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China’s Banks Remain Vulnerable to Stress in Wake of Pandemic

Capital positions across many of the Chinese banking sector’s small and medium-sized institutions remain vulnerable to varying degrees of stress, although China’s economy has been one of the more resilient to the coronavirus pandemic, says Fitch Ratings.

The latest annual Financial Stability Report published by the People’s Bank of China (PBoC) in November indicates that a third of the 30 large and medium-sized Chinese banks in a sample would fail the PBoC’s stress test even under a mild impact stress scenario, although several of the non-failing banks would still have capital levels considerably above regulatory minimum requirements.

The PBoC defines failing the stress test as core Tier 1 (T1) capital adequacy ratios (CAR) dropping below 7.5%, T1 CAR falling below 8.5% or total CAR falling below 10.5%. The central bank’s mild impact stress scenario envisions real GDP growth slowing to 1.6% in 2020, before recovering to 7.8% in 2021 and 5.9% in 2022. This is relatively close to Fitch’s forecast of 2.7% growth in 2020, 7.7% in 2021 and 5.5% in 2022.

The non-performing loan (NPL) ratio of the 30 sample banks would surge to 4.9% in 2020, 5.5% in 2021 and 6.7% in 2022, from 1.5% at end-1Q20, under the mild impact stress scenario. This does not consider write-offs and disposals of NPLs, policy easing, additional capital raising or any other forms of direct or indirect support. Under a more severe stress scenario, where the economy contracts by 2.9% in 2020 and expands by 4.5% per annum over 2021-2022, 21 banks would fail the PBoC’s test.

Fitch does not expect a sharp deterioration in banks’ reported NPL ratios, due to aggressive NPL resolution and continued forbearance, but this will be at the expense of rising provisioning pressure. The authorities are targeting NPL resolution of CNY3.4 trillion in 2020, compared with CNY2.3 trillion in 2019, and we estimate credit costs for Fitch-rated Chinese banks will increase to 1.9% of gross loans in 2020 from 1.4% in 2019. Issuance of Additional T1 and T2 capital will also help banks to maintain capital ratios above minimum regulatory levels, although common equity issuance is made difficult by banks’ below-book market valuations.

Fitch has previously highlighted the need for China’s largest banks to raise substantial capital or loss-absorbing debt over the next few years to fulfill their total loss absorbing capacity (TLAC) requirements. We have also pointed out the risk more broadly of potential banking sector capital shortfalls associated with credit at higher risk of impairment, which we believe has stabilized in recent years. The vulnerabilities illustrated in the PBoC’s latest stress tests reinforce these views and the need for continued financial sector reform to enhance the resilience of bank balance sheets.

Chinese banks raised about CNY500 billion annually in capital instruments over 2014-2018, but as regulators pushed banks to strengthen their capital base and broadened access channels, this jumped to CNY1.5 trillion in 2019. Capital issuance thus far in 2020 has reached around CNY1.2 trillion, the majority issued onshore and by state banks.

We believe issuance of capital instruments may become more challenging for smaller banks, especially given the recent write down in Baoshang Bank’s T2 bonds, which highlights loss-absorption risks and vulnerabilities over capital adequacy at smaller banks. The event highlights, in our view, the government’s lower propensity to support less systemically important banks – particularly their capital instruments.

The PBoC’s sensitivity analysis shows that if NPL ratios were to double or increase by 400% among China’s 1,520 small banks, some 589 and 977 banks, respectively, out of the sample would fail to keep their CARs above 10.5%.
Source: Fitch Ratings

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