Evaluating the current performance of the Chinese banking sector, with a focus on the

future challenges it faces

Introduction and Literature review

China’s banking system has gone under unprecedented transformation in recent years. In

1999 China’s big four banks; Bank of China, ICBC, Agricultural Bank of China (ABC), and

China Construction Bank (CCB), all had such a large number of non-performing loans

(NPLs) on their books that insolvency was a possible outcome. However, the government

decided to bail out the banks at a cost of 20% of GDP (Howie and Fraser, 2011). China’s

banks have since been taken public, with ICBC experiencing the largest IPO in the world in

2006, and becoming the largest bank in the world by assets in the process. Reputable foreign

institutions such as Goldman Sachs, Royal Bank of Scotland, and Bank of America showed

their confidence in Chinese banks by acquiring sizable stakes in ICBC, Bank of China, and

China Construction Bank respectively (IMF, 2006). Additionally, the integration of banking

stocks in the Shanghai Stock Exchange (SSE) drove a boom in the SSE from June 2006 –

November 2007 (Luo and Yao, 2010). Since China’s $486 billion stimulus in 2009 the

landscape of Chinese banking has changed (Howie and Fraser, 2011). Loan issuance has

proliferated in response to the new supply of money available to banks. According to data

obtained from the PBOC, domestic loans from the big four have grown from RMB20 trillion

in 2010 year-end to RMB38 trillion in 2013 year-end (PBOC, 2010-2013). While there has

been much loan growth, financial innovation has also been a recent development in China’s

post-2009 stimulus story. Shadow banking has become more prevalent in China’s financial

sector along with the rise of trust companies, and the proliferation of wealth management

products (WMPs); these new actors in China’s post-2009 story pose a threat to the future

stability of its banking sector, particularly to smaller and medium sized banks (SMBs). This

essay will begin with a methodology before diving straight into the results section; evaluating

the banking sector’s current situation but mainly focussing on its future.

2. Methodology

The vast majority of findings from this essay have been from observations based on searching

through data. PBOC aggregated data from Chinese banks and carried a summary of important

features of the make-up funding for Chinese banks, as well as how the banks apply those

funds. The PBOC splits the data for SMBs, state-owned banks and the big four state-owned

banks1. Bankscope was used for assessing bank-specific data, which aided detailed research

since the big four all have different financial circumstances, and they place similar items

(such as WMPs) on their statements under different headings such as ‘other deposits’ or

‘structure deposits’ or are not on financial statements at all (off-balance sheet, buried in the

‘maturities’ section), so an aggregate data produces unreliable results. CSMAR provides

research across a range of categories surrounding listed Chinese companies. The main focus

when scanning the data was to look for any abrupt changes in the numbers; this was an

expedient way of uncovering the drivers of the banks’ rise in assets since 2009 among the

slew of data. The indicators used were capital adequacy ratio, which is the amount of liquid

reserves a bank has at its disposal; the ratio is used to assess banks’ ability to cover losses in

the event of a credit fallout. Another indicator was net interest margin, which is the difference

between interest expense (the savings rate paid to depositors) and interest income (accrued

interest from loans), the measure is seen as a useful tool for determining the stability of a

bank’s business model. Bankscope covers financial details of thousands of banks across the

globe. It was used for individual bank analysis since assessing a bank’s exposure to off-

balance sheet wealth products was difficult considering they would be listed under different

headings.

3. Results and Discussion

3.1 The capital structure of SOBs

China’s current liquidity levels suggest that the four main state-owned banks will be able to

cushion themselves from a rise in NPLs. The China Banking Regulatory commission

(CBRC) sets out capital adequacy ratios, which require banks to have sufficient capital so the

bank has enough reserves to ward off a potential liquidity crisis. The minimum ratio the

PBOC permits is at 9.5% (Reuters, 2012), which the SOBs have managed to exceed. As of 31

December 2013, the big four have managed to maintain a stable capital adequacy ratio

despite a proliferation in loan growth in recent years. Figure 1 highlights the capital adequacy

ratio of the big four from the financial year end 2008 to the year end of 2013. While it is

evident that China’s capital adequacy ratios have dropped slightly since the government

stimulus in 2009, the levels are more stable than pre-crisis EU and US Banks. Bank of

America’s was at 11.02% in 2007, while RBS, the biggest bank in the world by total assets,

1 SMBs are defined as banks with less than 2 trillion RMB in assets, while the big four are ICBC, Bank of China, China Construction Bank (CCB), and Agricultural Bank of China (ABC).

had a ratio of 11.22% that year. This is compared to 13.34% at CCB and 12.46% at Bank of

China.

Figure 1: Capital adequacy ratios of the big four 2008-2013

2008-12-31 2009-12-31 2010-12-31 2011-12-31 2012-12-31 2013-12-310

2

4

6

8

10

12

14

16Big 4 Capital Adequacy Ratio (%) ABC ICBC CCB BOC

Time

Source: CSMAR 2008-2013

One of the reasons that the big four SOBs have stable capital ratios is through their interest

margins. Interest rates are fixed in China, deposit rates which banks pay out to their

customers have a ceiling limit which is lower than the maximum borrowing rate which banks

receive as income. The rate for savings is approximately 3% while for borrowing it is 6%

(WSJ, 2014). This discrepancy allows China’s banks to reap substantial rewards from net

interest margins; using savings deposits as a base with which to lend money is a traditional

form of banking. This is seen as a more stable form of earnings since savings deposits are

more secure than investments. This is because it is less likely that every depositor will

withdraw all their savings at once, whereas an investment in a share or a short-term loan is

subject to interest rate changes which are more volatile.

Figure 2: Comparing the net interest margins of pre-crisis Western banks with the more

recent margins in Chinese banks

Net interest margin (%) 2007 2006 2005 2013 2012 20114 largest global banks pre-crisis (exc. Chinese banks)

Big 4 China SOBs

RBS 0.99 1.38 1.46 ICBC 2.51 2.61 2.57Bank of America (B of A) 2.67 2.83 2.94 ABC 2.79 2.83 2.88JP Morgan 2.10 1.99 1.96 BOC 2.24 2.15 2.14Deutsche Bank 0.72 0.65 0.69 CCB 2.74 2.75 2.70

Source: Bankscope, various years

3.2 SMB vulnerability

While the deposit-heavy capital structure of the big four SOBs may be sufficient to ward off a

potential liquidity crisis; wider defaults will have a disproportionately more damaging effect

on small and medium sized banks (SMBs). These are defined as banks with less than RMB2

trillion in assets.

A prevailing trend in the Chinese banking industry since 2009 has been the proliferation of

capital, both in loan issuance and investments. Many of these investments are hidden off-

balance sheet as they are innovative financial products and not the traditional bank business

model of deposit taking and lending. A key component of the off-balance sheet phenomenon

is the recent and popular financial sector creation, the Wealth Management Products

(WMPs). WMPs are investment products that earn a higher return than a regular deposit with

a bank and are held under different conditions. The monies in a WMP are unredeemable until

maturity just as they are in structure and time deposits. Fortunately for the consumer of

WMPs, they need not wait a long time as many maturities last just seven days, with the bulk

of WMPs maturing in less than 3 months (Fitch, 2010). Banks first originate a variety of

different investments, package them up into a loan and convince retail depositors to buy

interests in the product. The WMP is then transferred to a trust company which guarantees a

portion of the loan (the percentage guaranteed by the trust company varies with each

product), the trust company then invests the money in projects of varying risk. WMPs show

up in banks financial statements in a few ways depending on the financial institution (making

regulation extremely difficult), listing them as ‘structure deposits’ seems most common,

while listing them in the off-balance sheet ‘maturities’ section is also quite common. Data

obtained from the PBOC shows that SMB banks savings deposits (of the traditional sort)

have grown 48% since 2010. Structure deposits on the other hand have increased by 189%

over the same period. Structure deposits are seen as less secure than savings deposits because

this is where some banks book riskier assets, such as WMPs, on their balance sheets

(Bloomberg, 2014). In addition, the SMBs have not only riskier sources of deposit funding on

their balance sheet but they have also turned their attention away from medium and long-term

loans, embracing the possibility of a higher return by engaging in higher risk. Figure 3

highlights the departure SMBs have made from offering long-term, in favour of short-term,

loans. The reasons short-term loans offer more attractive financial reward is because in China

they commonly mature after just seven days making commissions more frequent since short-

term loans are often renewed (Fitch, 2011). While at the financial year-end of 2011 medium

and long-term loans in the SMB sector stood at a greater value than short-term loans, the

trend was quickly reversed. As of financial year-end 2014, short-term loan issuance stood

19% higher than medium and long-term loans.

Figure 3: Comparing the fund uses by SMBs over the last three years.

2013.122012.122011.12 ¥60,000.00

¥70,000.00

¥80,000.00

¥90,000.00

¥100,000.00

¥110,000.00

SMB short-term loan issuance vs medium & long-term loan issuance

1. 短期贷款 Short-term Loans 2. 中长期贷款 Medium & Long-term Loans

Year

Tota

l loa

n (m

illio

ns)

Source: PBOC 2011-2013

The PBOC’s full breakdown of where SMBs deploy their capital raises additional concerns.

Figure 4 illustrates SMBs' drive to be competitive; striving for higher returns by initiating

greater risk. The worrying trend from the chart is that the category ‘shares and other

investments’ rose 264% in 12 months, while the reserves SMBs hold with the Central Bank

increased by 15% in the same period. It is evident therefore that SMBs are adding risk in their

portfolio while not offsetting that risk by increasing their reserves with the Central Bank;

eroding their capital reserves in real terms. If some of these risky investments begin to falter

there will therefore be a reduced cushion for the SMBs to fall back on meaning a greater

likelihood for liquidity problems, which will prevent the affected banks from issuing further

loans. This would not be a problem if only a few banks were doing this, but the data collected

by the PBOC includes all SMBs so this phenomenon is industry-wide.

Figure 4: Comparing how the SMBs invest their capital 2012-2013.

¥44,478.

19

¥7,239.12

¥73,950.

56

¥42,896.

75

¥87,650.

82

SMBs capital deployment 2012/12/31

Portfolio Investments

Shares and other investments

Medium & Long-term loans

Reserves with Central Bank

Short-term loans

¥53,096.2

0

¥26,361.86

¥84,507.2

8

¥49,201.88

¥104,912.

59

SMBs capital deployment 2013/12/31

Portfolio Investments

Shares and other investments

Medium & Long-term loans

Reserves with Central Bank

Short-term loans

Source: PBOC 2012-2013

3.3. SOBs involvement in riskier investments

While SOBs may be in a comparatively better position in terms of their larger deposit base,

they too have been engaging in increasingly risky practices as well. The desire to remain

competitive has led to SOBs engaging in riskier investments in order to achieve a higher

return. Structure deposits (which are seen as disguised WMPs) grew from

RMB7,548,040,000 in 2012 year-end to RMB11,162,760,000 by 2013 year-end; a 48%

increase (PBOC 2012-2013). However, banks differ in how they report WMPs on their

books. For example, Bank of China lists them as 'structured deposits', ICBC however, buries

them under ‘maturities’ in their financials. This means data from the PBOC may understate

the real amount of credit that is in the financial system making the CBRC’s job of regulating

the banks more difficult. Figure 5 shows how ICBC lists its WMPs off-balance sheet.

Additionally the table illuminates ICBC’s attempt to remain competitive by participating in

the short-term deposit game. While the increase in fee commissions can be beneficial, it does

exacerbate instability. The shorter term maturities from 3-12 months and < 3 months grew

much quicker than the longer maturities (the data is not arranged in chronological order to

emphasise the differences).

Figure 5: ICBC ‘other deposits’

ICBC 'Other Deposits' (mln) Year

Maturity 2012.12.31 2013.12.31

< 3 months ¥7,842,064.00 ¥8,569,890.00

> 5 years ¥2.00 ¥2.00

1-5 years ¥1,053,988.00 ¥1,081,790.00

3-12 months ¥1,966,871.00 ¥2,159,729.00Source: Bankscope 2012-2013

It is important to assess the asset quality of these innovative financial products in order to

ascertain whether WMPs are inherently a positive force in China’s banking industry.

According to a report on China’s banks by Standard & Poor’s (2013), much of these WMPs

are invested in loans for companies in real estate and construction materials (cement, steel

etc.), as well as coal. However, more and more of these WMPs are failing, meaning that retail

investors would lose their structured deposit; to prevent this from happening banks often

bailout the depositors at their original investment cost, therefore the investors agree to take no

interest gain. Zhongding, an investment product created by Hua Xia bank in 2012 which

promised an annual 11-13% return, defaulted so investors were bailed out at cost (Reuters,

2013). Another WMP, this time with ICBC, was a high-profile default since its size was

$496 million. Part of the underlying asset was an investment in Shanxi Zhenfu Energy, which

defaulted on its debt payments. Despite the underlying asset being near worthless, ICBC

bailed out the investors at cost (CNBC, 2014). As previously mentioned, some isolated cases

of defaults are manageable; the problem arises if there are defaults en masse. A worrying

after-effect of the Zhongding loss was that when Hua Xia offered another WMP yielding 6%,

all clients rejected the offer, citing a loss of confidence. This could potentially be a precursor

for future liquidity issues.

Indeed the level of bad credit that the SOBs are reporting has increased year-on-year since

the end of 2011. Figure 6 highlights the loan losses the big four SOBs have posted each year.

Perhaps the most striking is ABC’s rise in NPLs of 3457% in two years. ICBC’s loan losses

increased by 119% from 2012 year-end to the end of 2013. Despite the growth in loan losses

it should be noted that the actual level of NPLs relative to the banks’ total loan book is

miniscule; the average NPL rate for each of the big four banks stands at 1.02% of total loan

book. These levels are stable considering that RBS, the biggest bank in the world by assets in

2007, had an NPL ratio of 8.94% as of year-end 2013. However, the figure in 2007 was at

1.24%, which is still higher than the average of the SOBs. According to Fitch Ratings (Fitch,

2010), the main reason behind low NPLs is that the ratio is relative to gross loans, so the

faster loan issuance grows, the lower the NPL ratio. Additionally, both Fitch (2010) and

Standard & Poor’s (2013) believe that the level of NPLs has been downplayed by all the

Chinese banks (just as RBS understated NPLs by continual issuance of more loans pre-2008

crisis), and the real level is around 3-5%.

Figure 6: NPL write-downs from big four since the end of 2007.

2007-12-31

2008-12-31

2009-12-31

2010-12-31

2011-12-31

2012-12-31

2013-12-31

0

4000000000

8000000000

12000000000

16000000000

Current loan loss written off (RMB)

BOCCCBICBCABC

Statistical Deadline

Loan

writ

e-do

wns

(RM

B)

Source: CSMAR 2007-2013

3.5 An accelerating money supply coupled with declining GDP growth can lead to problems

Since China’s economic stimulus in 2009 the money supply in China has proliferated. The

stimulus was in response to a financial crisis occurring in Western countries in 2008, which

caused demand for Chinese exports to drop from a 20% year-on-year growth in October 2008

to a 2.2% decline in October 2008 (Li et al. 2012). The $486 billion stimulus enabled China

to continue with a persistently high GDP growth in the face of declining exports. However,

figure 7 taken from China’s National Bureau of Statistics highlights the diminishing returns

of M2 in the economy. It has changed from a semi-symbiotic relationship pre-2008, to a

decoupling over the last few years; the growth rate of M2 has been exceeding GDP every

year since 2008. The substantial gap between GDP and M2 has been increasing due to a

slowdown in China’s economy, yet credit has continued to abate. High profile bankruptcies

in the steel and coal industries have only increased the rhetoric of China’s slowdown

circulating in the media. The debate over whether China will experience a hard-landing or a

soft-landing over the next few years takes away from the real issue which is that despite all

the talk of a ‘landing’, credit is still taking off, as can be seen by the trajectory of M2 in

figure 7. If GDP continues to slow while credit continues to grow, then the law of

diminishing returns takes place whereby it costs yet more credit to receive that extra yuan of

growth. This has historically led to economic difficulty in future due to credit excess (Fitch,

2013).

Figure 7: Comparing level of M2 in the economy, versus its gross domestic output

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 20120.0

200000.0

400000.0

600000.0

800000.0

1000000.0

1200000.0 Money Supply vs. GDP over the last 11 years

M2 (money supply)

GDP

Year

Capi

tal (

100

mill

ion

yuan

)

Source: National Bureau of Statistics - various years

4. Conclusion

China’s banking industry faces more challenges over the next few years owing to the

unprecedented credit growth in the economy with a declining macroeconomic outlook; the

proliferation of off-balance sheet investment products without corresponding sufficient

capital reserves. However, any evaluation of the future of Chinese banks must discern

between the four large SOBs and the SMBs. Any economic fallout that may come from a

liquidity shock, as seen in June 2013, or from an en masse default of investment products,

can be handled by the SOBs given their capital reserves and the support it is presumed they

would receive from Central government. SMBs on the other hand, have chosen a riskier

business model in order to stay competitive, and as such do not have as sufficient a capital

base to stave off a potential decline in investments. China’s banking sector has come a long

way since the PBOC was split into four separate banks, and while their immediate future is

uncertain, China’s long-term future is far more optimistic; the place of their banks on the

future global stage is not in doubt.

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