In the wake of the global financial crisis, China saw an explosion not only in the level of debt supporting the economy, but in the development of complex and opaque shadow banking structures. The existing market narrative claims that an implicit economy-wide government backstop, coupled with ample foreign exchange reserves, are sufficient to contain any potentially rapid deleveraging of the Chinese financial system.
While the majority of credit creation in the Chinese economy takes the form of loans to major corporates from a handful of state-owned national banks (ICBC, BoC, ABC, CCB, BoComm), the riskiest lending has come from a tangled web of smaller banks and non-bank financial institutions. These rely on unstable funding and hold much of their credit exposure either off-balance sheet or hidden in forms designed to evade regulatory and market scrutiny.
We see this web of non-traditional banking as a key source of potential liquidity risk for the Chinese economy. In this white paper, we explore the Chinese credit system to not only raise questions as to the structural stability of this system, but also to provide specific investment recommendations on individual listed bank stocks.
The Complex System of Credit Intermediation in China
To some extent, all financial systems rely on implicit and explicit government guarantees to function. The Chinese financial system, however, extends this concept many times over. As savings make their way to the ultimate borrowers, they are intermediated, wrapped, and pledged through successively weaker layers of financial institutions.
The chain of intermediation often takes the stylized form described below:
Big banks lend out their funds to smaller banks in short duration, interbank funding markets. Smaller banks then “channel” interbank and WMP deposits into non-bank financial institutions in the form of DAMPs, TBRs, etc. This exposure is recorded as ‘investment receivables’ to avoid regulatory curbs on lending, when they end up on the balance sheet at all. Non-bank financial institutions (Trust Companies, Securities Companies, Wealth Management departments of banks) deploy this funding in “trust loans” to speculative real estate projects or the bonds issued by quasi-governmental entities such as LGFVs, local infrastructure projects, and local SOEs.
This system bears a passing resemblance to the American shadow banking system (including CDOs, CLOs, and ABSs) that almost brought down the world financial system in 2008. However, there are several key differences.
- Opaque market pricing of the end products.
- Higher complexity in the way credit is packaged, wrapped, and then shuffled through intermediaries.
- Greater dependence on guarantees by more credit-worthy entities that usually culminates in a claim on the central government.
The complexity and opacity of China’s banking system both makes analyzing systemic risk difficult and motivates the initial hypothesis of this whitepaper – the highest risk for a liquidity event resides outside of the big-5 national banks. We are most concerned by those banks with weak financial indicators and an outsized exposure to struggling regional economies.
Identifying Banks with the Weakest Financials
The weakest banks hold 20% of all Chinese banking assets by our estimation. We developed a ranking methodology that groups banks based on available data for non-bank credit intermediation, funding stability, and asset quality.
The first column, share of loans to total assets, estimates involvement with non-bank credit intermediation. In the weakest banks, only 35% of total assets are loans. What is the remainder? Many Chinese banks evade loan-to-deposit ratio requirements by disguising risky loans with an alphabet soup of financial engineering – DAMPs, TBRs, and WMPs. These often then get stuffed into the investment receivables account of the balance sheet. This means that traditional banking indicators radically understate risk for some Chinese banks.
The second column, share of deposits to liabilities, proxies funding stability. In China’s banking system, many banks with the worst indicators for asset quality also rely heavily on the least stable kinds of funding available, such as interbank borrowing. For example, the proportion of deposits to total liabilities is only 47% for Industrial Bank, well below the total average of 70%. This leaves the bank highly exposed to interbank borrowing, which is of short duration and is the first to go in a liquidity event. See Brothers, Lehman.
The third column, assets CAGR, approximates asset quality. Historically, rapid asset growth is a leading indicator of poor lending standards and hence banking losses. The average assets CAGR of China’s weakest banks is more than double that of the strong banks. For example, the Big Five banks have expanded their balance sheets at the comparatively conservative rate of 11% per year, while the balance sheet of Bank of Jinzhou – a particularly egregious case that we will explore in depth later – has recently grown by 45% per year.
In the appendix, we provide a complete ranking and detailed financial indicators data for all of China’s listed banks.
Identifying the Weakest Regions
Just as China’s banking system defies homogeneous representation, China’s regional economic outcomes are divergent as well. The prosperous coastal cities have healthier and more diverse economies than the autonomous western regions or China’s rust belt. Given the scarcity of data on asset quality, we believe that identifying regional exposure is crucial for understanding the risk in China’s banks.
We grouped China’s provinces by fiscal deficit, local government debt burdens, GDP growth, and reliance on commodities extraction. China’s Western, North East, and Rust Belt regions – which represent roughly a third of national GDP – look risky by our metrics.
The worst scoring region, China’s West, includes household names (kidding) such as Ningxia, Qinghai, Xinjiang, and Tibet. This region, comprising 14% of China’s population but only 9% of national GDP, is burdened by a large fiscal deficit, a heavy local debt load, and a reliance on commodities extraction. Consistent with our intuition, the strongest provinces – such as Pearl River Delta hub Guangdong province – can be found along the prosperous eastern coast.
In the appendix, we provide a detailed ranking for all provinces.
Putting It All Together – Valuations and A Guided Tour of Four Chinese Banks
For the listed banks, we were able to go a level deeper, and look at the actual composition of their balance sheet combined with provincial exposures. Using these measures, we derived an overall quality score.
In the chart below, we show how this score relates to price-to-book multiples for the 41 listed banks in our survey. Interestingly, we seem to systematically over-estimate valuations for banks listed in HK that can be shorted and under-estimate valuations for banks that are listed in Mainland China.
Because non-performing loan data is notoriously optimistic, we believe that the provincial exposure of China’s banks is a reasonable proxy for current or future losses. We used branch locations to estimate geographic exposure for China’s listed banks. Then, we combined those exposures with a gauge of provincial strength (details in the appendix) to estimate provincial risk for each bank.
This score, combined with the bank financial indicators highlighted earlier in this report, gives us our final result – a ranking for all listed Chinese banks.
Bank of Jinzhou is operationally confined to Liaoning province, from China’s slowing North East, which recently copped to overstating economic data for four years. Additionally, the bank was fined 1 million yuan by the Beijing Banking Regulatory Committee last month for breaking the rules on loan origination to risky concerns. With investment receivables comprising more than half of total assets, a high provincial risk score, rapid balance sheet growth, and only 53% of total funding coming from deposits, Bank of Jinzhou is the riskiest listed bank in our study.
Bank of Gansu operates in Gansu province, a region referenced in classical Chinese poetry as the gateway between civilization and the complete desolation of the Gobi Desert. Notwithstanding, the bank’s assets have exploded over the past four years – CAGR 70%, which required the bank to list on the Hong Kong Stock Exchange to raise more capital. Nearly half of the HKD 5.7 billion raised came from “cornerstone investors” – large Chinese SOE’s in unrelated industries who invest to ensure IPO success.
Industrial Bank is China’s weakest national bank. Although a national operating scope diversifies away its provincial risk, it has a high proportion of assets in the investment receivables account and a low ratio of deposits to total liabilities. Additionally, the bank was scored as having the loosest lending requirements for mortgage loans obtained in Guangzhou province.
On the other hand, Jiangsu Zhangjiagang Rural Community Bank is representative of China’s strongest regional banks. Not only is it operationally confined to one of China’s best regional economies – coastal Jiangsu province – it boasts strong financial indicators as well. Analysts from the sell-side bank Shenyin Wanguo – one of China’s best – note in their initiating coverage report that Zhangjiagang bank’s exposure to high quality local businesses makes it stand out from its peers.
China’s perma-bears have been wrong for 10 years. We’re not predicting a financial crisis here; China Inc. has a track record of consistently succeeded in forestalling collapse and embarrassing the naysayers. Instead, we submit a framework to analyze the relative strength of China’s banks, and one which provides a potentially interesting investment opportunity.
All financial crises play out similarly – the weakest financial intermediaries suffer from pain on both the asset and liabilitiy side of the balance sheet. As losses on the assets accumulate, lenders begin pulling liquidity from the liabilities side, which in turn raises the cost of doing business. Asset sales to meet creditor demands for liquidity end up tightening conditions further leading to a vicious cycle culminating with the weakest borrowers being pushed over the brink.
In the face of a liquidity event, China’s regulators will have two options. Either they allow listed banks to be priced by the market, in which case the valuation gap will widen even further between the good and bad bands. Or, the central bank must provide sufficient domestic liquidity to staunch the spiral described above. This would place huge pressure on China’s currency. The PBOC war chest of FX reserves – the largest in the world – has fallen below the IMF recommendation for coverage of broad money supply. In the face of capital account pressure, they may no longer be able to defend the value of the currency.
China’s financial regulators have been proactive in trying to head off such a situation. They have imposed more restrictive macroprudential measures and started a process of forced recapitalization for some of the weakest banks. Unfortunately, credit continues to grow faster than income, and we have yet to see a radical reorientation of the economy away from investment in fixed assets and commodity production/consumption. We question whether such a transformation is possible without the transparency and accountability of free markets and information.
Meanwhile, the clock is ticking.
*Alex Campbell, CIO of Black Snow Capital, co-authored this report.