Banks Raise Dams, Fend Off Toxic Debt Crisis

Huo Kan and Wu Hongyuran via Caixin | Figurative dams and diversion canals have been popping up across China’s financial landscape as banks scramble to prevent a flood of toxic debt.

So far, creative engineering has helped bankers keep non-performing loans under control. With support from and sometimes in spite of government regulators, banks have effectively managed the financial stress by rolling out a steady stream of debt-management tools since late 2011.

Their efforts are continuing. Banks have found ways to sell off bad debt and roll over loans. Meanwhile, the People’s Bank of China and China Banking Regulatory Commission (CBRC) are testing a new bad-loan securitization program.

And regulators are not especially worried. A CBRC official who asked to remain anonymous told Caixin that healthy provisioning means the nation’s banks can currently accommodate up to 3 trillion yuan in debt write-offs. “The overall risk is still under control,” said the official.

An executive at a state-owned bank who requested anonymity agreed banks overall have set aside enough money – up to 3 percent of the total amount on loan – to cover risks.

Nevertheless, the debt waters are rising. According to government data, the banking sector’s total burden of bad loans rose in October for the 16th consecutive quarter to 1.92 trillion yuan. Toxic debt levels have climbed by more than 500 billion yuan since the beginning of the year.

The ratio of bad loans to total loans rose 0.78 percentage points in October from September to more than 2 percent, official data show. State-owned and private commercial banks held most of the overdue debt – about 1.27 trillion yuan – while the bad-loan ratio for these banks clocked at 1.76 percent.

Non-performing loan levels are expected to rise for “a while”, a source close to the central bank who asked not to be named said.

And the official figures may be telling only part of the story. A November 24 survey by China Orient Asset Management Co., a state-backed fund asset manager in Beijing, found that more than 93 percent of surveyed bankers think the bad loan situation is worse than the data indicates.

A bank official in the eastern province of Jiangsu said the current level of provisioning is not high enough to adequately hedge against risk. And many banking sector observers think toxic debt levels will continue rising as the economy slows over the next few years. An executive at China Huarong Asset Management Co., a Beijing-based asset management firm, said he expects another five to 10 years of bad-loan headaches.

“Macroeconomic indicators for October and November were not good,” said the executive, who declined to be named. “And considering that restructuring will only deepen, the banking industry’s non-performing loans will continue to grow.”

Bag of Tricks

Managing rising debt levels to date has been a tricky affair. The key for many successful bankers has been to, by creative means, keep bad debt off their balance sheets.

Industry sources said that some banks have let borrowers take out new loans to repay old debt. Another trick involves scaling down overdue loan levels by adjusting loan contracts or swapping assets. In some cases, banks have partnered with trusts, fund companies or asset management firms in ways that let them shift bad loans off their balance sheets and onto the partner’s.

In addition to enforcing provisioning rules, the Jiangsu bank executive said, the CBRC has been telling bankers to quicken the pace of writing off some bad loans.

Between January and August, according to government data, banks wrote off more than 240 billion yuan worth of bad debt, about 85 billion yuan more than during the same period of 2014.

Banks are also working to reduce bad loan ratios. A bank employee in the southwestern city of Chengdu said many banks package and “sell” bad loans to insurance companies, securities firms and trusts. At the same time, the banks agree to buy back the debt in five to 10 years.

These agreements make a bank’s “real bad-loan ratio unclear,” the source said, adding that in fact “there are many ways for a bank to move bad assets off a balance sheet.”

For instance, he said, some banks persuade their employees to buy property that had been used as collateral by a delinquent borrower. Others sell the assets attached to bad loans to private or state-owned companies.

“There are many brokers who help central government-owned companies buy bad assets from banks,” the bank employee said. Companies improve their financial books through these deals, while banks reduce their bad loan ratios.

The bank accounting staffer said some companies even agree to offer higher prices to banks for the bad assets in exchange of loans with preferential terms.

Some borrowers have won more time to repay loans. And some companies pay off debt with funds raised by issuing corporate bonds, a source at a city commercial bank who asked not to be named said. Most of these bonds are bought by banks.

“They agree that companies will issue bonds and banks buy them,” the source said. “The money is used to repay debt in order to get a (payback period) extension.

“There are also measures for adjusting the interest rates, repayment methods and guarantee requirements.”

Another alternative for banks is to package bad loans and sell them to state-backed asset management companies (AMCs). Since the CBRC and Ministry of Finance started letting these entities buy debt from financial institutions in 2012, provincial governments have formed 15 AMCs. There are also four national AMCs.

A survey by China Orient in November found that more than four-fifths of bankers would be willing to sell bad loans to AMCs. Nevertheless, the Jiangsu bank executive said AMCs’ capacity to dispose of bad assets is limited, especially given the current economic slowdown.

“If they can’t digest or dispose of existing assets, they will not have enough money to buy new assets,” he said.

Some banks have balked at selling bad loans to AMCs if they think the offering prices are too low.

“Most assets are sold at prices that are too low,” said an employee at the country’s largest bank, the Industrial and Commercial Bank of China (ICBC).

The manager of a provincial government-run AMC in the eastern province of Zhejiang said banks are selling bad loans for 32 percent of their original value, down from 43 percent in 2014.

No wonder AMCs are considered a last resort for banks, said an accounting office employee at a commercial bank. Banks generally hold out for as long as possible in hopes a borrower will repay before throwing in the towel by selling a bad loan to an AMC, he said.

The government’s test of a new bad asset securitization program follows industry calls for such a program to help banks dispose of non-performing assets. A similar program started in March 2005 but closed in 2009 due to the financial crisis.

Since January, central bank and CBRC officials have mentioned on several occasions that they will push for bad asset securitization. Details of the program have yet to be finalized.

And the program hasn’t been universally embraced. Li Yamin, a bank analyst at Pingan Securities, does not expect the program to help much because it’s expected to cover only a small number of loans. Other experts think the program will simply shift the burden of bad loans, rather than lead to solutions.

Bad and Worse

Some areas of the economy have been more prone to toxic debt than others. Retailers and certain manufacturers, such as those in the shipbuilding and aluminum sectors, have been particularly hard hit in recent years because their businesses have slowed. Bad loans have been mounting particularly rapidly for mining and trading companies.

“A company’s ability to repay weakens when a business is under pressure, and more new money is borrowed to pay off old loans,” said a CBRC official, adding that many companies in trouble can borrow more from banks through mutual guarantee arrangements with partner companies.

Small businesses have found it increasingly hard to pay off loans, according to a source close to the CBRC. The value of all soured loans tied to small and family-owned businesses rose 250 percent from September 2014 to the same month this year. Meanwhile, toxic debt levels among large companies rose 300 percent year-on-year.

The debt issue’s seriousness also varies by region. The bad loan ratio among banks in the northern province of Shanxi was a high 4.5 percent at the end of March and in the northeastern province of Heilongjiang it was 3.6 percent. But in Zhejiang it was only 2.35 percent at the end of September.

A bank employee in coal-rich Yulin, a city in the northwestern province of Shaanxi, said one local bank’s bad loan ratio has surged to more than 30 percent after years of good times for the coal industry.

Managing Debt

Another problem is that local governments and regulators have encouraged banks to hide bad loans, at least indirectly. The Jiangsu bank executive said provincial CBRC and government officials typically ask local banks to work toward cutting bad loan ratios shorting after loans issued to a major company have soured.

Local governments themselves are under debt pressure. A Ministry of Finance survey in 2014 said nationwide local government debt stood at 15.4 trillion yuan – a figure that many analysts called low.

“The bad loan ratio for (local) bank branches is between 2 percent and 3 percent now,” said a state-owned bank’s risk control manager. “If local government debts were included, the ratio would exceed 10 percent.”

Complicating the bad loan management business are certain regulatory requirements, such as a rules for writing off bad loans, an ICBC official said.

According to the Jiangsu bank executive, one rule says a lender cannot write off a bad loan until all applicable judicial procedures have been followed and failed to secure repayment.

The problem is that sometimes these procedures are so hard to follow that a bad loan cannot qualify for a write-off.

The bank executive would like to see banks given more power to decide whether a loan can be written off.

The CBRC has indeed promised to loosen write-off requirements, but for now, hurdles abound.

For example, under one rule, said a bank accounting department employee, a write-off cannot be completed with a paper certificate issued to the borrower. But some certificates are nowhere to be found, especially if a key executive for a borrowing company has disappeared.

CBRC rules also say that a loan more than 90 days in arrears qualifies for “special monitoring” for being at risk of default. As of October 1, according to government data, 3.77 percent of all bank loans in the country by monetary value were fell into the special monitoring category, 66 percentage points above December 2014’s level.

The total value of special monitoring loans on October 1 was 800 billion yuan, up 200 percent from the same time 2014. Meanwhile, 20 percent of all special monitoring loans had been downgraded to riskier categories of non-performing loans.

At banks many loans “tied to problematic lending are in the special monitoring category,” said a Huarong executive.

Ratings agencies and financial analysts have been paying close attention to the special monitoring system. The ratings agency Moody’s, for example, recently commented on the fact that special monitoring loans at Pingan Bank, a Ping An Insurance subsidiary, rose to 3.58 percent of all lending as of July 1 from 2.85 percent in December.

This increase is “an indicator that the risk of a possible deterioration of the bank’s assets, especially amid the economic downturn, is rising. The bank’s bad loan ratio is likely to rise,” a Moody’s report said.

Tang Xiuli, vice president of Wenzhou Bank in the Zhejiang city of the same name, wrote in June in an article published in a journal under the central bank, China Finance, that banks lack adequate bad-loan provisions because their balance sheets are inaccurate. These inaccuracies have further disturbed regulators’ policymaking process.

A report by China Orient said “the real bad loan ratio is likely to be double the figure on the books.”

For now, banks are managing. But over the long run, high bad loan ratios “will hurt shareholders and depositors’ confidence in a bank,” said a Jiangsu bank staffer. “They have to deal with it.”

The Jiangsu bank executive said some banks have formed special teams whose job is to address bad loan issues. Many banks have also set aside more money to hedge against future losses. And a summertime downturn for China’s stock markets stoked banker fears.

“Every bank feels upset,” the executive said. “But it’s something we have to face.”