Banks need more capital after credit boom, IMF says

China’s banks should increase their capital buffers to protect against any sudden economic downturn following a credit boom, the International Monetary Fund said.

In its first comprehensive assessment of China’s financial system since 2011, the IMF recommended “a gradual and targeted increase in bank capital.” In a worst-
case scenario, IMF stress tests suggested the country’s lenders would face a capital shortfall equivalent to 2.5 percent of China’s gross domestic product – about USD280 billion in 2016 – together with ballooning soured loans.

Overall, 27 of 33 banks stress-tested by the fund, covering about three quarters of China’s banking- system assets, were under-
capitalized by at least one measure. A larger financial cushion would better reflect potentially underestimated risks stemming from the banks’ exposure to opaque investments, and absorb losses as implicit government guarantees are removed, the fund said.

China’s top four banks, led by the world’s largest lender by assets Industrial & Commercial Bank of China Ltd., have enough capital, the fund said. But it said the nation’s smaller lenders, including those focused on individual cities “appear vulnerable.”

The findings reflects the burden on a financial system that’s doubled in size in 10 years while China evolves from an export-oriented economy to one based on services and consumption. The call for capital highlights the risks during that transition caused by government policies aimed at protecting jobs or propping up failing state entities.

“Stress test results reveal widespread under-capitalization of banks other than the Big Four banks under a severely adverse scenario,” the fund said in its report. “Increasing capital would enhance the resilience and credibility of the financial system, as well as reassure markets.” The fund didn’t name the specific banks that need more capital.

Responding to the report, the People’s Bank of China said the assessment was generally fair but disputed the IMF’s interpretation of the stress test results.

“Comments about the stress test in the report do not fully reflect the results of the tests,” the central bank said in a statement on its website. “China’s financial system has shown relatively strong capability to cope with risks.”

President Xi Jinping has highlighted financial stability as a top priority. People’s Bank of China Governor Zhou Xiaochuan warned in October about the risk of a ‘Minsky moment,’ or a sudden collapse of asset values.

Speaking to media yesterday on a video call, the IMF’s deputy director of monetary and capital markets, Ratna Sahay, said China’s financial system held three main risks. She pointed to an increase in credit that in other countries has been linked to financial distress. An increasingly complex and opaque financial system makes it hard to identify risks, and implicit guarantees encourage excessive risk-taking, she said.

Credit growth needs to slow, guarantees should be gradually removed, and banks need more capital during that process, Sahay said. “Banks need to have some buffers in order to protect against any possible distress that might happen,’’ she said.

While bank capital shortfalls “appear manageable,” the fallout from any deleveraging process could amplify the need for funds, the IMF said in its report. In a “severely adverse scenario,” the capital shortfall at 33 banks tested by the fund could amount to 2.5 percent of GDP, it said.

“We are talking about capital shortfalls in a stress-testing scenario,” Sahay told Bloomberg Television’s Kathleen Hays in an interview. “It’s in that scenario, it’s not the current situation. They are moving in the right direction, they understand that the risks are large and they are mitigating them.”

China’s credit growth has outpaced expansion in GDP, and the credit-to-GDP ratio is now about 25 percent above the long-term trend, the IMF said in its report. Such a level is “very high by international standards and consistent with a high probability of financial distress,” the fund said.

The official proportion of non- performing loans at banks – 1.7 percent in the second quarter of 2017 – may understate the reality, the IMF said. The true extent of soured loans at Chinese banks has been debated by analysts and investors for years. The People’s bank of China said Thursday the ratio has stayed low because banks have written off bad debts.

Under the IMF’s “severely adverse” scenario, the non-performing loan ratio at the 33 tested banks jumps to 9.1 percent from 1.5 percent, and their common equity Tier 1 capital ratio, a benchmark gauge of financial strength, plunges 4.2 percentage points. Banks would be unable or unwilling to maintain their pace of lending, and the fiscal impact might exceed the direct recapitalization needs of the banking system “by a wide margin,” the IMF said.

The dangers in removing implicit guarantees in China – the belief among investors that the government will compensate them for losses – and the risks posed by off-balance sheet items also justify higher levels of capital, two of the report’s authors, Sahay and James P. Walsh, said in a separate article accompanying the report’s release. Wealth management products, hugely popular investments that offer superior yields to traditional bank deposits, make up a large proportion of China’s shadow banking sector.

“Off-balance sheet WMPs also represent a significant risk to capital,” the report said. “They are not guaranteed, but banks almost always compensate retail investors for principal losses. In a stress scenario, the costs to the banks of supporting WMPs could be substantial and could, in case of a run, place the liquidity position of some banks under strain.”

The IMF also ran stress tests to assess liquidity at China’s banks. While conditions at China’s four big banks were strong, the tests showed that four banks would suffer liquidity shortfalls within 30 days, the IMF said. Late Wednesday, China’s banking regulator unveiled new liquidity thresholds for small banks, saying it needed to fill a gap in its supervision.

Authorities need to put less focus on high GDP projections, and better supervise financial conglomerates and reforms to tackle implicit guarantees, the IMF said. But allowing firms to fail and investors to lose money will be challenging.

“Credit growth will not slow sustainably unless tolerance for job losses and slower economic growth rises, particularly at local level, and new sources of revenue are found for local governments,” Sahay and Walsh wrote in their article.

Total borrowing will climb to around 328 percent of gross domestic product by 2022 from around 260 percent in 2016, according to Bloomberg Economics.

Among the IMF’s recommendations

Create a body, focused solely on financial stability, to improve oversight of systemic risk. Financial supervisors need to have greater independence to pursue their mandates without concern about being overruled. Banks should hold more liquid assets, and rules on lending among financial institutions should be amended to encourage safer, and longer-term, lending. Reforms to reduce the reliance on public funds in managing weak financial institutions, while ensuring they can fail safely. Address data gaps that impede systemic risk monitoring and effective financial regulation and supervision