China's first bank seizure in decades highlights growing small bank risk

State-owned CCB will ba taking over the business of Baoshang Bank.

The first government takeover of a Chinese bank in more than two decades indicates not just the increasingly precarious financial situation faced by smaller lenders but also the spillover risk of banks grappling with deteriorating asset quality.   

In a strategically-timed announcement, regulators announced that they are taking over Baoshang Bank, a regional lender based in inner Mongolia, after identifying 'serious credit risks' although authorities have been pledged to extend guarantees for Baoshang's interbank liabilities and corporate deposits of up to $7.23m (CNY50m) individually, in addition to a full guarantee over retail deposits.

Founded in 1998, Baoshang is part of an investment conglomerate led by financier Xiao Jianhua who disappeared in early 2017 and could soon face trial, according to Bloomberg. The bank has over 8,000 staff and total assets of $83b (CNY576b) as of September 2017. 

Also read: Small Chinese banks struggle to strike balance between curbing risk and lending

State-owned China Construction Bank (CCB) has been appointed to manage Baoshang's business for one year, highlighting the critical role state lenders are required to play to ensure financial stability in the world's second largest economy and the corresponding risks this entails. "The state banks' balance sheets are superior to the rest of the system, but their health could be undermined if they are ultimately relied upon to prop up a significant number of weaker banks, although it is not yet clear how Baoshang may impact CCB in this case," Grace Wu, senior director for financial institutions at Fitch Ratings said in a note. 

According to Fitch Ratings, there are almost 4,000 small city and rural banks in China which typically have more vulnerable funding and liquidity profiles, larger shadow-financing activities and lower loss-absorption capacity than state banks and larger commercial banks.

"We also believe that underreporting of asset quality problems is most significant at the smaller banks, and they have higher loan concentration risks from single and related-party borrowers," added Wu. 

Concerns over operational deficiencies and governance have long hounded small banks who are grappling with tight credit conditions against the economic slowdown and Beijing's unrelenting campaign to deleverage. A stress test conducted by the central bank shows that capital positions across much of the banking sector is vulnerable and Fitch estimates those likely to fall below the minimum thresholds under stress would include most of the city and rural banks, and cover more than 20%-25% of banking-system assets (excluding the policy banks).

“Small and medium banks are the weakest link in the deleveraging process, because of a lack of deposits and their dependence on market funding,” Wu said in a separate report. 

Also read: Are small banks bearing the brunt of China's bearing the brunt of China's bad loan problem?

The Baoshang takeover highlights the difficult balancing act faced by regulators as they try to clean up risky lending practices without triggering a loss of faith in banks that might damage the world’s second-largest economy amidst a trade war with America, adds Bloomberg. 

Already, delinquencies rose to a record $17.88b in January, according to a report from DBS, with the energy sector accounting for the largest number of defaults ($6.94b).  “Given the reduced risk appetite and huge maturing volume, the outlook is poor, with $523.23b (RMB3.5t) in corporate bonds due in the next twelve months," Nathan Chow, strategist/economist at DBS said in an earlier report.