China’s vanishing banks are threatening social stability

China’s Banking Crisis

·         Chinese state is struggling to deal with troubled institutions

·         China’s worst-performing small banks have threatened social stability

The Chinese banking crisis poses a severe threat to the nation's financial stability. As smaller banks collapse or are absorbed into larger ones, the risk of systemic failure grows. This crisis, fueled by bad loans and exposure to the property market downturn, has the potential to undermine social stability and erode public trust in financial institutions and the government's ability to manage the economy.

The worst-performing small banks have already threatened social stability, the main concern of Xi Jinping, China's leader. Fraud on a large scale caused several to freeze withdrawals in 2022, drawing depositors onto the streets of a provincial capital. But state intervention is risky, too.

The savings and loan (S&L) crisis terrorized America’s banks for years. Starting in the mid-1980s, a mix of aggressive lending growth, poor risk controls and a property downturn contributed to the collapse or consolidation of over 1,000 small lending institutions. China’s smallest banks are now suffering from many of the same ailments. But until recently few have collapsed or merged with others.

Disappearing Banks

That is starting to change. In the week ending June 24th, 2024, 40 Chinese banks vanished as they were absorbed into bigger ones. Not even at the height of the S&L crisis did lenders disappear at such a clip.

China's banking sector is facing a full-scale crisis. In just one week, 40 banks disappeared, absorbed into larger institutions. Today, Jiangxi Bank of China went under, further escalating the crisis. China's smaller banks are struggling with bad loans and exposure to the ongoing property crisis. Scope of the Problem Some 3,800 such troubled institutions exist. They have 55 trillion Yuan ($7.5 trillion) in assets—13% of the total banking system—and have long been mismanaged, accruing vast amounts of bad loans. Many have lent to real estate developers and local governments, gaining exposure to China’s property crisis. In recent years, some have revealed that 40% of their books are made up of non-performing loans. Bank of Jiujiang, a mid-tier lender, recently revealed that its profits might fall by 30% due to poorly performing loans. This rare disclosure highlights the severity of the situation. The authorities have been pushing for more transparency, but the true extent of the bad debt problem is still emerging. The four state AMCs created to manage bad debts are now struggling themselves, with one needing a $6.6 billion bailout in 2021.

China’s main way of dealing with small, feeble banks: making them disappear. Of the 40 institutions that vanished recently, 36 were in the Liaoning province and absorbed into a new lender, called Liaoning Rural Commercial Bank, which was created as a receptacle for bad banks. Since it was set up in September, five other institutions have been established to do similar work, with more expected.

The Root Cause: Property Sector Recession

China's property sector is in a deep recession. Overextended real-estate developers and local governments have defaulted on loans, creating a cascade of financial instability. Property prices have plummeted, and construction projects have stalled, further straining the financial system.

"The Chinese property market crisis has become a significant drag on the country's economy, with real estate investment declining by nearly 10% in 2024. The collapse in consumer confidence, driven by job insecurity and defaulted project deliveries, has left a surplus of unsold properties valued at $4 trillion. As China’s real estate sector, which once contributed 30% to its GDP, falters, it threatens not just domestic growth but also has far-reaching implications for global trade and commodity markets."

Hidden Bad Debts and Regulatory Crackdown

Adding to the complexity, banks have been using asset-management companies (AMCs) to offload toxic loans, creating a facade of stability. These AMCs buy bad loans but avoid taking on the credit risks, leading to a buildup of hidden bad debts. The National Administration of Financial Regulation (NAFR), a new banking regulator, has been cracking down on these practices, issuing fines and increasing oversight.

What is coming?

This regulatory vanishing act will probably pick up pace. S&P Global, a rating agency, reckons it will take a decade to complete the project. While fewer bigger banks are easier to regulate, combining dozens of bad banks only creates bigger, badder banks. The fact remains that the Chinese economy is in an extended and pretend state. Years of credit-fueled growth has finally run its course, and the result will lower growth for China and a negative impact on the global economy. Slower growth of the Chinese economy will, in turn, exacerbate their banking problems too. This will very likely end in massive liquidity injections, stimulation of the economy, and investors flocking to hard assets. As China’s economic growth slows further, technocrats will need to do more than wave a wand at the problems of the lowest rung of the banking system.

China’s Vanishing Banks threaten Social Stability

China is grappling with a significant threat to its social stability due to the failing health of its small banks. Under the leadership of Xi Jinping, social stability is a primary concern, yet the worst-performing small banks are exacerbating this issue. A massive fraud in 2022 led several banks to freeze withdrawals, causing depositors to take to the streets in protest. While state intervention is an option, it carries its own risks.

The Savings and Loan (S&L) crisis in the United States offers a historical parallel. Beginning in the mid-1980s, aggressive lending, poor risk controls, and a downturn in the property market led to the collapse or consolidation of over 1,000 small lending institutions. China’s smallest banks are now suffering from similar issues. Until recently, few had collapsed or merged, but that is changing. In the week ending June 24th, 40 Chinese banks were absorbed into larger institutions. This rate of consolidation surpasses even the height of the S&L crisis.

The full-scale crisis in China’s banking sector is becoming increasingly evident. As of today, Jiangxi Bank of China has also gone under, further escalating the situation. These smaller banks are overwhelmed by bad loans and their exposure to the ongoing property crisis. There are approximately 3,800 troubled institutions with 55 trillion Yuan ($7.5 trillion) in assets, which constitutes 13% of the total banking system. These banks have been poorly managed for years, accruing vast amounts of bad loans, often lending to real estate developers and local governments, thereby gaining significant exposure to China’s property market downturn.

Scope of the Problem

Many small banks have non-performing loans comprising up to 40% of their books. For example, the Bank of Jiujiang recently disclosed that its profits might fall by 30% due to poorly performing loans, a rare and alarming transparency. The authorities are pushing for more disclosure, but the true extent of the bad debt problem is still emerging. The four state Asset Management Companies (AMCs), created to manage bad debts, are now struggling themselves, with one requiring a $6.6 billion bailout in 2021.

China Shadow `Banking System is failing 

Shadow Banking: China has faced challenges related to its shadow banking sector, which refers to non-bank financial activities (NBFCs) outside the traditional banking system. The government has implemented measures to rein in shadow banking activities and reduce associated risks. China's shadow banking system has expanded dramatically since the 2008 international financial crisis, causing widespread concern. In December 2020, a report by the Policy Research Bureau of the China Banking and Insurance Regulatory Commission conducted an in-depth study of China’s shadow banking problem for the first time. 

The development history of China’s Shadow Banking

I.            From the early 1980s to before 2008: Non-bank financial institutions such as trust companies and insurance companies were established, and various institutions mainly developed around their own business scope.

II.            After 2008: Following the international financial crisis, monetary policy became moderately loose, and financial institutions removed rigid constraints on credit scale. To avoid supervision, banks moved a large amount of assets off-balance sheet, leading to the rapid growth of various cross-market and cross-industry shadow banks.

III.            2013: Non-standard assets invested in bank financial management accounted for 27.49% of all financial management. Regulatory authorities issued notices to regulate the financial services of commercial banks.

IV.            2013-2017: Internet financial products and online P2P loans suddenly emerged, and the third-party Internet payment market grew significantly.

The main characteristics of China’s shadow banking

a)      Bank-centered: China’s shadow banking has "bank centralization characteristics" and differs from the shadow banking structure in developed economies.

b)      Regulatory arbitrage is common: Taking advantage of imperfect regulatory systems and inconsistent standards, various institutions engage in regulatory arbitrage activities in the "gray area," leading to many instances of "driving without a license."

c)       Rigid redemption expectations: Most products promise to maintain capital or minimum returns and have rigid redemption expectations. Insufficient information disclosure and low transparency.

d)      Profit from channel fees: China’s shadow banking products are mainly loan-like products, and charging channel management fees is the main profit model.

e)      Outstanding credit risk: Bank-led, customer rating standards are significantly lower than those for loan customers, leading to greater credit risk.

Shadow Banking as Defined by the Financial Stability Board

1.       Two-Step Method

·         Broad scope: Develop a comprehensive understanding of the overall scale of shadow banking through statistics.

·         Narrow scope: By focusing on the risk characteristics of wide-scope shadow banks, separate statistics are made for narrow-scope shadow banks.

2.       Scale of Shadow Banking

At the end of 2020, the balance of wide-caliber shadow banking was 236.44 trillion Yuan, and the balance of narrow-caliber shadow banking was 150.47 trillion Yuan. The two totaled about 386.91 trillion-Yuan, accounting for 87.02% of the assets of national financial institutions.

The role of shadow banking in Chinese financial system is gradually increasing, with potential systemic risks.

3. Evolution of Shadow Banking

3.1 The overall scale has increased overall.

·      Since 2016, the scale of shadow banking has shown an overall upward trend, reaching a peak in 2020.

·      Reasons for the increase in scale include rising demand for credit instrument financing, slowing growth in the real economy, and different understandings of standard definitions by financial institutions.

3.2 The scale of a single institution grows.

·      In the field of shadow banking, the scale of a single institution has grown, and the monopoly effect of financial institutions has become prominent.

·      In 2020, the top five financial institutions in shadow banking accounted for 40.42% of the total balance of wide-caliber shadow banking.

3.3   Risk characteristics are relatively prominent.

·      The risks of shadow banking are mainly reflected in three aspects: credit, liquidity, and interest rate.

·      In 2020, the overall risk of shadow banking is relatively stable, but the risks of individual financial institutions are more prominent, and there are potential risks.

3.4   Regulatory progress of shadow banking

3.4.1      The regulatory system is gradually improved.

·      In 2018, the China Banking and Insurance Regulatory Commission conducted regular supervision of shadow banking for the first time.

·      In 2020, the China Banking and Insurance Regulatory Commission will strengthen supervision in scale management, business management, capital management, risk management, and information disclosure by promoting dual control of the total amount and quality of shadow banking risks.

3.4.2      Dual control of total risk and quality

·      Control the total amount of risks and guide financial institutions to scientifically and rationally allocate funds through integration, selection of the best, and prudence.

·      Risk quality control, by improving the risk management level and strengthening credit risk, liquidity risk, and market risk management.

3.4.3      Further advancement of standardization and specifications

·      Improve the risk quality control mechanism and guide the expansion of the scope of wide-caliber shadow banking, which will help comprehensively respond to shadow banking risks.

3.4.4      Strengthen capital supervision.

·      Strengthen capital constraints on shadow banking and improve risk management levels.

·      Strengthen risk awareness and prevent risk spread.

The report concluded that China's shadow banking system has some problems in terms of scale, risk, and supervision, which require great attention. The China Banking and Insurance Regulatory Commission will further improve the shadow banking supervision system, comprehensively respond to shadow banking risks, and ensure the stable operation of the financial system by promoting dual control of the total amount and quality of risks, strengthening standardization and regulation, and strengthening capital supervision.

China's Real Estate Crisis

Since 2020, China's real estate market has been under significant strain. Potential home buyers are increasingly concerned about job security and future earnings, reducing their intent to purchase property. Additionally, defaults on project deliveries have eroded consumer confidence, exacerbating the situation.

Key Indicators of Decline

a)      Investment Decline: Real estate investment in China has declined by 9.8% in 2024, following a 10% decline in 2023.

b)      Economic Impact: The real estate sector, which used to contribute 30% to China's GDP, has seen a slump that dragged economic growth down to 5% in 2023.

c)       Unsold Assets: The total value of China's unsold land and property is estimated at $4 trillion, up from $3 trillion at the peak of its real estate boom.

China’s real estate crisis has global repercussions, potentially dampening international trade and affecting commodity markets. In response, the Central Bank of China has taken several steps to boost the sector:

a)      Government Funding: China has allocated $41.5 billion to state governments for purchasing unsold property from struggling developers, enabling them to complete delayed projects.

b)      Reduced Down Payments: The minimum down payment ratio has been reduced from 20% to 15%, the lowest in history.

c)       Interest Rate Adjustments: The floor level of the interest rate for individual commercial housing loans has been abolished. In some cities, the rate of interest is as low as 3.5%, but banks can now go below 3% due to ample liquidity in the banking system.

Banks' Narrow Path past Property Crisis

China's major banks have managed to avoid catastrophic failures despite the property bubble burst. However, they face the looming threat of poor earnings. Real estate directly and indirectly accounts for an estimated 159 trillion Yuan of total bank loans in the country, equivalent to 38% of lenders' assets in 2023. Non-performing loans stood at 1.59% of the total at the end of 2023, down from 1.73% two years earlier. This is impressive considering the property sector, which accounts for around a fifth of GDP, is engulfed in a liquidity crisis affecting indebted developers like Country Garden and the bankrupt China Evergrande.

Developers make up a small percentage of banks' real estate exposure. Most of the exposure comes from residential mortgages and corporate borrowing collateralized with property. These loans typically do not exceed 60% of the asset's value and are concentrated in wealthier cities where home values have been stable. Thus far, defaults have been rare. Despite underreporting overall bad loans, Chinese banks spent years before the property crash cleaning up their balance sheets. Since 2016, the face value of total loans disposed of has surpassed 1.5% of GDP annually, reaching nearly 3% or more than 3 trillion Yuan in 2020.

Stable earnings growth in the three years before the pandemic helped: annual net income at the country's five largest lenders grew over 4% on average. However, profitability is being squeezed amid sluggish loan demand and increased household deposits. Average net interest margins on earning assets at the Big Five fell to 1.55% last year from over 2% in 2019, and are forecast to fall further to 1.36% this year.

Recent policy changes have not helped. Earlier this year, the central bank cut a benchmark interest rate used for long-term lending to funnel cheap credit into strategic sectors. Authorities also unveiled new property measures, including a 300 billion Yuan relending program to support unsold home purchases and mortgage rate reductions. Banks are under pressure to lend to cash-strapped developers and renegotiate existing loans with local government financing vehicles, with total LGFV exposure as high as 17% of bank assets.

The Impact on Banks

China's property crisis is bleeding into its banking sector. Non-performing loans at China's big four banks jumped 10.4% in 2023, from 1.117 trillion Yuan in 2022 to 1.23 trillion Yuan. While the banks were profitable last year, their margins are being pressured by the fallout from the real-estate debt crisis. Beijing is urging banks to boost financing for property developers on a "white list" of companies.

The real-estate sector has been in crisis since the second half of 2021, when a liquidity crunch at Evergrande came to light. Evergrande is now in liquidation, and other developers have begun defaulting on bond payments, raising fears that the crisis could spill over into other sectors of the economy and globally.

How failing banks threaten social stability in a country?

Failing banks threaten social stability by causing economic disruption, increasing unemployment, fostering social unrest, eroding trust in institutions, impacting mental health, widening inequality, and potentially leading to increased criminal activity. Effective government intervention and policies are crucial to mitigate these risks and maintain social stability.

1.       Economic Disruption

a)      Loss of Savings: When banks fail, depositors may lose their savings, leading to widespread financial insecurity. This can reduce consumer spending, negatively impacting the economy.

b)      Business Failures: Businesses reliant on bank financing may struggle to operate or expand, leading to increased bankruptcies and unemployment.

c)       Credit Crunch: Bank failures can cause a credit crunch, where loans become scarce, further stifling economic growth and exacerbating financial difficulties for individuals and businesses.

2.       Increased Unemployment

a)      Job Losses: Bank failures often lead to job losses within the banking sector and related industries, contributing to higher unemployment rates.

b)      Economic Downturn: The resulting economic downturn from reduced consumer and business spending can lead to further job losses in other sectors.

3.       Social Unrest

a)      Public Protests: Loss of savings, increased unemployment, and economic uncertainty can lead to public protests and social unrest. People may take to the streets to demand government action and accountability.

b)      Loss of Trust in Institutions: Widespread bank failures can erode public trust in financial institutions and the government’s ability to manage the economy, leading to increased social instability.

4.       Political Instability

a)      Government Credibility: The government may face criticism and loss of credibility for failing to prevent bank failures or adequately protect depositors.

b)      Policy Changes: Political pressure may lead to hasty policy changes or reforms, which can further destabilize the economy if not well-planned and executed.

5.       Mental Health Impact

a)      Stress and Anxiety: Financial losses and economic insecurity can lead to increased stress, anxiety, and other mental health issues among the population.

b)      Social Strain: The mental health impact can strain social relationships and community cohesion, further destabilizing society.

6.       Inequality and Poverty

a)      Widening Gap: Bank failures can widen the gap between the rich and the poor, as wealthier individuals may have more means to protect their assets.

b)      Increased Poverty: The economic downturn and job losses resulting from bank failures can push more people into poverty, leading to increased social problems and demands on social services.

7.       Criminal Activity

a)      Rise in Crime: Economic hardship and unemployment can lead to an increase in criminal activity, as people may turn to illegal means to support themselves and their families.

b)      Financial Crimes: There may be an increase in financial crimes, such as fraud and embezzlement, as people and businesses struggle to survive.

Examples from History

a)      Great Depression (1930s): Bank failures in the United States led to massive unemployment, loss of savings, and widespread economic hardship, contributing to social unrest and significant changes in government policy.

b)      Global Financial Crisis (2008): The collapse of major financial institutions caused economic downturns worldwide, leading to protests, social unrest, and significant political and economic reforms in many countries.