China’s Banking Industry and Associated Risks

Banking activity is growing rapidly in China’s $30tn banking system and even though the country faces a sluggish economy, its banking system consists of some of the largest banks of the world. The combined value of Industrial and Commercial Bank of China, China Construction Bank, Agricultural Bank of China and Bank of China is now at par with the four big US banks (JPMorgan Chase, Bank of America, Citigroup and Wells Fargo). With a considerable influence of the Chinese government in the banking network, the sector continues to develop commercially and globally.

Banking activity is growing rapidly in China’s $30tn banking system and even though the country faces a sluggish economy, its banking system consists of some of the largest banks of the world. The combined value of Industrial and Commercial Bank of China, China Construction Bank, Agricultural Bank of China and Bank of China is now at par with the four big US banks (JPMorgan Chase, Bank of America, Citigroup and Wells Fargo). With a considerable influence of the Chinese government in the banking network, the sector continues to develop commercially and globally.  The Chinese Government has considerable control over its banking system, owning a majority of the largest banks. They also have significant power over banks’ lending and deposit-taking activities. The Chinese government is also heading toward more market reforms shifting from a more state-oriented model towards a market- oriented model. China had long witnessed a high rise in shadow banking, but with the government intervention in December 2014, it saw a sharp fall in the Chinese shadow banking system. By February 2015, Beijing declared partial success over shadow banking. But as the banking activities in China continue to expand, the banking system itself remains large and complex. Though the government and the central bank tries to address as many issues diligently, there are some that could pose a problem for the future banking system of China.

Chinese banks have time and again been criticized for lack of transparency especially when it comes to publishing their financial situations. To address this issue, the central bank has already changed its definition of loans and deposits. China’s banking regulator is in the process of making a similar change, where it will turn its loan to deposit ratio into a tool to monitor how banks are investing off the books, according to a report from Barclays. Fitch said these new regulations would help in improving transparency, as it will increase the disclosure of shadow bank lending on the balance sheet. As the default rate rises, matters may worsen for the banking sector. Last year, the International Monetary Fund urged China to restrain its credit growth. 

Foreign banks continue to face stringent capital, liquidity and administrative requirements when opening a branch in China. According to an interview with Knowledge@Wharton, Sushil Saluja, senior managing director (financial services) for Europe, Africa, the Middle East and Latin America of management consulting, technology services and outsourcing firm Accenture said that China Banking Regulatory Commission (CBRC) requires that foreign banks have to operate a representative office in China for at least two years before they are allowed to open a branch in mainland China. Foreign banks can apply for only one new branch at a time.  Even though foreign banks in China have a long process to follow, it seems that the banking sector in China is slowly linking to the western world. One recent example is Industrial and Commercial Bank of China (ICBC) purchasing 60% stake in Standard Bank’s UK operation for $690 million. Many analysts are of the view that such acquisitions could also be a cause of worry as cash is being pulled out of the banking system as domestic companies go abroad for acquisitions. Even though domestic banks in China are slowly becoming equipped and gaining expertise in the new age of banking, they still are not as well placed as foreign banks in providing expertise in capital-market products in China such as risk, FX, hedging, derivatives products and M&A.

According to latest analysis by the Volatility Laboratory at New York University’s Stern School of Business, the cost of supporting these banks in the event of a financial crisis has quadrupled in the past three years to $526.2 billion. This cost is the largest in any banking system across the globe. Not only the cost of propping up the banks but even the bad debt levels seem to be rising across Chinese banks, to a five-year high of 1.6 percent at the end of 2014. China’s slowing economy has increased financial risks at the country’s heavily indebted companies and local governments, which owe a combined $15 trillion, according to a state audit and private estimates.  The central bank raised concerns about these debt levels and stated that it would avoid excessive credit stimulus so as to mitigate risks.  But the trouble in China’s banking sector does not end here. 

The new Basel III accords require banks to maintain high levels of capital on the books while restraining their balance sheets. With these new Basel III accords, Chinese banks could face some challenging situations, as they will struggle to increase their capital as a percentage of their assets. To meet these requirements, Chinese banks will see a shift from traditional corporate lending to retail lending and this could be a good sign since corporate loans have a higher risk of default than retail loans. Chinese banks need to find a balance between corporate and retail lending and devote their limited resources without a high default risk. According to a report, Chinese banks are looking for ways to cut provisions for some loans – even if it means lending to companies leasing ships, tractors and building equipment in some of China’s most vulnerable sectors. China recently injected $7.2 billion into money markets and relaxed the amount banks are required to hold as reserves so as to make more money available for loans. It is not only the large banks that need to abide by Basel III, but even the small banks have to face similar challenges. “The majority of the personnel in the small banks lack knowledge and expertise of assessing risks,” said Spark Wang, a regulatory intelligence expert at Wolters Kluwer Financial Services in Shanghai. 

As the Chinese economy slows, the government seems cautious as it tries to revive growth and prevent further damage. It will not be wrong to assume that if not regulated well, the biggest banks in China could be the riskiest part of Chinese financial system.