The practice of sweeping bad loans under the carpet may make balance sheets cleaner, but the fiscal sleight of hand does little to mask serious, underlying problems in China's banking sector.
The China Banking Regulatory Commission has stepped in to unmask bad practices. It said banks have to come clean on non-performing assets that have been shifted offline.
Under the euphemism "product innovation," banks have been issuing wealth management products that are invested directly or indirectly in their own bad loans.
"Financial institutions have used the transfer of income rights from credit assets to improve their business," said the commission. "But that part of the process was non-standard and opaque."
On April 28, the regulator sent a directive to all lenders requiring them to make full provision for any transferred loan rights. Individual investors were banned from investing in bad loans through bank-issued wealth management products.
The directive, known as Notice No. 82, was hailed by analysts as a major crackdown on the shadow banking system, a gray zone of interbank operations that has been tolerated for years.
The main structure of the new rules takes aim at credit beneficiary rights, a product derived from shadow-banking deals and then sold between banks. The size of such shadow-loan books rose by a third to US$1.8 trillion in the first half of last year, equivalent to 16.5 percent of all commercial loans on the mainland, according to data compiled by UBS.
There have been variations of regulatory intervention into shadow banking practices every year since 2009, but this time, the banking commission seems more determined to use a nuanced approach to get at the heart of the problem, according to Jimmy Leung, banking and capital markets leader at PwC China.
"The starting point of the notice lies on the crackdown of abnormal interbank business that is not traded out for commercial purposes, protecting the unsophisticated investors as well as the order of financial markets," Leung pointed out.
Mid-sized lenders could bear some of the heaviest brunt, market insiders said. They have been the most active insurers of wealth management-related shadow banking products in recent months, according to a report by ratings agency Moody's.
The rapid expansion of these products has exacerbated regulatory efforts to monitor the banking sector, the report pointed out.
In a separate report released by PwC China earlier in April, the consulting firm noted that the ratio of investment in asset management and wealth management products surpassed the proportion of loans as major interest-bearing assets for joint-stock banks and city banks in 2015.
"Some commercial banks that rely heavily on interbank funds and increased investment in loans and receivables could see their liquidity deteriorate in the short term, as their trust business and wealth-management products shrink," said Chen Guo, analyst at Changjiang Securities Co.
The ratio of investment receivables nearly tripled against total loans for Chinese banks in the last three years, according to Wind Information data. At the end of 2015, investment receivables at listed banks totaled around 15 percent of yuan loans, valued at 59 trillion yuan ($9 trillion).
Higher reserves will be needed to comply with the new rules. The riskier the asset, the more capital must be set aside. That comes at a time when lenders are already facing mounting bad loans and debt-to-equity swaps with delinquent borrowers.
The profit growth of banks dwindled to single digits in 2015. Bad loans surged 51 percent to 1.27 trillion yuan. Bad-loan buffers of Industrial and Commercial Bank of China and the Bank of China fell below the 150 percent regulatory minimum level, according to quarterly earnings reports filed with the Hong Kong Stock Exchange.
Banking regulators are considering lowering the loss-loan coverage ratio for certain lenders to free up banks' capital into more fee-generating business, PwC's Leung said. But that would only relieve, not reverse, the liquidity crunch.
The new rules might force banks to sell more bonds or hybrid security products to raise funds for provisioning needs, analysts said.
Chinese banks will need to raise up to 1 trillion yuan in capital over the next few years if the rules are applied to their total shadow lending exposure, Bloomberg said, citing estimates from Sanford C. Bernstein & Co.
Leung noted it will be six to nine months before the effects of the new rules can be gauged. The numbers will first be revealed in the banks' annual report of the year 2016.
NOTICE No. 82
The directive, known as Notice No. 82, from the China Banking Regulatory Commission takes aim at credit beneficiary rights, a product derived from shadow-banking deals and then sold between banks. The size of such shadow-loan books rose by a third to US$1.8 trillion in the first half of last year, equivalent to 16.5 percent of all commercial loans on the mainland.
