WHERE ARE THE RISKS
1. The big Chinese banks are well funded through their deposit networks and their relationship with the government and SOEs. However, small banks lack this advantage and have, thus, become more reliant on wholesale funding.
2. An increase in reliance on wholesale funding raises systemic risk because when the interbank market seizes up during times of financial stress, these small banks would be vulnerable to funding squeeze creating a domino effect on the system leading to a systemic collapse.
3. the situation in China is different. The People’s Bank of China (PBoC) would most likely step in either to keep funds flowing or force the major banks to take over the small troubled ones.
HOW BANKS CIRCUMVENT?
1. The weakest link in China’s banking system is the increasing complexity of credit creation, which involves multiple layers of transactions between banks and non-deposit-taking financial institutions (NDFIs) aiming at eschewing regulatory constraints on lending.
2. Trust companies cannot take deposits but are allowed to make loans and invest in real estate and securities. They package their investments or loans into wealth management products (WMPs) and sell to banks, which may re-sell them to their clients or keep them as investment.
3. The credit risk of the final borrower does not change regardless of how many layers of credit creation are added. But complicating the credit creation process increases systemic risk: if any one of the players defaults, it will set off a domino effect by triggering counter-party risk. According to industry estimates, two-thirds of the credit created by this complicated process ends up as loans to the real economy.
JUSTIFICATION
1. Under Chinese regulations, a corporate loan carries 100% risk-weighting for capital adequacy purposes. An indirect loan counts as an interbank claim and carries only a 20% risk-weighting. So the process lowers the banks’ capital charge and allows them to expand their loan books by breaking the regulatory constraints but not breaching the regulations. But it also encourages rent-seeking and financial excess to build up.
2. Banks also exploit this multi-layer process to dress up their sickly balance sheets. For example, Bank A might sell a bad loan to an asset management company, which then sells the cash-flow rights of the loan to a brokerage, which packages them in a WMP and sells it to Bank B. Bank B then repackages the WMP into a new investment product and sells it to Bank A.
3. In this transformation, Bank A “magically” turns a bad loan into a “safe” interbank claim on Bank B, which is recorded as investment in A’s balance sheet. The “paper” risk of Bank A disappears, but the underlying risk from the bad loan is still there. Most importantly, the process has increased systemic risk.
FINAL THOUGHTS
1.Such activity is similar to the situation in the US before the subprime crisis in September 2007, leading many observers to fret about a financial meltdown in China sooner or later. However, the comparison with the US situation is not appropriate at this stage.
2. The state is behind the Chinese financial system as virtually all banks in China are owned (directly or indirectly) by the government.
3. The majority of the Chinese banks do not rely on wholesale funding, which is a major determinant of bank vulnerability during the US subprime crisis. The US crisis was triggered by private creditor decision to cut off funding for over-extended firm such as Bear Sterns and Lehman Brothers.
4. In China, the state ownership and implicit guarantee policy distort rational creditor behaviour which, in turn, helps preserve the system. In the event of defaults by small institutions, the government can also order the big state-owned banks to keep the credit lines open.
