Chinese banks in a tight spot as capital adequacy ratio cut-off period looms
MONEY CHANNEL: Bank of China, the second-biggest lender on the mainland, says it is eyeing a listing in Hong Kong in the first half of this year, to improve its competitive edge
China’s domestic banks are in a race against time as they rush to meet an important deadline. By December 31 this year they are expected to have reached the statutory 8-percent capital adequacy ratios set by the China Banking Regulatory Commission (CBRC). Yet as the date approaches, many banks are far from ready.
According to its World Trade Organization commitments, China is scheduled to scrap restrictions in terms of ownership, operation and establishment on foreign banks operating in China in December.
At that time, foreign banks will be allowed to provide retail renminbi business to local residents and set up branches in any Chinese city.
In order to improve its capital structure, Bank of Beijing issued 3.5 billion yuan of subordinate debt on December 26, 2005 through a private placement. Shanghai Pudong Development Bank and Huaxia Bank also said they are trying hard to raise money for a desperate cash injection.
“If they fail to reach the international standard, they would not only violate government policy, but ruin their reputation. That will be bad news for their development,” said Professor Liu Fuxiang of the University of International Business and Economics.
According to Liu, if a bank fails to reach the standard, CBRC would ask it to replenish its capital or shrink its business according to Prompt Corrective Action. If it then fails again, these banks will risk the danger of being merged or restructured.
A percentage of the asset base, the capital adequacy ratio refers to the ratio of a bank’s capital to its risk-weighted credit exposure. It’s vital for a bank’s survival and development, as well as a country’s financial security.
Statistics show that only 25 of China’s over 130 banking corporations currently meet the standard in terms of capital adequacy ratio.
Enormous gap
IN NEED OF FUNDS: The Industrial Bank Co. has become the first Chinese bank to issue hybrid capital bonds to replenish capital
According to Yin Zhongli from the Financial Research Institute of the Chinese Academy of Social Sciences, the CBRC released Measures Governing Capital Adequacy Ratio for Commercial Banks in March 2004, quickening its steps in integrating with the international standard in terms of capital supervision.
Based on the document, capital adequacy ratios of Chinese commercial banks must reach over 8 percent after 2007. It means the banking industry needs to find more than 200 billion yuan every year, posing a major challenge to the sector.
Though major state-owned banks eased their pressure in this regard through listing on the stock market, there are no signs of quick cash fixes for most other commercial banks.
Yin said domestic commercial banks were eager to make loans before 2004 as asset growth, business expansion and market shares were important operation targets at that time. This produced generally low capital adequacy ratios, poor asset quality and accumulative risk.
Huaxia Bank Governor Wu Jian said that generally low capital adequacy ratio of the Chinese banking industry was attributed to three aspects.
First, excessive credit exhausted a large amount of capital. It is estimated that between 1999 and 2003, the loans of 14 national commercial banks increased 16.35 percent on average every year, 8.41 percentage points higher than GDP (gross
domestic product) growth. Of them, loans of 10 joint-stock banks jumped 33.82 percent every year, 25.88 percentage points higher than GDP growth. But the growth of their capital was slow, leading inevitably to an enormous capital gap.
Second, unreasonable asset structures worsened the capital consumption. For Chinese commercial banks, loans generated for various institutions accounted for 90 percent of total credit, but private consumption loans made up only about 10 percent. Thus, the capital adequacy ratio decreased continuously because of over-large risk assets and limited capital supply.
Third, bad assets ate into the capital. According to the CBRC, non-performing loans of major Chinese commercial banks stood as high as 13.21 percent by 2004. If these major banks need to make provision for these bad loans according to regulations of the People’s Bank of China, the central bank, the sum would amount to 1.2 trillion yuan.
Meanwhile, the banks also need to make provision of over 450 billion yuan for enormous non-credit asset losses, and the provision can’t be reckoned into the banks’ capital.
As competition in the financial market gets tougher, the capital burdens on commercial banks might not ease up for a while, and the capital gap would probably broaden, Wu said.
Tight credit?
The shortage of bank capital has made financial experts worry that a credit crunch might be on the cards for China this year. The type of credit crunch referred to differs from the government tightening policy to cool down the over-heated investment in the last two years, in that it points to the measures of more deposits and less or no loans adopted by commercial banks aiming to raise the capital adequacy ratio.
The worry is not groundless. According to central bank figures, the ratio of deposits to loans of financial institutions in January 2006 decreased 5.4 percent compared to the same period last year. In fact, various commercial banks began a credit squeeze last year and their credit in 2005 shrank by a large margin compared with 2004.
Xia Bin, Director of the Financial Research Institute under the Development Research Center of the State Council, said in early 2005 that the worrying fact was not money supply but the credit squeeze.
In the past, most banks sought to expand blindly even though they had insufficient capital. But now that the CBRC has made the bottom line clear, commercial banks have to behave themselves, said Xia.
According to Xia, once commercial banks tighten credit, small and medium-sized enterprises would suffer heavy blows, as most of their loans are with these joint-stock banks instead of the four state-owned giants--the Industrial and Commercial Bank of China, Bank of China, China Construction Bank, and Agricultural Bank of China.
Multi-channels
Last December, the CBRC issued the Notice on the Issuance of Hybrid Capital Bonds by Commercial Banks for the Replenishment of Supplementary Capital, allowing eligible commercial banks to issue hybrid capital bonds and include them in their supplementary capital. This important tool, recognized by the Basel Accord for the capital replenishment, opened a new channel for Chinese banks to raise their capital adequacy ratios.
With the CBRC’s approval, the Industrial Bank Co. has become the first Chinese bank to issue hybrid capital bonds to replenish capital.
The new channel will help commercial banks to expand quickly this year. It is reported that China Merchants Bank, China Minsheng Banking Corp. and Huaxia Bank are also going to issue such bonds to ease capital pressure for further expansion.
Before this, commercial banks usually used foreign money or issued subordinated debt to replenish capital. Other channels include profit deduction, stock or bonds issuance, or private equity offering.
But the average return on assets of China’s stock market-listed banks is as low as 0.35 percent, so only a very small part of capital comes from profit. Therefore, issuing bonds and inviting strategic foreign investors are the main methods for them to replenish capital.
Last year, many foreign financial institutions bought stakes in Chinese banks. According to CBRC Vice Chairman Tang Shuangning, so far some 19 overseas financial institutions, including ING Group, International Finance Corp., Deutsche Bank, Goldman Sachs Group and Allianz Insurance, became shareholders of 16 Chinese banks, producing a total investment of almost $16.5 billion.
In 2003, the CBRC raised the limit of 15 percent to 20 percent for the stake a single foreign investor can hold in a domestic bank and increased the limit from 20 percent to 25 percent for all foreign shareholdings in a bank.
Problems remain
Some officials and experts are worried about commercial banks’ issuance of such a large amount of bonds.
CBRC Vice Chairman Tang Shuangning believed that the most important task right now is to keep away the risk that might arise from banking institutions engaged in bond business. “Attention should be paid to excessive mutually held subordinated bonds,” said Tang.
He pointed out that being in possession of excessive mutually held subordinated bonds does not really raise their capital adequacy ratio, and risks of commercial banks are not dispersed outside the banking system. Once problems occur, a systematic financial crisis, including financial institutions and the bond market, might be sparked.
Pan Gongsheng, head of the stock reform office of the Industrial and Commercial Bank of China, said as hybrid capital bonds issuers could legally delay the payment of principal and interest of holders without breaking contracts, investors might suffer losses. Moreover, as the term of hybrid capital bonds is as long as over 15 years, their trading might be sluggish and they might be difficult to cash.
Despite all these capital-raising channels, most commercial banks still find it difficult to replenish sufficient capital.
Huaxia Bank Governor Wu said the hope of raising funds through the capital market is slim. Currently, the annual funding quota of the domestic capital market is only about 100-200 billion yuan, which is far from the gap of the banking industry.
Meanwhile, domestic commercial banks have to pay heavy taxes, including 5 percent sales tax and 33 percent income tax, which eat into profits.
Those joint-stock banks also have to distribute dividends to shareholders. So far, it’s unrealistic to raise capital through improving profit capability.
Finally, the cost of capital replenishment is high. Due to a sluggish stock market, strict supervision, and complex approval process, commercial banks can’t implement their fund-raising project according to plan. To commercial banks in urgent need of capital, the capital raised by any channel can support their expansion for only one year, and they are stuck in financing troubles every year.