WSJ: Chinese Banks Are Worse Off Than You Think

I had an op-ed in today’s Wall Street Journal (July 22, 2010).  The direct link is here.  My article was written in direct response to a prominent Reuters article that appeared late last week, which is worth reading by way of background.  Anyone who wants to see the supporting reasoning behind my claim that probable loan losses could wipe out banks’ reported profits and seriously compromise their capital base should read my earlier post on this subject here.

Chinese Banks Are Worse Off Than You Think
Rosy loan-to-deposit ratios hide a serious nonperforming-loan problem

by Patrick Chovanec

Investors are worried about the health of China’s banks. They’re afraid—with good reason—that the massive, state-directed lending binge that was instrumental in pumping up China’s GDP figures the past two and a half years will end up producing an equally massive pile of bad debt. Barely a week goes by without new word of a troubled project or impending default.

Never fear, say the banks and some analysts. They point to the extraordinarily low loan-to-deposit ratios of Chinese banks, averaging around 65%, as evidence that these banks have plenty of cash to cushion themselves against any future loan losses they might suffer. Everything is under control.

This argument is misleading, and offers a false sense of comfort.

First of all, the loan-to-deposit ratio is a measure of liquidity, not of solvency. A high ratio suggests that a bank may be relying too much on volatile short-term borrowing rather than stable long-term customers to fund its lending. It risks getting caught without enough cash reserves on hand to satisfy its creditors, forcing it to sell other assets at a loss, which could eventually cause the bank to fail. Having plenty of cash reserves on the left (asset) side of a bank’s balance sheet can help prevent such a crisis. But it has nothing to do with a bank’s capacity to absorb losses from bad loans without going bankrupt.

A bank’s solvency in the face of losses depends on the loan-loss provisions it has set aside and the capital it has built up on the right (equity) side of its balance sheet. Chinese banks like to boast that they have an average “loan-loss coverage ratio”—the amount of equity set aside, divided by the amount of nonperforming loans—of 220%, up from 80% at the end of 2008. Optimists argue this shows banks have set aside more than twice the amount of equity they would need to make up for all their bad loans.

But that ratio considers only those loans a bank has formally designated as nonperforming, and banks have hardly recognized any bad loans stemming from their recent bout of lending. China’s banks are required to set aside loan-loss reserves equivalent to 2.5% of their total loan portfolios. Yet based on the lessons of previous rounds of credit expansion, it’s more likely that up to 20% or even 30% of their loan portfolios will turn bad at some point in the wake of the latest expansion.

Indeed, estimates leaked by Chinese bank regulators suggest that 23% of loans to local government-sponsored infrastructure projects are an outright loss, with another 50% at risk of cash default. If Chinese banks made appropriate provision for these losses alone, it would reverse the record earnings they have been reporting and eat into their capital base. Apply these estimates across other risky loan categories, such as real-estate development and business lending diverted to speculation in stocks or property, and their capital is in real danger of being wiped out. The loan-to-deposit ratio doesn’t matter; they can have captive deposits and lots of cash, and still be bankrupt if they threw it all away on bad loans.

In fact, all that excess liquidity Chinese banks have on their balance sheets is really part of the problem. It isn’t there because the banks are cautious lenders, but because China’s external imbalances—the inflow of money from both the current and capital accounts, accumulated as foreign-exchange reserves—keeps driving up the domestic deposit base.

Unless this constant injection of money is sterilized and kept out of circulation, with cash reserves piling up and the loan-to-deposit ratio pushed ever lower, the result is runaway lending. That is precisely what happened when banks were allowed to draw on their reserves to fund the lending boom. The high levels of liquidity in China’s banks aren’t a cushion against bad debt. They are the reason those banks loaned money so recklessly in the first place.

Even as a measure of liquidity, however, the loan-to-deposit ratio can be misleading. To bring lending back under control, China’s central bank has ratcheted up the reserve requirement ratio, the amount of cash banks must keep on deposit at the central bank, to 21.5% for larger banks. An average loan-to-deposit ratio of 65%, as of June, would seem to imply at least a 13.5% cushion of ready liquidity still in the system.

However, many of the “non-loan” assets that banks are holding are actually disguised forms of lending such as bonds held to maturity or structured equity in other financing vehicles. Such pseudo-lending has exploded this year as constraints on overt lending have tightened.

The industry-wide ratio of 65% also disguises a big imbalance between large and small banks, which is central to the interbank lending market. Most of the deposits flowing into China from current and capital account surpluses land in the large banks, while China’s smaller banks drive a disproportionate amount of the lending. The large banks have an average loan-to-deposit ratio of 63%. The ratio for small to medium-size banks is 81%, which means many of them must borrow from their larger, deposit-rich cousins to meet their regulatory reserve requirements.

Recent spikes in the interest rates at which banks are borrowing from and lending to each other—the interbank and repo rates—show just how tenuous this relationship can be, as smaller lenders push themselves to the limit, hoping the big banks can foot the bill. The volatile interbank market suggests that rank-and-file Chinese banks are dancing a lot closer to the flame of a liquidity crisis than broader measures might indicate.

People who look to low loan-to-deposit ratios as proof that all is well with Chinese banks need to think again. The statistic tells you nothing about solvency and precious little about real liquidity. If anything, it’s a symptom of the deep imbalances that lie at the heart of China’s banking system.

[As a side note, it’s interesting that the large bank/small bank dynamic in China is the inverse of the relationship that long existed in the U.S. pre-liberalization, where smaller, local banks gathered deposits and lent them to the large “money center” banks that drove commercial lending.  The Chinese arrangement, in which large deposit-rich banks lend to smaller banks, would seem to imply that financial risk may be less concentrated, but that visibility and discipline may pose a greater challenge for regulators.]