Thursday 25 September 2008

Mainland Banks Sitting on a Time-Bomb Too

Yet even as bank shares are rocketing, the business environment for mainland lenders is deteriorating. Worse still, although mainland banks have mostly avoided exposure to the sort of structured products that have inflicted such damage on banks in the United States and Europe, there is disturbing evidence that they are replicating similar products in the mainland market, with similar potential risks.
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Guanyu said...

Mainland Banks Sitting on a Time-Bomb Too

Tom Holland
24 September 2008

It’s been a good few days for the shareholders of mainland banks. Encouraged by news that the mainland’s sovereign wealth fund plans to purchase stock in big state lenders, investors in Hong Kong and Shanghai have rushed to buy, pushing prices up sharply in both markets.

Yet even as bank shares are rocketing, the business environment for mainland lenders is deteriorating. Worse still, although mainland banks have mostly avoided exposure to the sort of structured products that have inflicted such damage on banks in the United States and Europe, there is disturbing evidence that they are replicating similar products in the mainland market, with similar potential risks.

As the mainland economic growth rate begins to ease in response to the global slowdown, there are early signals that asset quality at mainland banks is weakening. Although the proportion of non-performing loans at listed banks fell to just 2.2 per cent at the end of the first half of the year, down from 2.5 per cent at the end of 2007, the drop was almost entirely the result of strong loan growth. In other words, the absolute amount of bad loans barely fell at all; it was just that the total value of loans outstanding grew in comparison.

Meanwhile, according to a new report from Fitch Ratings, the value of loans classed as performing, but on which payments are up to one year overdue, rose 31 per cent over the first six months of the year to 188 billion yuan (HK$214 billion) (see the first chart).

That is a small amount compared with total loans outstanding. And as Fitch’s analysts point out, after the reforms of recent years, mainland banks are now more strongly capitalised and better provisioned against bad loans than ever before.

Even so, there are reasons to worry. For one thing, loan defaults tend to lag conditions in the real economy by six months or so. As a result, with business activity only beginning to soften now, any steep increase in bad loans is only likely to show up at the end of the year or in 2009.

Secondly, there are signs that mainland banks have been making far more loans than they have admitted, and that they have been using repackaging techniques borrowed from the US mortgage market to conceal the extra lending by shifting it off their balance sheets.

Since the end of last year, mainland banks have been evading government credit quotas by selling client loans either to special purpose vehicles set up by the banks or to third-party trust companies.

The special vehicles and trust companies then repackage the loans and sell them to wealth management clients as a higher-yielding alternative to bank deposits, or a lower-risk alternative to equity investment.

How big this market is is unknown, precisely because the lending has been hidden, but Fitch estimates loans worth 315 billion yuan were repackaged and sold in the first half of the year. Other estimates put the figure closer to 400 billion yuan. Either way, sales of wealth management products soared in the first half.

Banks have been using other methods to hide credit growth, too. For example, they often act as intermediaries for “entrusted” loans between corporations, a market Fitch estimates to have grown by around 200 billion yuan over the first half of the year to almost 1.5 trillion yuan outstanding.

In theory, both techniques should entail little risk for the banks because the credit exposure has been shifted off their balance sheets and on to third parties. However, as the events of recent months have shown, such supposedly safe practices have a nasty habit of blowing up in bankers’ faces. Should borrowers default leaving bank wealth management customers bearing the losses, it is likely either that regulators would force the banks to share at least some of the pain, or that investors could sue the banks for mis-selling.

Meanwhile, laws concerning entrusted loans are unclear. It is quite possible that the banks could be found liable for the loss in the event of a default.

With bank stocks up 35 per cent or more since last Thursday, these might seem distant concerns. But uncertainty hangs like a dark cloud over the outlook for mainland bank earnings. When the euphoria of recent days has died down, it may begin to affect their share prices too.