(Bloomberg Opinion) -- China’s small bank problem may be about to get a lot bigger. The slowing economy is exposing vulnerabilities built up by years of aggressive lending — and Beijing’s plans to preserve stability by merging weak lenders with each other could end up creating an even worse headache.
The country’s hundreds of rural commercial and city lenders account for 27% of banking assets, but their influence is far larger than this because of their web of connections to the wider system. Small banks are significant players in the interbank market, relying on larger lenders for funding. They are active in selling wealth management products, through which companies raise financing and individual savers seek returns. And their bonds are widely held by insurance companies.
Cracks in the sector emerged in May when the government seized Baoshang Bank Co., its first takeover of a lender in more than two decades. An orchestrated rescue of Bank of Jinzhou Co. followed in July, involving state-owned financial institutions that included Industrial & Commercial Bank of China Ltd. And the following month, local media reported that Shandong province’s government would become the largest shareholder in Hengfeng Bank Co.
Authorities are considering a sweeping package of measures to shore up smaller lenders, including merging those with less than 100 billion yuan ($14 billion) of assets and making them accountable to local governments, Bloomberg News reported earlier this month. Consolidation makes sense: China has more than 3,000 small banks, many of which are struggling to cope with rising bad loans and a government crackdown on shadow banking. Bigger banks attract more deposits, aren’t so dependent on interest income, and have the luxury of prime clients that don’t fail, such as state companies.
Disruption stemming from the tremors at smaller banks has shown the need for action. Spreads on negotiable certificates of deposits spiked after the Baoshang rescue — another key funding source for many lenders. Authorities have injected liquidity into other institutions, and tamped down speculation that some were on the brink of insolvency in an effort to prevent runs. Small banks have always been weaker than their larger counterparts, but the divide has widened since 2015 as liquidity tightened, according to analysts at Natixis SA. City commercial banks are particularly vulnerable, given a thinner deposit base than rural lenders.
The devil will be in the details. The danger for Beijing is that mergers will be poorly executed and fail to impose root-and-branch changes on lenders’ culture and risk-management practices. The result could be a plethora of small, weak banks stapled together into one too-big-to-fail toxic institution. The banking regulator’s ability to monitor large mergers, particularly on the country’s peripheries, is uncertain. Jinzhou is headquartered in the northeast rustbelt province of Liaoning while Baoshang is based in Inner Mongolia, Bloomberg Intelligence analyst Matthew Phan notes.
Addressing ownership and lines of accountability will also be crucial. Baoshang was part of Xiao Jianhua’s Tomorrow Group, an investment conglomerate that was under investigation in China — feeding speculation that the bank’s downfall stemmed from loans made to connected companies.
Part of Beijing’s solution should be to take the stronger players public. There were 15 city or rural commercial banks awaiting approval to list as of Nov. 1, according to Michael Chang of CGS-CIMB Research. Only 35 currently trade in either Hong Kong or on the mainland exchanges of Shanghai and Shenzhen.
Selling shares is no panacea — after all, Jinzhou trades in Hong Kong. Still, listing does expose companies to the scrutiny and discipline of public markets. Listed banks tend to be better run and more profitable. Shenzhen-listed Bank of Ningbo Co., for instance, has posted higher net income gains and lower nonperforming loans than many of its peers.
Forced mergers may well be necessary, but the evolution of China’s approach is more suggestive of policy being made on the fly than of a carefully thought-out strategy. After the Baoshang takeover spooked markets, authorities kept themselves at one remove and leaned on state-owned companies to act as rescuers. This is now Plan C. The price of failure could be huge.
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Nisha Gopalan is a Bloomberg Opinion columnist covering deals and banking. She previously worked for the Wall Street Journal and Dow Jones as an editor and a reporter.
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