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Rattled China Investors Worry What’s Next After Bank Seizure

Rattled China Investors Worry What's Next After Bank Seizure

(Bloomberg) -- Is it the start of a new era for China’s $42 trillion financial industry, or a one-time shock that will be quickly forgotten?

Five days after the first government seizure of a Chinese bank in 20 years, investors are still grasping for answers. 

The takeover of Baoshang Bank Co. -- announced with scant explanation on Friday night -- left China watchers guessing at whether it marks an end to the implicit backstop for banks that has served as a linchpin of the country’s financial stability for decades. Regulators have said they’ll guarantee Baoshang’s smaller depositors, and while they’ve warned some creditors of potential losses, they haven’t said what the final payouts could be or given public guidance on whether the takeover will be a blueprint for other lenders.

Complicating matters is the fact that Baoshang has been linked to a conglomerate under investigation by Chinese authorities. It’s unclear to what extent, if any, that makes the bank a unique case in the eyes of the ruling Communist Party. 

Opaque policy decisions are par for the course in China, but the Baoshang episode has attracted greater-than-usual attention as the country’s smaller lenders grapple with record corporate defaults and a regulatory crackdown on shadow-banking activities. 

Any sign that the government has decided to provide a less-than-complete backstop for the industry would probably lead to a sustained jump in funding costs and weigh on the economy just as it gets squeezed by the U.S. trade war. Authorities will have to consider those consequences against the risk that continued implicit guarantees will fuel moral hazard and lead to even bigger crises down the line. 

Read more: China Lenders’ Dollar Debt Takes Hit After Baoshang Takeover

Some investors aren’t sticking around to find out. Shares and bonds of smaller Chinese lenders declined this week, while the nation’s interbank borrowing costs jumped. 

Struggling Banks

There’s little doubt among analysts that Baoshang’s financial position justified the government’s action.

China’s regional banks have in recent years used shadow-financing to obscure their exposure to risky borrowers. Baoshang’s most recent financial report showed that so-called investment receivables, which include instruments such as trust beneficiary rights that analysts say are often loans disguised as investments, stood at 153 billion yuan ($22 billion), accounting for more than a quarter of its total assets.

Jason Bedford, a UBS Group AG analyst who in 2017 was the first to highlight Baoshang’s troubles, said there are several other banks that have “identical leading risk indicators” to Baoshang. Hengfeng Bank Co., Jinzhou Bank Co. and Chengdu Rural Commercial Bank Co. all failed to publish their latest financial statements, have a large portion of their balance sheets invested in “loan-like investment assets” and are subject to negative local media coverage, he said in a note to clients published Tuesday.

Rattled China Investors Worry What’s Next After Bank Seizure

Hangfeng said in an emailed reply to questions that it hasn’t completed auditing and reviewing its financial statements, and that its exposure to trust beneficiary rights has dropped. It added that its operations are stable and corporate governance has improved. Officials at Jinzhou and Chengdu Rural didn’t reply to requests for comment.

Tomorrow Group Connection

But Baoshang isn’t just a struggling regional bank: it was also part of the investment conglomerate led by financier Xiao Jianhua, known as the Tomorrow Group, which is being probed by Chinese officials, according to people familiar with the investigation. Authorities were arranging for a state-owned firm to buy a stake in the bank before realizing its situation was more precarious than they thought, forcing the takeover, the people said. Xiao, who disappeared in early 2017, could soon face trial, they said.

“It’s clear to me that the fall of Baoshang Bank has to do with both the fall of Tomorrow Group and credit risks,” said Chen Shujin, chief financial analyst at Huatai Securities Co. in Hong Kong. “Baoshang is facing higher credit risks as Tomorrow Group’s assets have lost their money-making capability.”

Alicia Garcia Herrero, chief Asia-Pacific economist at Natixis SA in Hong Kong, said Baoshang’s connection with Tomorrow Group mean that it’s unlikely Friday’s move will be repeated with other banks. China’s big lenders will acquire troubled smaller firms in future, she said.

“Baoshang is really a related-party case with massive concentration in one client,” said Garcia Herrero, referring to Tomorrow Group. “It is a politically motivated takeover.”

End of the Backstop?

Many analysts focused on the fact that authorities said they will only guarantee Baoshang depositors and creditors with less than 50 million yuan at the bank, and negotiate with everyone else. Interbank creditors, mostly financial institutions, will get no less than 70% of their principal, people familiar with the matter said. That could mean losses for creditors but also leaves the door open to full repayment.

What Bloomberg’s Economists Say...

The takeover of Baoshang Bank by Chinese regulators should put investors on notice -- an implicit backstop for the banking sector is no longer a sure thing
David Qu, Economist, Bloomberg Economics in Hong Kong
For the full note click here

Ting Lu, chief economist for China at Nomura Holdings Inc., said Friday’s move broke the “hard guarantee” of government backing in China’s banking system.

“This takeover has a profound historical significance,” Lu and his colleagues wrote in a note published Tuesday, adding that it could lead to higher funding costs for small and medium-sized banks.

On the other hand, Fitch Ratings said on Tuesday that the move “could even serve to strengthen market assumptions of state support for banks in general, as there is now an explicit example of intervention from the authorities to indirectly support a small non-systemically important bank to avoid system instability.”

Takeover Template

Other analysts noted that, whatever the reasons behind the seizure, China has now established a template for handling bank failures. China Construction Bank Corp., the nation’s second-largest lender, will be responsible for managing Baoshang’s business for one year, and a takeover taskforce will negotiate with creditors.

The case will be a pilot project for the government, according to Morgan Stanley analysts.

“Assuming the Baoshang takeover is successful, there could be more bank takeovers and restructuring cases in coming years, we believe, squeezing out some weak banks over time,” they said in a note published Saturday.

To contact Bloomberg News staff for this story: Lucille Liu in Beijing at xliu621@bloomberg.net;Alfred Liu in Hong Kong at aliu226@bloomberg.net;Jun Luo in Shanghai at jluo6@bloomberg.net;Ling Zeng in Shanghai at lzeng30@bloomberg.net

To contact the editors responsible for this story: Sam Mamudi at smamudi@bloomberg.net, Michael Patterson

©2019 Bloomberg L.P.

With assistance from Bloomberg