Are Chinese banks massaging their losses? | FT Alphaville

Are Chinese banks massaging their losses?

Ratings agencies aren’t generally known for expressing negative views, but Fitch has really done a number on Chinese banks in its annual review on the sector, currently making headlines around the world.

The basic idea is that while Chinese banks appear largely unscathed from the credit crisis there are things going on beneath the surface of Chinese finances.

For instance, the asset quality of the country’s banks:

For more than a year, Fitch has been voicing concern about the asset quality outlook for banks in China. But rather than worsening, the asset quality figures reported by most Chinese banks have actually been improving in 2009 . . .

Fitch has emphasized all along that asset quality deterioration is a medium‐term issue for banks in China because of the extended time it can take for loans to be recognized as impaired due to widespread rolling‐over of delinquent credits and the bullet‐oriented structure of most corporate lending. This is not to be overlooked, as one could argue that many of the flaws in the global financial system might still be hidden today if banks in the US had been more lenient in classifying delinquent mortgages.

Ouch.

In fact, if you dig deeper into the numbers, Fitch says, there was basically CNY450bn ($66bn) missing  in non-performing (NPLs) and special mention (SM) loans in 2008.

China’s listed banks began disclosing the downward rate of migration within their five-tier loan classification brackets in 2009. It’s basically the rate that loans are deteriorating. And as Fitch notes, “at first glance, some of the ratios are surprisingly high given how little movement there is each period in the balances of NPLs, SM loans and charge-offs.”

For instance, in 2008 listed Chinese banks reported an average migration rate of normal loans to NPL or Sm status of 3.7 per cent. According to Fitch’s calculations, that would imply about CNY500bn of combined new NPLs and SM loans in 2008 — but the reported amount of NPLs and SM loans adjusted for charge-offs rose by only CNY50bn. What happened to that other CNY450bn?

Are Chinese banks, in FT Alphaville parlance, err, massaging their losses?

Here’s what Fitch suggests:

  • The migration ratios currently reported by many banks appear to be systematically overstated owing to deficiencies in the mathematical formulas underlying the ratios; and
  • even taking into account this overstatement, it would appear that a substantially greater amount of loans are migrating to SM and NPL status each period than changes in the balances of NPLs or SM loans would indicate. This means that a large number of existing NPLs and SM loans must either be moving upward in the classification, or getting repaid or disposed of to offset this downward movement.

That might not sound too bad, but bear in mind the discrepancy effectively means the migration numbers currently reported by Chinese banks can’t be relied upon, and are pretty much useless when it comes to comparing one bank’s migration rate against another’s.

And on the second point — the mysterious movements in loans — there’s a much bigger issue at play:

Over the past two years, the most disconcerting trend Fitch has observed in China’s banking sector is the growing prominence of unreported loan transactions. In a special report in September 2008, the agency highlighted one type of this activity, which is the sale and re‐packaging of loans into wealth management products that are then sold on to investors. Since that time, Fitch has noticed the growing popularity of another type of transaction, which is the outright sale of loans to other financial institutions. In both instances, the vast majority of activity is not recorded by Chinese banks on‐ or off‐balancesheet, and therefore is invisible to investors and analysts.

The idea here is that repackaging or selling off these loans allows China’s banks to free up space to extend new loans and keep up with the state’s rather rigorous lending quotas.

The banks themselves say such transactions aren’t an issue, since the credit risk is totally transferred to the buyer — hence why they don’t disclose them in their financial reports. But Fitch worries that the banks could still be “reputationally liable” for losses on the loans. They note that:

Indeed, in the very few instances of default on loans underlying wealth management products to date, Chinese banks either have stepped in and completely covered investor losses, or are engaged in heated legal disputes.

While Fitch has major concerns about the transparency of this activity, it recognizes that to some extent it is a natural outgrowth of a rapidly developing financial system, where capacity to extend new credit is facilitated by active securitization markets. However, China is in the awkward position of having reached the point where greater securitization could be helpful precisely at a time when the reputation of all securitization activity has suffered a major blow. Nevertheless, allowing such activity to continue in an unregulated manner with extremely poor disclosure could lead to substantial hidden contingent liabilities, and is one of the major factors weighing on the Individual Ratings of Chinese banks.

Maybe not massaging their losses then, but certainly (potentially) their liabilities.

The whole report is really worth reading.

Related links:
Chinese capital likely more strained, Fitch says – Bloomberg
Tidying up after China’s lending binge – WSJ