Will China Avoid a Banking Crisis?

Bloomberg ran an interesting article which described how China is trying to handle its banks and prevent a banking crisis similar to the recent credit crisis in the US and Europe.

To date, China has been copying all of the regulatory responses of its G-20 counterparts.  Since none of these responses worked or involved actually disclosing the current asset and liability-level data, we can be sure that the banking crisis in China is unlikely to be avoided.

Why the confidence.  Unfortunately for China, without current asset and liability-level data, no one can be certain if the banks are solvent or not.  What is clear is that the banks have exposure to real estate that vastly exceeds their capital base.

When doubts about their solvency begin, depositors are highly likely to line up at the banks to get their money back.

Fortunately for China, it has a significant amount of capital held at the government level that can be used to recapitalize its banking system.  However, recapitalizing is not the same as restoring trust in the banking system.  For that, the only solution is to provide the current asset and liability level data so that market participants can see for themselves that the banks are solvent.

China’s banking regulator set capital targets for the nation’s five biggest lenders above the minimum 11.5 percent ratio amid concern that credit risks may rise, three people with knowledge of the matter said.

When there are doubts about a bank's solvency, regulators always address it by having the bank's increase their capital ratios.  There are three ways for a bank to do this.

• Shrink the size of the balance sheet.  This typically results in the lowest margin and lowest risk assets being sold.  As a result, the risk of the bank stays the same or increases. 

• Sell stock.  This requires some level of disclosure.  Prior to investing, investors are going to want to know what is happening with the loan portfolio.

• Retain earnings.  Since the regulators are concerned about the bank's solvency, they are undoubtedly willing to engage in extend and pretend with the loan portfolio.  As a result, the banks can show higher earnings to retain.

The move may help China’s policy makers curb loan growth after inflation accelerated and real estate prices rose following a $2.7 trillion two-year credit boom. The central bank this month raised the amount of deposits lenders must set aside to the highest in at least two decades, while the banking regulator ordered a new round of stress tests on property loans. 

The current way that regulators like to show they are on top of what is going on at the banks is stress tests.  The problem with stress tests is that they lack credibility unless the underlying data is provided so that market participants can repeat the test for themselves and show that the regulators' conclusions are accurate or inaccurate.

... The banking regulator has stepped up measures to limit systemic risks since last year, including requiring banks to move off-balance sheet assets onto their books and curtailing credit to local governments and the property sector. The government has also raised down payments on second mortgages and ordered local authorities to cap new-home prices in some areas. 

There’s a “high likelihood of a significant deterioration” in banks’ asset quality after the two-year credit boom, Fitch Ratings said April 12. Fitch lowered its outlook on China’s long-term, local-currency rating to negative because of the risk that the government would have to bail out its banks. 

Naturally, market participants distrust that the actions taken be the bank regulators have actually fixed the underlying credit problems.

China, which holds the most banking assets in the world after the U.S. and Japan, faces economic uncertainties and lenders need to strengthen risk management, CBRC Chairman Liu Mingkang said on April 19.

As has been repeatedly said on this blog, the best way to strengthen risk management is to disclose current asset and liability level data to the market.  With all the market participants looking at the data, including competitors, there is much more accuracy in the evaluation of risk of the bank.  As a result, the cost and availability of funds to the bank becomes a better indicator of the level of risk at the bank and the market can discipline banks that take on too much risk.