Compounding China’s Bank-Capital Blues

Compounding China’s Bank-Capital Blues

Beijing’s Misguided Rules Prevent Fund Raising When It’s Most Needed

AARON BACK

Jan. 16, 2014 3:17 a.m. ET

Chinese banks are in capital-raising mode after gorging on aggressive lending. Outdated rules barring banks from issuing equity below book value are needlessly hindering the process.Three Chinese banks listed in Hong Kong at the end of last year jointly raised almost $5 billion. In September, China Merchants Bank 600036.SH +0.28% separately raised $5.5 billion through secondary offerings in Shanghai and Hong Kong. Distressed debt specialistChina Cinda Asset Management

1359.HK +0.20% raised $2.5 billion, money that could be put to use cleaning up bad loans across the rest of the financial system. And there is more in the pipeline, with Harbin Bank considering a $1 billion Hong Kong listing.

China is wise to shore up its banks by tapping markets now. Overdue loans are creeping up as growth slows, and banks need to prepare for higher capital requirements under the Basel III rules in 2018. Bank shares have gone nowhere the past three years despite booming profits. Capital worries are a key concern among investors.

The main obstacle to further fundraising is of China’s own making—the regulatory principle that banks can’t issue equity at below book value. Granted, bankers generally prefer to avoid that anyway, because it is highly dilutive to existing shareholders. In essence they would be selling $1 of assets for less than that.

But in China, this is due to more than just the wariness of bankers. They are prevented from doing so based on old rules intended to prevent state-owned assets from being sold too cheaply. This prohibition, though, applies even to majority privately owned banks, analysts say.

The trouble is that aside from China’s largest state-owned banks, most lenders currently trade at less than book value. When that’s the case, investors are essentially saying the bank’s assets are held at too-rich values, its liabilities are understated or the bank won’t be able to earn returns in excess of its cost of capital and so will destroy value.

What investors believe about many Chinese banks is that their books are stuffed with bad loans.

Take, for instance, China Minsheng Banking Corp. 600016.SH -1.93% At the end of the third quarter this midsize bank had a Tier 1 capital ratio of 8.2%, less than the 8.5% it will need by 2018 and lower than the ratios of most of its Hong Kong-listed peers. But Minsheng trades at 0.95 times its book value as of the end of the third quarter, and at that valuation it will struggle to get regulatory clearance to raise new equity capital. Other banks trade at deeper discounts.

There are unsatisfactory ways around the conundrum. All the banks that issued shares last year did so below estimated end-2013 book, but above book value for end-2012, which regulators permitted. But this handy time-period arbitrage might not work when banks are in desperate need for capital.

Another fix: For the first time, China will soon allow banks to issue preferred shares, a way to boost Tier 1 ratios without diluting shareholders. But Western banks found during the financial crisis that when push came to shove, investors don’t see preferred shares as a reliable enough cushion against losses. They value common equity above all other forms of capital. Indeed, this is why, since the crisis, regulators globally have replaced Tier 1 ratios with what are known as Tier 1 common in the U.S. and core Tier 1 elsewhere, and which are mostly dependent on common equity.

The irony in all this is that once capital is raised, even at cheap levels, investor confidence often is shored up and shares tend to recover. China Merchants Bank issued stock at barely above end-2012 book value in September, and its share have since rallied and now trade at 1.16 times book, one of the highest valuations in the sector.

There’s no indication China will abandon its dated capital-raising rules anytime soon. Until it does, the need to raise capital will continue casting a long shadow over bank shares.