China's Banks: Big, Profitable, Starved For Capital

Neil Gough Dealbook April 23, 2012

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HONG KONG "” China's banks are among the biggest and most profitable financial institutions in the world.

But the state-backed banks are also starved for capital after an aggressive lending spree that was encouraged by the government.

Within the last year, seven of the biggest Chinese banks tapped the markets for 323.8 billion renminbi ($51.4 billion ) in new funds, according to Citigroup estimates. Several financial firms are expected to raise another $17.7 billion in the next few months, with China's fifth-biggest lender, the Bank of Communications, accounting for $9 billion.

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Banks around the world have been tapping investors for new funds as they struggle with slumping share prices and waning profits. But Chinese firms have maintained that their profit growth is strong and their balance sheets are solid, raising red flags among some analysts about the banks' persistent capital needs.

The concerns were heightened after rare and blunt criticism by Prime Minister Wen Jiabao. In early April, he accused banks of reaping easy profits, and called for breaking up the monopoly held by the country's biggest lenders.

"Frankly, our banks make profits far too easily. Why? Because a small number of major banks occupy a monopoly position, meaning one can only go to them for loans and capital," Mr. Wen said, according to China National Radio. "That's why right now, as we're dealing with the issue of getting private capital into the finance sector, essentially, that means we have to break up their monopoly."

The uncertainty introduced by Mr. Wen's comments means China's banks may find it harder to raise capital, especially if investors are worried about a breakup of the banks’ dominant position. But the irony is that this "monopoly" has served none better than the Chinese state.

Before they started going public a decade ago, all of China's major banks were, in effect, lenders for government policies. Now, despite partial reforms to the broader financial system, the banks remain integral to the Chinese model of state-directed capitalism, where government-supported firms and projects enjoy preferential access to banks loans at what many analysts say are artificially low interest rates.

The current wave of bank capital-raising is partly the legacy of an unprecedented, multiyear lending boom. Beijing responded to the financial crisis with a 4 trillion renminbi national stimulus plan. The initiative relied heavily on infrastructure spending and was primarily financed with loans from the state-controlled banking industry. Local governments chipped in with additional spending of their own, which likewise depended on banks to finance projects.

This lending spree has proved to be extremely profitable for the banks, as Mr. Wen observed. The country's four biggest lenders reported combined profits of 623 billion renminbi for 2011, up about 25 percent from 2010.

The least profitable among them "” the Agricultural Bank of China "” made $18.9 billion last year. That is just shy of the $19 billion that JPMorgan Chase, America's most profitable bank, made last year.

This week, the so-called Big Four are expected to report that first-quarter profit rose 10 to 26 percent, according to Simon Ho and Paddy Ran at Citigroup in Hong Kong.

But banks' balance sheets have ballooned as a result. Last month, China's four biggest lenders "” Industrial and Commercial Bank of China, the Bank of China, China Construction Bank and Agricultural Bank of China "” reported a combined 14 percent increase in total assets, to 51.3 trillion renminbi. That is roughly the size of the German, French and British economies combined.

So far, the banks appear to have emerged unscathed. The Big Four lenders all showed declining levels of nonperforming loans last year. On average, such troubled loans at the four banks fell in 2011 to 1.15 percent of total lending, down from 1.34 percent in 2010.

But the worry is that, over time, the massive infrastructure, real estate and other projects that were the products of China's stimulus-driven lending binge will fail to turn a profit. Borrowers, including local governments, may then fall behind on their interest payments and could default on their loans. Much concern has centered on local-level governments, which had racked up a debt pile of 10.7 trillion renminbi by the end of 2010, according to official estimates.

Analysts say a wave of souring loans will have a magnified effect on the Chinese banking industry, given its historically weakened capital position.

"For the first time, a large number of Chinese banks are beginning to face cash pressures," Charlene Chu, a banking analyst at Fitch Ratings, wrote in a research report. "It is because of this cash constraint that the forthcoming wave of asset quality issues has the potential to become uglier and more destabilizing than in previous episodes of loan portfolio deterioration."

The potential risks on banks' loan books can be unpredictable.

China's ambitious plans to construct a nationwide high-speed rail network, for example, have been praised by politicians from Shanghai to Sacramento as the kind of aggressive stimulus spending that yields instant and tangible economic benefits. But a collision between two trains on a high-speed rail line in eastern China in July, which killed 39 people and injured more than 200 others, has prompted some rethinking in Beijing. Now, analysts question whether the Ministry of Railways can continue servicing the more than 2 trillion renminbi in debt that it amassed before the accident.

The systemic risks of a bad debt bubble bursting are not lost on Chinese banking regulators, who are trying to require banks to bolster their reserves. Under a new set of rules, the country's biggest lenders will need to increase their capital levels to 11.5 percent of assets by the end of 2013. Their core Tier 1 capital ratio, the strictest measure of a bank's ability to withstand financial shocks, will need to be at least 9.5 percent. These requirements are more rigorous than the rules that apply to American and European banks.

But increasing regulatory capital may not be enough, because that only focuses on the loans that banks keep on the books. In late 2010, financial regulators in China started cracking down on new loan growth in order to fight inflation. Seeking to comply with regulators, but also to continue chasing profits, banks responded by pursuing newer and more creative forms of off-balance-sheet lending. A GaveKal researcher, Joyce Poon, who is based in Hong Kong, has estimated that outstanding off-balance-sheet lending rose to around 12 trillion renminbi by the first half of 2011, doubling since the end of 2009.

"China's conservative turn in financial regulation, while understandable given the global excesses that led to the 2008 financial crisis, meant that financial institutions' search for profits increasingly led them into regulatory gray areas," Ms. Poon wrote in a research report.

China's leading banks have another reason for devouring capital. They need to maintain big dividend payouts to their biggest shareholder: the state.

The firms' recapitalization programs are "largely due to massively excess dividends the banks have paid in recent years," said Nicholas Lardy, an expert on the Chinese financial system and a fellow at the Peterson Institute for International Economics in Washington.

The problem is that paying out high dividends blows holes in their base capital. Thus, banks need to continue tapping the markets for fresh funds, often diluting minority shareholders by issuing new shares. The finance ministry, the banks' ultimate controlling shareholder, always buys in, keeping its stakes topped up.

The amount of cash that is churned in the process is staggering. In 2010, China's five biggest banks (the Big Four plus the Bank of Communications) paid more than 144 billion renminbi in dividends and raised more than 199 billion renminbi on the capital markets, according to GaveKal.

"This is the nonsense of it," says Fraser Howie, a managing director at CLSA Asia-Pacific Markets, who is based in Singapore and is a co-author of "Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise." "There's an awful lot of money just going round and round from one pocket to another, giving the appearance of strength when it's really not there."

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