(Bloomberg) -- Jason Bedford might be the only person on Earth who reads every line of every financial statement issued by nearly 250 Chinese banks.
His conclusion after completing the ritual for the umpteenth time: the industry needs capital, and lots of it.
The 40-year-old UBS Group AG analyst, whose star is rising after he issued early warnings about the troubles roiling China’s smaller banks, says the lenders he covers now face a potential capital shortfall of 2.4 trillion yuan ($349 billion). His tally of assets at a broader universe of Chinese lenders in “distress” is 9.2 trillion yuan, or about 4% of the commercial banking system and nearly 10% of gross domestic product.
While Bedford is quick to point out that China’s financial industry is on a sounder footing than it was a few years ago thanks to a major cleanup effort by regulators, he sees a difficult road ahead as authorities grapple with how to fix the country’s problem banks without spooking markets. A Bloomberg Intelligence index of Chinese and Hong Kong bank stocks has slumped more than 10% since early May and touched the lowest level in almost seven months on Wednesday.
Investors around the world have grown increasingly concerned about the risks lurking within smaller Chinese lenders after the shock government seizure of Baoshang Bank Co. in May. The takeover imposed losses on some creditors, casting doubt on the implicit guarantee that has underpinned the country’s financial stability for decades.
This week, another regional lender was rescued by a consortium that included Industrial & Commercial Bank of China Ltd., fueling concern among some shareholders that the nation’s biggest banks will be called on to help clean up the sector’s mess. The China Banking and Insurance Regulatory Commission didn’t immediately reply to a faxed request for comment.
Amid the turmoil, Bedford -- a Mandarin-speaking Canadian who used to audit Chinese banks for KPMG -- has emerged as one of the foremost experts on risks facing the industry. His deep-dive thematic reports, which flagged problems at Baoshang and Bank of Jinzhou Co. long before they were widely recognized by the market, have become required reading for international investors who want to understand where China’s $40 trillion banking system is headed.
In an interview at Bloomberg’s Hong Kong office, Bedford discussed his approach to analyzing Chinese banks, his outlook for the industry and the state of China’s financial reforms. Comments have been edited and condensed.
On Baoshang Bank:
What caught my focus and what wasn’t known at the time was the buildup of these investment assets on bank balance sheets: trust beneficiaries rights and directional asset management plans. When they first appeared, they were very small and primarily used to understate risk-weighted assets. They were largely though just a loan with a wrapper around it to make it look like an investment. Later on they also became used as a tool to understate nonperforming loans.
On his approach:
I tend to work more on deeper dive, thematic research. I actually prefer to look at and meet with unlisted banks because they tend to have more entertaining disclosures. They also tend to be more stressed than the listed names.
On how small banks will shake out:
The low point for the system was probably 2016. Back then I actually thought the system could implode. Everything was at its greatest excess -- shadow loans, aggressive accounting treatments. Trust beneficiary rights peaked in both relative and absolute terms. They’ve declined since then. Now we are cleaning up the bad debt, although we may need more asset management companies, and we’ve changed bad-loan recognition rules.
On financial regulation:
We’re going in the right direction. It’s going to be quite a long road, and not an easy process to go through. But it’s hard to argue that much of what is being done isn’t the right thing to do. Ultimately we are laying the foundation for a sounder banking system.
On China’s push for micro-and-small business lending:
The banks that get MSE lending right are incredibly profitable. But MSE loans do tend to have a higher risk because of the lack of control or structure around them, and the specialized skills needed in managing them. The goal to get the economy to lend more to private businesses is a good thing, my real concern is around pricing. Mandating pricing levels at too low a level could be a problem.
Read more: China Banks Reduce Small-Business Loan Rates to Breakeven
On areas to watch:
We are in the midst of a cleanup. First I looked at bad debt disposal, then the asset management companies -- the stresses they are going through, how much they can take on. Now I’ve been looking at system recapitalization needs and where the problems lie. The banking system needs capital, so anything that gets us closer to that objective is a positive.
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