Chinese Banks’ Divided Capital; The divide in China’s banking system between the biggest and the rest is widening. Shareholders risk falling between the cracks

Chinese Banks’ Divided Capital

AARON BACK

Oct. 30, 2013 8:42 a.m. ET

The divide in China’s banking system between the biggest and the rest is widening. Shareholders risk falling between the cracks. The country’s largest state-owned banks appear reasonably well-capitalized. But balance sheets are looking precarious at the more nimble, midsize lenders. This is partly because the big-four state banks benefit from an uneven playing field. They are, for instance, the preferred channel for the central bank to inject short-term funds into the banking system. This means they can turn around and charge smaller banks high rates in the interbank market when liquidity is scarce, as happened in June’s credit crunch.It is also because midsize lenders have chosen to grow aggressively, in many cases beyond their means. That matters to shareholders, because they face dilution when the banks turn to the markets to raise capital.

Under China’s version of Basel III, midsize lenders will need Tier 1 capital ratios—mostly common equity—of at least 8.5% of assets by 2018. Larger, systemically important banks will need 9.5%. Mike Werner, analyst at Bernstein Research, figures banks will need at least a full percentage point more, and well before 2018, to keep shareholders from getting jittery.

Two of China’s biggest, China Construction Bank Corp. 601939.SH +0.23% and Industrial & Commercial Bank of China Ltd. 601398.SH +0.26% , are well prepared. They boasted Tier 1 ratios of 10.9% and 10.6% at the end of September, according to third-quarter results released Thursday. But Minsheng Banking Corp. 600016.SH +0.33% , China’s largest private lender, had a Tier 1 ratio of just 8.2%.

China Merchants Bank Co. 600036.SH +0.55% Ltd., another midsize lender, has just raised 33.8 billion yuan ($5.6 billion) of fresh capital, bringing its Tier 1 ratio to 9.4%. Yet it is unclear how long this will last. If the bank keeps adding to assets faster than retained earnings, the capital ratio won’t rise as needed. The bank’s total assets were up 24% from a year earlier at the end of September, while third-quarter net profit rose just 16% from a year earlier.

And all these ratios assume the banks’ books tell the whole story about their credit risks, something few market participants believe, for either small or large banks.

China Merchants Bank, for instance, had off-balance-sheet wealth management products, a kind of high-interest deposit whose proceeds are invested in riskier assets, valued at 509.6 billion yuan ($83.7 billion) at the end of September. That is equivalent to nearly 200% of shareholder equity. If those investments start going bad, the bank would likely face pressure to take them back on their books and make customers whole on their deposits, meaning capital ratios could deteriorate quickly.

When banks grow too fast, shareholders can be left holding the bag. China Merchants Bank has now had four follow-on equity offerings since it listed in 2002, while Minsheng has had three since listing in 2000. They may not be done yet.