in their efforts to improve internal controls. Just this week, it emerged that Shanghai Pudong Development Bank Co. had engaged in a $12 billion fraud. Several provinces have recently admitted to hiding bad debts. One reason banks have difficulty raising capital is that they're prohibited from selling new shares below book value; investors price their stocks well beneath this floor because they don't trust official financial data. More reliable controls would help restore that trust, thereby boosting share prices and making it easier to address all the other problems banks are facing.

China is embarking on what promises to be a years-long process of stabilizing and rationalizing its financial system. Better to do it the right way from the start.

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

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