Shadow Boxing With Risk at Chinese Banks

September 22, 2013, 2:51 p.m. ET

Heard on the Street: Shadow Boxing With Risk at Chinese Banks

AARON BACK

Chinese banks are bringing some holdings out of the shadows. But they might not be shining a harsh enough light on them. For some time, Chinese banks have used off-balance-sheet vehicles to lend to trusts, which are lightly regulated finance intermediaries. Now, new regulations are forcing them to take some of those instruments back onto their books as Chinese authorities look to rein in the “shadow-banking” sector. That led in the first half of this year to a surge on some bank balance sheets of credit extended to these trusts. Yet banks, especially smaller ones, may not be adequately reflecting, or preparing for, the risk that could be embedded in these holdings. The tangled web starts with wealth-management products, a kind of high-interest deposit banks offer clients. These were created to sidestep caps on rates for traditional deposits. Sometimes, banks guarantee the client’s principal in these products; when they don’t, the products don’t appear on bank balance sheets.

This freed banks to take risks with proceeds from these products they may not take with ordinary deposits. In particular, much of the money found its way to trusts. These, in turn, often extended financing to questionable borrowers, such as highly leveraged property developers that Beijing discourages banks from lending to directly.

Chinese regulators in March issued new rules that limit exposure of wealth-management products to certain risky investments. To meet those limits, banks are converting some trust loans into regular on-balance-sheet assets, analysts say.

This appears to be a bigger issue for smaller and midsize Chinese banks, Bernstein Research noted in a recent report. At China’s big four state-owned banks, exposure to trusts is still low, at just 0.2% of total assets, Bernstein said. But at several smaller banks there was a significant increase in the first half of the year, often in holdings of “trust beneficiary rights.” This is a kind of derivative that gives a bank the right to cash flows generated by loans held by trusts.

Hong Kong-listed China Merchants Bank, 3968.HK -1.45% for instance, reported that at the end of June it had 45.9 billion yuan ($7.5 billion) of trust beneficiary rights, up from nothing six months earlier. It also had 103.8 billion yuan of loans made to other banks with trust beneficiary rights serving as collateral. While total exposure to trusts is only equal to about 4% of total assets, it is equivalent to roughly 70% of shareholder equity.

At Shanghai-listed China Everbright Bank, 601818.SH +1.02% the situation is more stark. It had 263.4 billion yuan of beneficiary rights for trusts, securities companies and others on its books at the end of June, up 61% from the end of last year. These are now equivalent to 208% of shareholder equity.

In theory, banks didn’t face losses when trust loans were tied to off-balance-sheet wealth-management products, because banks could pass them on to savers. In practice, banks would have faced pressure to make customers whole. But now that the risks are on banks’ books, there is no doubt they could end up holding the bag if loans sour.

Despite this, it remains unclear what level of provisions or impairment charges banks have taken against their trust exposures. And it isn’t known what kind of loans or investments the trusts have made.

Chinese banks may not be entirely on guard against unpleasant surprises that could be a consequence of the country’s historic credit binge. Investors should be.