China to Close a Lending Loophole; Draft Rules Would Limit Lenders’ Ability to Route Loans Through Shadow-Banking System

China to Close a Lending Loophole

Draft Rules Would Limit Lenders’ Ability to Route Loans Through Shadow-Banking System

Nov. 27, 2013 11:54 a.m. ET

BEIJING—A Chinese regulator is planning to make it harder for banks to use the nation’s sprawling shadow-banking system to get around lending limits, the latest salvo in its efforts to rein in credit growth. According to two bankers who have seen draft rules put together by the China Banking Regulatory Commission, the regulator wants to limit the ability of financial institutions to label corporate loans as loans between banks, which are typically of lower risk and subject to fewer restrictions. The process typically involves loans to trust companies—wealth-management companies that are the biggest nonbank lenders in China—that are then repackaged as so-called interbank assets.Beijing’s efforts to rein in credit growth in recent years have been repeatedly stymied by the emergence of a network of nonbank lenders that often work with banks, which have grown increasingly adept at finding creative ways to continue lending.

The draft rules, which are expected to take effect in some form in February, are aimed at the interbank lending market, usually used by banks to borrow at low interest rates from one another to cover their short-term funding needs. Increasingly, banks are using short-term interbank loans to obtain funds to make longer-term loans to companies, a mismatch that contributed to a credit crunch in June. The overnight rate banks charge one another rose as high as 30%, as banks scrambled to renew short-term borrowing to fund longer-term corporate lending.

According to Standard Chartered STAN.LN +0.21% PLC, a U.K. bank, about 20% of small and medium-size Chinese banks’ funding currently comes from the interbank market, up from between 10% and 15% prior to 2012. Earlier this month, the central bank flagged its intention to crack down on the practice, which it said had “made it more difficult to manage liquidity and prevent risk.”

“There are…widespread expectations that regulators may tighten interbank (asset shuffling) businesses soon…[that may] have led to banks becoming more cautious about lending short-term liquidity in the interbank market,” said Wang Tao, an economist withUBS

, UBSN.VX +0.83% in a recent note. Over recent months, the central bank has also repeatedly signaled that it won’t pump as much cash into the economy as it has recently, a development that has also made banks less willing to lend to one another, analysts say.

On Nov. 18, the benchmark weighted average of the seven-day repurchase rate—a measure of interbank borrowing costs—rose to 5.94%, the highest level since the June credit crunch, and well above 3%, where the market hovered earlier in the year. It was at 4.77% Wednesday, after the central bank injected cash into the banking system.

Chinese banks are allowed to lend no more than 75 cents for every dollar in deposits they hold, a severe constraint on their ability to expand, but interbank loans don’t count toward banks’ loan-to-deposit ratios. Moreover, corporate loans require banks to hold four times as much capital for every dollar lent out as for interbank loans.

As a result, disguising corporate loans as interbank loans has become a popular way for banks to expand their lending while minimizing their costs. A often-used method has been for a bank to make a loan to a company through a trust and then use the trust asset as collateral for a short-term loan from another bank. In the process, the loan gets reclassified as an interbank asset.

The new rules would make it harder to do this. The regulations also require banks to count their interbank lending as part of overall loan quotas, which the regulator sets for each bank. The quotas currently don’t cover lending on the interbank market.

A loan manager with a midsize Chinese bank said the new rules, if they go into effect as planned, would seriously pinch bank business.

In a bid to force banks to manage their liquidity better and avoid maturity mismatches such as the one that roiled markets in June, the new rules would also limit interbank loans to a maximum of one year. The draft also calls on banks to make provisions for potential losses from interbank lending.

The rules also would cap a bank’s interbank lending at 50% of its total deposits. Outstanding borrowing and lending with a single financial institution wouldn’t be allowed to exceed 100% of any bank’s own net capital, and any bank’s loans to all nonbank financial institutions wouldn’t be permitted to rise above 25% of its net capital.

China’s banking regulator said in the new draft rules that it will step up its supervision of banks that are active in the interbank market.