Beijing aiming to go ‘bigger than Basel’

Last week, when the Basel Committee was drawing up the fresh new rules for bank capital, it received a great deal of attention around the world, and worries about how it would alter the state of play for global banks.

But in China, there was nary a ripple. That’s because the parallel universe of the Chinese banking system had already been prepared for capital adequacy and other regulations that, in the estimate of some analysts, went even farther than Basel III norms.

It wasn’t just another showcase attempt at ‘getting to the finish line first’.

It may have had something to do with the fact that Beijing probably has started receiving more information on how serious the risk is from “massive lending” to local governments’ financing vehicles last year, says Societe Generale analyst Wei Yao.

Last week, China’s banking regulator, the China Banking Regulatory Commission (CBRC), announced it was considering adding leverage ratios and dynamic reserve requirements to further regulate Chinese banks.

It also said it planned to release its new capital supervision and regulation framework after the Basel Committee finalises Basel III accords at the end of this year.

The new rules are reported to include a 2.5% loan loss provision ratio, a 3.5-4% capital-to-loan ratio, a 100% liquidity coverage ratio and more specifications on the capital adequacy ratio.

“The CBRC announcement reflects China’s response to the global trend of stricter regulation and its own efforts to encourage banks to change their current business model and replenish their capital through earnings retention and better capital management,” notes Moody’s Investor Service analyst Katie Chen.    

Yao, however, points to hidden risks. “At the moment, Chinese banks look fairly well capitalised on the book, but there are some big time bombs on their balance sheets.”

These are principally in the form of loans to local governments and affiliated investment companies.

“Although China sill has time to deal with the problem, the risk is very real and fiscal reforms are needed to tackle the root cause of the problem.”

Currently, Chinese banks are bound by three ratios: a 150% provision coverage ratio (bad loans provisions relative to non-performing loans), a 10-11.5% total capital adequacy ratio, and a 75% loan-to-deposit ratio.

“In their latest financial reports, all the commercial banks said they had met the requirements, but these seemingly good results were achieved with massive issuance of new shares and convertible bonds,” points ouot Yao.

China’s top four state-owned banks, for instance, raised 150 billion yuan (about $25 billion) in equity this year along.

The regulation proposed by CBRC will further constrain loan growth, and smaller banks, in particular, will be affected.  

But in Yao’s opinion, the root cause of the problems in China’s banks is a “defective fiscal system”.

China’s local governments have been running fiscal deficits for years because under the current system, all governments are required to send most of the taxes collected locally to Beijing - and then rebate part of these taxes back based on the contribution. “Although there are some transfers from rich provinces to poor ones, the usual outcomes are that poorer regions get a smaller share.”

At the same time, local governments are responsible for funding local infrastructure projects and social services - and typically end up spending more than they can afford.

That systemic problem was accentuated by last year’s explosion in bank lending to offset the shock to the economy from a collapse in global export markets.

“In a scenario where 50% of the loans generate loss loans at a 50% rate, the total loan losses of the banks will be around 6% of the total loans and 7% of 2009 GDP,” estimates Yao. This may be manageable, but it assumes that no new loans are made.

“There’s still some time before the local government loans turn bad, but the risk is very real,” adds Yao.

To prevent the problem from deteriorating or re-emerging in the future, what China needs - more than banking capital - is a “thorough reform of its fiscal system.”