A fundamental shift in banking in China in recent years has created huge off-balance-sheet assets, raising questions over whether the risks have been accounted for

08.12.2013 17:04

Regulatory Concern Grows along with Surge in Interbank Business

A fundamental shift in banking in recent years has created huge off-balance-sheet assets, raising questions over whether the risks have been accounted for

By staff reporters Zhang Yuzhe, Ling Huawei, Li Xiaoxiao

In less than three years, the interbank business has expanded rapidly in China, creating huge off-balance-sheet assets that are starting to worry regulators. By the end of the first quarter of 2013, interbank assets in listed Chinese banks reached a total of 11.6 trillion yuan, accounting for nearly 13 percent of their total assets. In 2006, the figure was 1.6 trillion yuan. Banks use these assets to bypass lending quotas and capital restraints, and some small banks rely on the market for funding, too. Interbank business was initially limited to lending between commercial banks to address short-term liquidity issues. Since 2010, it has undergone a gradual but fundamental change, expanding a variety of off-balance-sheet assets and creating many types of interbank products that are often purchased by themselves: through money amassed by their own wealth management products. The scale of banks’ wealth management products, which have grown since 2010, reached 9.85 trillion yuan at the end of June. For most banks, this is a way to expand business while reduce what they call “regulatory costs.”To smaller banks, it means easy and fast growth. Guangxi Beibu Gulf Bank, with regular lending of only some 30 billion yuan, is able to boost its total assets to 120 billion yuan. The secret to this is massive interbank lending. It is an open secret that many city commercial banks, in order to meet regulatory requirements on assets for listing or conducting cross-regional business, inflate their asset size by frequent interbank activities costing tens of millions of yuan in transaction fees.

Industrial Bank, known as the “interbank king” for its active role in the market, has moved beyond the initial stage of moving assets off balance sheets and entered the next stage: boosting revenues. Its interbank assets account for 36 percent of its total assets, but profits from interbank business make up half of its total profits. Behind this is a unique business model. Industrial Bank has built a bank-to-bank platform and become a broker: on its left hand is money from small and medium-sized banks’ wealth management products or interbank lending, and on its right hand is interbank repos from its peers that are up for sale. Industrial Bank does the selling and buying simultaneously, reaping all the intermediate business income.

But with assets being shifted on and off balance sheets in the banking system, risk has become an issue. In effect, the activity nullified regulatory policies, accumulated risk and largely limited the effectiveness of restrictive credit policies to rein in local government financing platforms and real estate developers.

Regulators are aware of this. In March, Vice Premier Ma Kai asked the central bank and the China Banking Regulatory Commission (CBRC) to pay attention to interbank assets and bank wealth management.

Authorities first tried to control the overall amount of credit to curb interbank lending. In March, the CBRC issued Document No. 8, which stated that non-standard wealth management assets at commercial banks could not account for more than 25 percent of total assets. The proportion of interbank business to assets at many banks is indeed more than 30 percent.

The so-called cash crunch that occurred in the interbank market in June, which forced up interest rates and froze a large amount of liquidity, once again exposed the rapid fluctuations in this market. It also showed that some banking institutions’ liquidity risks are alarmingly high. The central bank is leading the CBRC, China Securities Regulatory Commission (CSRC) and China Insurance Regulatory Commission (CIRC) to prepare targeted measures for standardizing interbank market operations.

Racing with Regulators

The interbank business, beginning in the 1990s, was initially limited to short-term interbank money lending. Now the types of players have expanded to include not only banks but trusts, securities, mutual funds, leasing companies and financial services companies, and its influence is felt by the credit market, the monetary market and the capital market.

Since the large economic stimulus plan unveiled in late 2008, the banking system had massive liquidity – ammunition to power investment and economic activities – but how much lending they could perform was tightly controlled by regulators. The result is that large amounts of funds have been allocated by the banks to the capital market in search of profit, and the burgeoning interbank market looked attractive. One after another, banks set up interbank business departments and their interbank assets have ballooned.

“The explosive growth in banks’ assets after the 4 trillion yuan stimulus in 2008 made them scramble to meet their capital adequacy ratio, and various off-balance-sheet, innovative fundraising methods soon emerged,” a banking industry source said. The essence of these innovations is that banks move assets off their balance sheets and circumvent restrictions on the lending quota or capital requirements.

It has been a cat-and-mouse game. Banks started by trying to channel the money gathered from wealth management products to buy their own notes in order to boost assets size. The practice was called off by the regulators in 2009. Then they performed a similar move, but let the money flow through trust companies, but the CBRC in 2010 set a cap on the scale of the business to banks’ total assets and required that to be included in the balance sheet. Interbank refinance soon became the new fad. It was adopted extensively by small and medium-sized banks and expanded rapidly in 2011 and 2012.

One method for interbank refinance involves cooperation between three banks – bank A commissions bank B to raise funds, and bank B, under its own name, borrows from bank C, paying back the principal along with interests before the maturity date. None of these banks had to include the transaction in their balance sheet until April 2012, when the CBRC demanded it. The refinancing path was no longer viable, and banks turned to a new method called trust beneficiary reverse repo.

The “Interbank King”

Industrial Bank is known in the industry as the “interbank king” because the ratio of its interbank business to total assets is highest among 16 listed Chinese banks.

The bank is a heavy player in the reverse repo business. In 2012, its assets related to reverse repos totaled 792.8 billion yuan, of which about half was from trust beneficiary rights. Through a reverse repo, the bank first buys securities and then resells at a higher price on maturity, a process in which the bank essentially acts as a loan maker. Compared to conventional repos and reverse repos based on bonds, the new type in interbank market has many attractions: for banks, reverse repos are more flexible in maturity terms, usually one year, that can better matched with wealth management products, their source of funding. For borrowers, issuing bonds to get capital comes with high requirements on disclosure and a strict review process. But interbank reverse repos can be based on a variety of securities, ranging from bonds, notes and credit assets to beneficiary rights, and the operation can be conducted with little scrutiny.

A China Merchants Securities report shows that reverse repo business accounted for 45 percent of interbank assets in 2012 and kept rising. In June, Barclays issued a report that warned of risks at Minsheng Bank and Industrial Bank, noting that they were walking a fine line by using bills and trust beneficiary rights based repos and reverse repos to arbitrage regulatory restrictions. The risk of default for these assets, the report said, is far higher than conventional, bond-based repos.

When a company is not qualified to obtain a normal bank loan, it can come to Industrial Bank for help, and receive a loan from the bank’s trust arm. Where does the money come from? The bank can turn to the interbank market, issue a reverse repo based on trust beneficiary rights, sell to other banks, and take a fee from the spread between borrowing and lending.

In the 2013, a ranking of trust companies by asset size sees China Construction Bank (CCB) Trust, a subsidiary of the bank, and Industrial Trust, a subsidiary of Industrial Bank, at the top. Industrial Trust had more than 500 billion yuan in assets in 2012. One industry source said that the main reason for the surge in assets under management at the two trust companies is the rapid rise of interbank business based on trust beneficiary rights.

Big Notes

In contrast to Industrial Bank, whose reverse repo are mostly beneficiaries-based reverse repo business, Minsheng Bank mainly benefit from notes-based repo.

Notes are commonly used in trade settlement. When a company passes a bank’s background check and pays a deposit of 20 percent to the bill’s value, the bank will issue a promise on future payment of the bill, which is called a bank acceptance note.

Through notes-based repo, the bank sells the notes to another bank to receive capital and buy it back before the note’s maturity.

Commercial banks, including Mingsheng, buy these notes-based repos from the large state-owned banks to help them circumvent loan limits, said a source at a large bank’s finance department. The process sees large banks sign acceptance notes to receive interest payments and company deposits, then offload the notes to small and medium-sized banks so they will not be included in the large bank’s total lending, then finally buy it back when the reverse repo reaches maturity.

The notes market has two main off-loader groups: one is joint-stock banks, such as Mingsheng, helping large banks cut their lending size. Another is small and medium-sized financial institutions with ample liquidity, like rural credit cooperatives and rural commercial banks, which help city commercial banks cut their credit scale.

Minsheng Bank has become one of the most influential players in the notes market. At the end of 2012, Minsheng had interest-earning interbank assets of 1.05 trillion yuan. Among these, 84 percent are notes-based reverse repos. In 2012, the company had revenue of 4.2 billion yuan from buying and selling notes, contributing 4.1 percent to its operating income.

The president of Minsheng Bank, Hong Qi, said he does not see much risk in the business, because “the notes are from the large banks. We have a review system on whose notes are acceptable and whose are not. There are quantitative criteria for how much to accept.”

Using the 2012 annual reports of listed banks, a CITIC Securities report calculated the scale of bills purchased for resale to be 2.4 trillion yuan, more than double the year before. Growth was particularly rapid among small and mid-size banks. In the past few years, the amount of bank acceptance bills has soared from about 2 trillion yuan per quarter to 4 trillion yuan.

Capital Providers

In the interbank market, who are the lenders? In addition to the deep-pocketed, big state-owned banks, rural financial institutions have been aggressive and become important lenders.

There are a total of 4,000 rural financial institutions (including rural commercial banks and rural cooperative banks) in China. Of these, 1,858 are rural credit cooperatives, 247 are rural commercial banks and 173 are rural cooperative banks. Their average loan-to-deposit ratio is between 60 and 70 percent, but for the majority it is less than 50 percent; many are scratching their heads about effective use of funds to improve performance.

A source at Chongqing Rural Commercial Bank said: “A lot of banks were in a panic during the cash crunch in June. We were not. Even Merchants Bank borrowed money from us to pay for its wealth management products.”

By the end of 2012, rural financial institutions had outstanding deposits of about 12 trillion yuan and loans of about 8 trillion yuan. After turning over to the central bank the required reserves of more than 1 trillion yuan, they still have 2 to 3 trillion yuan on hand, which went to investment in interbank deposits, bills and bonds. To obtain higher returns, bills and bank wealth management products are all favored by rural credit cooperatives. Some rural financial institutions lack professional capability on dealing with the byzantine investment vehicles, and outsource their entire capital market departments to their peers.

An industry source said that in the “bank-to-bank platform” built by the Industrial Bank, there are several hundred small banks, among which rural financial institutions form the largest group.

The platform that Industrial Bank has built since 2007 provides comprehensive financial services to small banks, including city commercial banks and rural credit cooperatives. Services include interbank business, agency business for various wealth management products and IT contracting business. In the early stages, the bank conducted mainly clearing services for its smaller peers, but in recent years, it has undertaken more capital transactions and even asset allocation on their behalf. For these small banks, depositing their money into the central bank yields only 0.64 percent in annual interest rates. Putting the money into Industrial Bank’s platform as interbank deposits, however, yields interest rates of 2 to 3 percent. The return will be higher if they buy trust beneficiary-based reverse repos.

Other banks are eyeing the platform model, too. Linfen Yaodu Rural Commercial Bank in Shanxi Province set up a similar bank-to-bank platform, dubbing it “rural credit interbank wealth management.” It is mainly aimed at selling its own wealth management products to rural credit cooperatives in the province. After collecting the capital, Yaodu Rural Commercial Bank commissions insurance agencies to manage the assets. The investments are directed into two categories: standardized bonds and money market products, and nationwide, high-yield, non-standard assets.

A source familiar with the bank said that in less than a year, Yaodu’s interbank assets have reached more than 10 billion yuan, accounting for one-third of the bank’s overall assets. The bank holds a 60 percent market share in the province, far exceeding local branches of major banks such as CCB and Industrial and Commercial Bank of China (ICBC).

However, in recent years small and mid-size rural financial institutions have become a focus as the CBRC runs through its inspection checklist of regulatory risks.

A Lust for Listing

Banks come to the interbank market for different reasons. Listed banks want to bypass capital and other restrictions. City commercial banks, however, use interbank assets to expand their balance sheets in order to meet listing standards.

City commercial banks generally use three methods to expand their assets size: increasing lending, increasing branches outside their home base and interbank business. The last option is the easiest because it has little regulatory oversight.

In 2012, when the domestic stock market was in the doldrums and the real estate market was tightly controlled, people increased their investment in wealth management products, especially those issued by city commercial banks that promised rates of return 0.4 to 0.6 percent higher than the market average.

Out of the total of 139 city commercial banks, 24 of them have assets over the 100 billion yuan threshold, including a Guangxi bank funded as recent as 2008.

Guangxi Beibu Gulf Bank’s fast growth is due to its interbank business. In 2008, the bank had total assets of only 16.07 billion yuan, with 562 million yuan in interbank assets, or 3.5 percent. By the end of 2012, the bank had total assets of 121.72 billion yuan, while its interbank assets accounted for nearly half, or 60.1 billion yuan.

A July 2012 report from Lianhe Credit Rating Co. shows that Beibu Gulf Bank’s interbank assets were mainly financial bills for resale, and its counterparties were mainly rural credit cooperative associations and city commercial banks. The bank had interbank liabilities of 58.33 billion yuan.

Looking at traditional deposit and loan business, the bank’s loans and advanced money amounted to only 35.01 billion yuan and it had deposits of only 36.54 billion yuan.

A source close to the bank said that Beibu Gulf Bank’s soaring interbank assets are coupled with a flexible incentive system. The bank gives its financial markets business team commission as high as 5 percent of profits, where the industry norm is 1 percent.

“In 2011, the bank said it planned to list on the A- (Shanghai) and H-share (Hong Kong) markets within two years,” a source close to Guangxi Beibu Gulf Bank said. According to regulatory standards, city commercial banks with assets of at least 70 billion yuan can apply for listing.

The Guangxi bank is not alone. By the end of 2012, more than 30 city commercial banks had interbank assets higher than 30 percent of total, and most of them have expressed willingness to list.

Drawer Agreement

Whether trust beneficiary rights or the purchase of bills for resale, all imply an important link: a bank guarantee.

A recent report by Shenyin & Wanguo Securities found that assets included in the interbank category are usually marked as risk-free, for which banks do not make provision. But in fact, the majority of the corresponding assets are credit assets, and a large amount of them are wrapped-up loans to companies that cannot qualify to receive loans through formal channels.

So why can the risk been ignored? Because of so-called drawers agreements, which are a form of implicit guarantee.

When a bank’s local branch or sub-branch launches interbank business related to trust beneficiary rights, to eliminate the other bank’s concerns, it will provide a sealed envelope that contains a letter of commitment from the branch. Upon receiving it, the other bank puts it in a safe.

“As long as nothing goes wrong, no one will pull it out,” an industry source said. “This is called a drawer agreement.”

Such a commitment letter is by nature a guarantee, or a flawed guarantee, because if risks occur with the trust beneficiary rights, there will be a legal dispute over what responsibilities the two parties have.

The legality of the letter is questionable. The branch needs authorization from the bank’s headquarters to make the letter effective, but such an authorization will require the headquarters to include the amount into risk capital and make provision for it.

If there is no authorization, this is at most an implicit guarantee outside of the control of headquarters and outside the purview of risk capital constraints. In other words, the document has no legal effect.

If the purchasing bank accepts this sort of agreement, its own risk controls are lax, meaning that the two sides have in fact reached a consensus. In the event risk rises out of control, there is a good chance that the side providing the commitment letter will pay compensation to avoid trouble, but nobody knows for sure. If a default occurs, an employee of the bank branch that wrote the letter may be fired for “illegal operations.”

A source at a joint-stock bank revealed that the secret guarantee phenomenon is very common in interbank reverse repo business, and that many branches and sub-branches use the method.

Regulatory Winds

“The interbank businesses of commercial banks are too many and too complicated,” a source at a financial institution said.

Compared to the lending business, regulatory policy concerning interbank business is lax. When loans to local government platforms and real estate projects are subject to strict regulatory constraints, raising funds through the interbank market is much more flexible.

The CBRC will further increase risk capital requirements in order to control the leverage ratio of interbank assets. However, a CBRC source said: “The new commercial bank asset management approaches enacted this year have increased risk provisions for interbank assets, and it’s unlikely they’ll be increased further. Reducing leverage is more an issue of banks’ internal risk controls.”

A regulation that went into effect in January raised the weighting of provision for credit risks of businesses with other commercial banks. The provision for interbank assets within durations of three months was raised from zero to 20 percent, and for those longer than three months was raised from 20 percent to 25 percent. In comparison, provision for lending to small and medium-sized companies is 75 percent, and that for government bonds is 20 percent.

In addition, although some interbank deposits are included in calculation of M2, or broad money, they are not included in the loan-to-deposit ratio assessment of banks, and corresponding deposit reserve funds thus do not need to be turned over.

The director of the Chinese Academy of Social Sciences’ Institute of Finance Banking Research Office, Zeng Gang, said that interbank business asset classes should be broken down. A 20 or 25 percent risk weighting does not reflect the different risks in interbank assets of different natures. For example, the risks of interbank deposits and reverse repos are different.

Since 2011, regulatory authorities have conducted several checks on interbank business and bills business and have issued four creeds. Almost every piece of regulatory policy has an immediate effect on the growth of interbank assets, but several months later, they expand again on a new path.

“This is the same as a barrier lake,” a central bank source said. “You can’t just build the dam; you have to dredge. Banks have risk management, the need to adjust balance sheets and the need to balance the concentration of risks.”

Developing a standardized market for asset-backed securitization is the inevitable choice, the source said.