China’s Tectonic Shift in Bank Funding

Stresses in China’s banking system eerily resemble those in its U.S. counterpart just ahead of its meltdown

By Anjani Trivedi
China’s Tectonic Shift in Bank Funding

Ghosts of financial crises past rarely revisit in exactly the same way. Still, stresses looming in China’s behemoth banking system eerily resemble the ones its U.S. counterpart suffered just ahead of its meltdown a decade ago.

They can be seen in this week’s Chinese bank earnings, which reveal a structural shift. The ample trapped savings in the form of deposits that have long funded banks’ lending are withering away. Deposits’ share of the system’s liabilities has slipped in the past decade to around 65% from around 80%, according to Deutsche Bank . And many of these deposits are short-term, leaving banks vulnerable to sudden withdrawals.

The remaining third of banks’ liabilities now come from wholesale funding markets, making the funding mix about the same as for U.S. commercial banks in 2008—the outset of the global financial crisis. That third includes borrowing from other banks and financial institutions, along with liquidity injections from the central bank.

At China Construction Bank , one of the country’s larger banks, deposits account for 68% of liabilities, down from 85% five years ago. The trend is even starker at midsize and small banks.

Shaky funding isn’t banks’ only problem. Many are warehouses of risky assets, increasingly unaccounted for on their balance sheets, an echo of the bundles of unrecorded derivatives and other products U.S. investment banks created and sold ahead of the crisis.

China’s version of this has become a structural issue. Many companies are reinvesting bank loans in investment products—but as those products are also issued by banks, it means money just flows unproductively around the banking system.

There is one key distinction from the precrisis situation in the U.S.: Chinese banks are still mostly state-owned, and it is widely assumed that Beijing will always support the banking system by injecting liquidity and, if needed, equity.

Yet regulators are already in a tight spot. Keeping the system flush with funds may only expand asset bubbles and make it harder to tamp things down in the future. Tightening too hard, though, risks bringing to a screeching halt an economy that has become debt-addicted: Total credit in the Chinese banking system is now 106% of deposits, up from 80% in 2013. For midsize banks, it’s 130%.

For now, China’s banks are getting weaker as they bear the cost of rising bad loans, including shrinking capital buffers. The ghosts of their misspent past could soon bring a deeper haunting.

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