June 14, 2016    7 minute read

Is The Chinese Banking System About To Collapse?

   June 14, 2016    7 minute read

Is The Chinese Banking System About To Collapse?

A few months ago a prominent hedge fund manager – Kyle Bass – came out warning of a “ticking time bomb” in the Chinese banking system. A warning such as this, from a man who predicted the 2008 mortgage crisis should not be quickly dismissed. The question is, why does this ‘time bomb’ exist? In short, hundreds of small, and midsize Chinese banks and even some of the Big 5 have been hiding billions of dollars’ worth of non-performing loans in investment receivables called Trust Beneficiary Receipts (TBRs) and Directional Asset Management Plans (DAMPs). This has resulted in a massive understatement of non-performing loans and the resulting credit risk of the banks meaning banks are highly undercapitalised, thus when these loans do start defaulting, Chinese banks won’t have enough capital to cover the defaults so causing their probable collapse.

According to international banking regulation, banks are required to set aside capital against their credit assets. The riskier the asset, the more capital must be set aside. For example, a loan carries a risk-weighting of 100%, thus, if a bank loans $20m, it must set aside $20m in capital to cover that risk. This means banks have a lot of capital just sitting on their balance sheet and not earning money. In addition to this, all banks should aim to maintain a Capital Adequacy Ratio of 8-9%, this essentially allows an equity buffer, so if loans and other credit assets start defaulting the bank can absorb those losses without going under. An additional regulation, which only applies to Chinese banks is that they are only allowed to lend out 75% of their deposits. This is another measure to insure against scores of defaults.

To avoid these regulations, Chinese banks have been using wealth management products (WMPs) such as TBRs and DAMPs. These credit products don’t count towards the 75% limit, allowing Chinese banks to lend out theoretically 100% of their deposits. A further advantage of TBRs and DAMPs is that unlike standard loans which carry a risk weighting of 100%, they only carry a risk-weighting of 25%, meaning Chinese banks can have less money sitting idly on their balance sheets. All this entails that there is

“A growing reliance on WMPs to manage regulatory capital ratios [which] could undermine the bank’s true capitalization.”

Before going any further, I should explain what TBRs and DAMPs are. TBRs and DAMPs are both part of a wider concept of shadow loans, which are a part of shadow banking. Shadow banking is simply unregulated activities by regulated institutions. As a report on shadow banking from Reuters explains, when structuring these deals (TBRs and DAMPs), “a bank typically engages a friendly trust, securities, or asset management company to set up a financing arrangement for a bank client”. Once the investment receivable (TBR, DAMP etc.) has been created by the asset management company or trust, the bank then buys the beneficiary rights to the investment product “using a special purpose vehicle”. Typically, the originating bank assumes all risk should the borrower default, as otherwise there is little incentive for the asset management company or trust to do this deal, as the bank clients are generally high-risk. Through this method, “banks put a layer of ownership in between to skirt those restrictions and grab some benefit.” According to a UBS analyst interviewed by the Economist, the intention “is often to make risky corporate loans look like safer lending between banks, thereby evading capital requirements and minimum loan-to-deposit ratios, among other rules”.

The creation of TBRs and DAMPs doesn’t just occur with new loans or credit products. As Kyle Bass explains “When loans approach a nonpayment status, Chinese banks typically push them off balance sheet…the basic premise is that the non-performing loan is transferred to a ‘Trust Company’ while the bank continues to be the ‘guarantor’… In exchange, the bank records the ‘asset’ as a Trust Beneficiary Receipt or TBR.”

This shadow banking system has grown 600% in the last three years alone, with wealth management products (such as DAMPs) and TBRs constituting the majority of the shadow banking system. Indeed, Reuters reports TBRs as the “fastest growing assets on the balance sheets of most listed banks including the big 5”. The ironically named Evergrowing Bank said last year that practically all its receivables were DAMPs or TBRs, and the value of its investment receivables (397bn Yuan) surpassed its loan book value of 290bn Yuan. At another mid-tier lender (Industrial Bank Co.) the volume of investment receivables (e.g. TBRs and DAMPs) doubled over the last nine months of 2015 to 1.76trn Yuan ($276bn), equivalent to its entire loan book, or the entire Philippine banking system.

Some readers may now be wondering why Chinese banks are intentionally lending to companies and organisations which have a high chance of defaulting. These loans are often made to borrowers that the government is trying to “wean off east credit” (WSJ) including shipbuilders, steelmakers, property companies and local governments. The majority of TBRs and other receivables are created to reduce the non-performing loan (NPL) ratio on their balance sheet. The past 30 years of unprecedented growth in China produced colossal amounts of debt, as Bass wrote to investors;

“Credit has never grown faster or larger than it has in China over the past decade.”

This debt is mostly tied up in industrial markets such as steelmaking, and property, and now that the economy is slowing and demand is falling many companies are facing the cold reality of their unviable debts. This has given the banks a choice, they could either present their non-performing and doubtful loans on their balance sheets for all to see, and consequently risk a run on the entire banking system, or they could disguise the loans as TBRs and other receivables, staving off the inevitable for a bit longer.

Some may now think that calling this crash inevitable is a bit strong. However, I would disagree. Research by the New York Federal Bank showed an inverse relationship between risk-weighted capital ratios and bank failure i.e. the lower the capital ratio, the higher the chance of bank failure, and as aforementioned, Chinese banks have very low capital ratios. The one thing which is trying stop this crisis is regulation from the Chinese authorities. The China Banking Regulatory Commission (CBRC) recently introduced the Orwellian-sounding Document 82. This is intended to crack down on the use of these assets in understating NPL ratios, it essentially requires banks to provision for loans that have been sold off as credit products to investors. Though this may sound like an easy fix, it will cause huge problems for banks who will now have to come up with enough capital to cover all their loans packaged as TBRs and other such credit products, thus Document 82 “could leave banks with a more than 1 trillion Yuan capital hole.”  To put this into context, “over the past two years China’s commercial banks generated 1.8 trillion of total equity through retained earnings. Raising additional capital is a tricky task for China’s banks and even if they do, it will be at the expense of existing shareholders.” Document 82 also requires banks to account for all loans in their NPL ratios and other metrics regardless of how they are packaged or where they are stored. The CRBC is obviously trying offer a valve to this overpressurised system, however it could just result in the system’s collapse as depositors and investors realise the extent of the bad debts being held on the banks’ balance sheets.

Bass believes that when the storm hits, China will save the banks through a devaluation of the renminbi arguing “it is what any and every government will do if put in a similar situation”. Whatever happens, China’s economic growth will slow even further, with some predicting as low as 4%, and it will take many years for the system to recover from this.

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