How Could Chinese Banks Lose More Than 30% of Their Equity?

06 Apr 2016

Life is really simple, but we insist on making it complicated – Confucius

Some market players believe that China would see a banking crisis soon, with losses expected to amount to USD3.5 trillion, or 30.4% of the banks’ total equity, or four times larger than the equity hit that US banks took during the subprime crisis.  Recent reports that China had almost USD600 billion unpaid receivables, the largest amount since the late 1990s, only aggravated such fears.

To understand the rationale of this “Armageddon” scenario, one needs to know where the biggest risk exposure of the Chinese banks is.  It is not the loans to the state-owned enterprises (SoEs) or the households.  The former enjoys implicit guarantee from the government and the latter has a strong balance sheet.

The highest credit risk lies in the loans to the corporate sector and non-depository financial institutions (NDFIs).  The latter include investment companies, brokerages, trust companies, auto-financing and financial leasing companies and private loan companies.  They do not enjoy the same degree of implicit guarantee as the SoEs and the banks, and are not regulated properly.

According to banking and official data, loans to the enterprises and NDFIs totalled RMB79.4 trillion in 2015 (see Table 1), which accounted for 84.5% of total loans.  Let us assume two loss scenarios, one with a 10% loss and the other with a 15% loss on these loans.

Official data shows that the banking system had an aggregate RMB2.3 trillion loan-loss provisions last year.  Experience also shows that Chinese banks had an average bad-debt recovery rate of 20%.  Assuming all the provisions would be used to cover losses and the same bad-debt recovery rate going forward, the potential net loss to the banking system would amount to RMB4.0 trillion and RMB7.2 trillion under scenario 1 and 2, respectively (see Table 1).

Chinese banks had an aggregate equity capital of RMB13.1 trillion in 2015.  The stylised example here shows that if banks’ bad-loan ratios were to rise to 10% or 15%, the estimated losses could wipe out 31% to 55% of the banks’ aggregate equity (see Table 1).

The losses we have assumed here are arbitrary.  If realised losses were lower/higher, the hit on banks’ equity would be lower/higher.  Given the prevailing economic weakness in China, a 10%-15% non-performing-loan scenario looks plausible.  There could also be bad debt arising from other loan categories.

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