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In response to the deepening property debt crisis affecting China’s economy, several of the country’s major banks have intensified their examination of smaller financial institutions’ asset quality and have implemented stricter standards for interbank lending, according to three undisclosed sources.
Over the past few months, two prominent state-owned banks and a leading joint-stock bank have increased their assessments of smaller lenders to identify those with subpar asset quality and a heightened risk of default, the sources revealed.
The state-owned banks have chosen to reduce interbank lending limits and establish shorter maturity periods for smaller peers identified as high risk, as per two of the sources familiar with the matter.
This move comes amid growing concerns about the well-being of smaller banks in the world’s second-largest economy. The ongoing property sector crisis and escalating local government debt have made these smaller institutions a vulnerability in the financial system.
The cautious stance adopted by larger banks in dealing with their smaller counterparts could exacerbate capital challenges for the latter, given their limited fundraising options. This situation might necessitate intervention from Beijing, requiring more supportive measures.
While larger Chinese banks typically rely on customer deposits for loans, smaller lenders have increasingly resorted to borrowing from local peers to raise funds. Data from the China Foreign Exchange Trade System (CFETS) reveals that mid-sized and smaller banks account for about half of the trading volume in the interbank lending market.
One senior official at a leading joint-stock bank, involved in reviewing credit exposure to smaller peers, stated that the bank has tightened its lending criteria. As part of this approach, the bank has ceased purchasing bonds issued by smaller banks with total assets below $40 billion.
Despite the measures being taken by local authorities to support the banking system, particularly smaller banks, concerns persist about the financial stability of the smaller institutions. Some local governments in China have sold record amounts of special bonds to inject capital into troubled regional lenders.
While around 4,000 small banks may not individually pose a systemic risk, the worry is that many of them have primarily funded themselves through short-term money market borrowing, creating collective risks if a few fail.
The increased reliance on interbank lending for funding makes banks more sensitive to counterparty risk. While the Big Five banks dominate the sector, smaller banks still account for a significant quarter of assets.
Some of the smaller lenders reviewed by big state-owned banks were identified as risky and located in highly indebted areas, such as parts of Northeast China, Inner Mongolia, and Henan province, according to sources.
The interest rates on negotiable certificates of deposit (NCDs), a routine fundraising tool for small lenders, have risen steadily in recent months, reflecting a liquidity gap amid heavy debt supply.
In a sign of growing stress, ten small and medium-sized banks defaulted on commercial paper at least three times over six months last year, according to a statement released on Nov. 30 on the Shanghai Commercial Paper Exchange website.
The banks include Ningxia Helan Rural Commercial Bank and Shaanxi Baoji Weibin Rural Commercial Bank, among others.
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