China's Bolstering Lenders for New Assault on Shadow Banking

(Bloomberg) -- Investors who pushed up Chinese bank shares last week on news of lower reserve requirements may have been celebrating too soon.

The subtext to Tuesday's move is an effort to prepare the banks for a painful new phase in China's campaign to reduce financial-sector risks, as regulators free up deposit rates and accelerate their crackdown on the nation's $16 trillion shadow banking sector.

“China is gearing up to crack a hard nut with deleveraging and financial reforms, and the central bank is offering some coordinated policies to ensure it will be a smooth transition,” said Xia Le, chief Asia economist at Banco Bilbao Vizcaya Argentaria SA in Hong Kong.

The People's Bank of China's decision to free up more liquidity for banks by slashing reserve ratio requirements, at a time when funding conditions are plentiful, shows the central bank is trying to insulate lenders for the next phase of reform, said Ming Ming, head of fixed-income research at Citic Securities Co.

A key element of that reform process is a plan to give banks greater freedom to set interest rates, flagged by PBOC Governor Yi Gang at the Boao forum earlier this month. That will help banks better compete for deposits from Chinese savers and hasten the shift away from shadow instruments such as wealth management products.

Already, China Construction Bank Corp., Bank of China Ltd. and other large lenders have started trying to attract funding by rolling out certificates of deposit with sharply higher interest rates.

But the move away from off balance sheet WMPs to on-balance sheet deposit funding is likely to be painful. Guosen Securities Co. analyst Wang Jian described interest rate liberalization as like “throwing a bomb at banks” in an April 11 note, saying the need to offer higher deposit rates to attract funds could push them into riskier lending, to real estate for example, in order to protect profits.

That helps explain the lifeline thrown to banks last week with the surprise 1 percentage point reserve-requirement ratio cut for large commercial lenders and some other banks, effective April 25. The move will help banks to repay 900 billion yuan ($143 billion) of outstanding medium-term lending facility loans they borrowed from the central bank, according to the PBOC. It is expected to unleash another 400 billion yuan of liquidity, which can be used to raise lending.

Cutting the reserve ratio during the campaign against shadow banking and looser controls on interest rates “helps to alleviate systemic risks,” said Li Qilin, chief macroeconomic researcher at Lianxun Securities Co. “Such measures are needed to offset the negative impact in the reforms.”

Margin Squeeze

Despite a year-long campaign against shadow banking and measures to curb interbank funding, Chinese banks remain relatively flush with liquidity. But any decision to free up interest rates could quickly change the equation, prompting some banks to push up deposit rates in a scramble for funds, squeezing their margins at a time when funding from off-balance sheet WMPs is on the wane.

When the PBOC removed the ceiling on deposit rates in 2015, it maintained a system of “informal guidance” which limits how much banks can offer to savers. That enhanced the popularity of the off balance sheet wealth management products, that offer higher yields and implicit guarantees on repayment.

Analysts at China International Capital Corp. estimate that the removal of informal guidance will lower the net interest margins of listed banks by 0.9 basis point, and reduce profits by 0.6 percent. That assumes deposit rates will increase by another 10 percent from the current level.

Chinese banks fell on Monday, led by the shares of smaller lenders, which are seen as worst-hit by this policy. China Zheshang Bank Co. slumped by a record 4 percent in Hong Kong as of 1:56 p.m. local time, while Bank of Zhengzhou Co. declined 2 percent.

Scrapping the ceiling on deposit rates was once described by the central bank as the "riskiest" element of interest rate reform. But the campaign against shadow banking is now a higher priority. "A full liberalization of deposit rates will ensure the success of deleveraging," said Ming at Citic Securities.

Chinese households and companies hold more than $20 trillion of bank deposits, more than anywhere else in the world. Yet, deposit-taking has never been easy for banks, especially smaller lenders which lack the branch network and customer base to compete with large state banks. The small banks have been especially enthusiastic users of WMPs as a funding source.

Over the past year, regulators have rolled out a flurry of measures, ranging from curbing of banks' outsourcing of asset management to their purchase of peers' short-term debt. These policies have helped lower interbank leverage with the pace of growth in their lending to other financial institutions falling to the least in nine years, while the loan balance to peers declining to the lowest level since 2015.

--With assistance from Russell Ward and Jeanette Rodrigues

To contact Bloomberg News staff for this story: Helen Sun in Shanghai at hsun30@bloomberg.net, Jun Luo in Shanghai at jluo6@bloomberg.net.

To contact the editors responsible for this story: Marcus Wright at mwright115@bloomberg.net, Richard Frost at rfrost4@bloomberg.net.

With assistance from Helen Sun, Jun Luo