Bank Defaults Seen as Dark Side of Deposit Vows: China Credit

Apr 20, 2014 12:25 pm ET

April 21 (Bloomberg) -- Chinese Premier Li Keqiang’s plan to introduce deposit insurance is meant to comfort the nation’s savers as bad loans mount. In the bond market, it’s fueling speculation he’s preparing to let some banks collapse.

Authorities may tolerate failures of smaller banks once depositor safeguards are in place, Kwong Li, chief executive officer of China Lianhe Credit Rating Co. said. Among lender bonds rated at or below AA, the extra yield investors demand to hold the 2022 securities of China Bohai Bank Co. in the northern city of Tianjin surged to an 11-month high of 245 basis points on April 17. The premium on the notes due 2019 of Harbin Bank Co., a lender near China’s border with Russia, has jumped 41 basis points in the past year to 217.

“With the deposit insurance coming online, the government is signaling they may be willing to let some of the smaller banks default or be consolidated,” Li said in an interview in Shanghai on April 15. Bank defaults “probably won’t happen until deposit insurance is in place.” Lianhe Credit is Fitch Ratings Ltd.’s China joint venture.

Premier Li pledged last month to introduce protection for savers this year as he shifts toward letting the market set rates, a move that may push up borrowing costs for smaller lenders even as it forces them to pay higher interest to depositors. Almost 1,000 customers rushed to outlets of Jiangsu Sheyang Rural Commercial Bank on March 24 amid rumors the lender may go bankrupt, Xinhua News Agency reported March 26.

Cash Shortfalls

The nation’s banking regulator has ordered some smaller lenders to set aside more funds to avoid cash shortfalls, after bad loans jumped to the most since the global financial crisis, three people familiar said in February.

Concern banks may face increasing difficulty collecting debts is mounting after the first default on an onshore yuan note last month when Shanghai Chaori Solar Energy Science & Technology Co. missed part of an interest payment. Slowing economic growth is adding to speculation more companies won’t be able to fulfill debt obligations.

Credit-default swaps insuring the nation’s debt against non-payment climbed 9.5 basis points this year to 89.5 basis points, after expansion in gross domestic product cooled to 7.4 percent in the first three months of the year, the least in six quarters.

Stemming Unrest

Failures of high-yield trust products have sparked investor protests, highlighting the potential for unrest deposit insurance would seek to preclude. At least 30 people wearing white masks with the words “despicable bank” faced special- forces officers in front of a China Construction Bank Corp. branch in Taiyuan last week, as they demanded their money back from a troubled 973 million yuan ($156 million) trust product.

Fang Xinghai, a bureau director at the Office of the Central Leading Group for Financial & Economic Affairs, said in November one or two small Chinese banks may fail this year because they get about 80 percent of their funding from interbank markets and higher-cost deposits in savings vehicles known as wealth management products. The group is the highest- level agency within the Communist Party for financial and economic policies.

The government will be more willing to let small banks go under once deposit insurance is in place, according to Christine Kuo, a senior credit officer at Moody’s Investors Service.

‘Safety Net’

“Chinese regulators are preparing a safety net,” Kuo said in an April 17 interview from Hong Kong. “Going forward, when small financial institutions have some problems perhaps the government won’t necessarily help them out once they have deposit insurance in place to protect retail depositors.”

Sour debt at lenders increased for the ninth straight quarter at the end of last year to 592.1 billion yuan, the highest level since 2008, data compiled by China Banking Regulatory Commission show. New non-performing loans amounted to more than 60 billion yuan in the first two months of this year, compared with 100 billion yuan for all of 2013, China Business News reported on April 9, citing unidentified people in the banking industry.

As it moves to limit the risks from any defaults, the government will “encourage consolidations among the smaller banks, and mergers of the smaller banks with the bigger ones,” Lianhe Credit’s Li said.

Bad Debt

The average non-performing loan ratio for Chinese banks rose to 1 percent at the end of last year, compared with 0.97 percent in September, CBRC, the nation’s banking regulator, said Feb. 13. The figure may climb as high as 2 percent by next year, Moody’s Kuo said.

The People’s Bank of China currently caps interest paid on deposits at 1.1 times its benchmark rate, which stands at 3 percent for one-year deposits.

Central bank Governor Zhou Xiaochuan in November identified deposit insurance as a mechanism needed to handle risks as China moves to a system in which interest rates are set by the market and not regulators. The dominance of state-owned lenders has left savers believing in an implicit government guarantee, even though China is the only major Asian economy without a formal insurance system, according to Citigroup Inc.

Introduction of a deposit insurance scheme doesn’t imply authorities will tolerate bank defaults given the risks such failures would pose to the financial system, according to Brian Ingram, the chief investment officer at Ping An Russell Investment Management Co., Russell Investments Group’s joint venture in China.

‘Unexpected Consequences’

“Even a default in a small bank could have consequences the government itself might not be able to foresee,” Ingram said in an interview on April 16 in Shanghai. “Bank runs, as we’ve seen in other parts of the world, can trigger unexpected consequences, in terms of crises of confidence.”

Full deregulation of deposit rates would cut banks’ net interest margins, a measure of loan profitability, by at least 50 basis points, and smaller lenders will be hardest hit, according to a Bloomberg News survey in September.

Benchmark borrowing costs have risen, with the yield on China’s 10-year sovereign note up 86 basis points over the past year to 4.28 percent. The premium investors demand to hold AA- rated similar-maturity corporate securities has climbed 7 basis points over the same period to 393 basis points.

While credit costs may rise further and deregulation will keep pressure on net interest margins, the government will seek to ensure any defaults don’t trigger systemic risks, according to Moody’s Kuo.

“Initially the tolerance is going to be very small,” Kuo said. “Only small banks will probably be allowed to default, which won’t cause any systematic issue.”

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