China’s biggest banks have a lot of funding to do.
On November 11, the Basel Committees Financial Stability Board (FSB) updated its guidance on capital requirements for the world’s 30 systemically important banks. The announcement targeted China’s biggest lenders – Industrial & Commercial Bank of China, Bank of China, the Agricultural Bank of China and China Construction Bank (which was only added to the list a week before the FSB’s announcement).
The amended rules require the four banks to put aside the same levels of capital as their Western peers. That means they need to raise $600 billion in total loss-absorbing capital (TLAC) by 2025, almost twice the shortfall for European and American banks combined.
The amounts sound huge. And, indeed, China originally was absolved because it claimed its lenders could not raise so much from its undeveloped bond markets.
The new rules also come on top of the banks’ regular capital needs. China’s bank total lending increased by 17% in 2015, according to the People’s Bank of China. And with non-performing loans having risen 30% (official statistics say NPLs are only 1.5%), they will need more tier-1 and tier-2 capital each year.
However, debt bankers are fairly sanguine China’s banks can raise the sums required.
“China’s banks issue about $40 billion per year in tier-1 and tier-2 issuance already,” one syndicate manager said. “They just need to increase that to $60 billion per year between the onshore and offshore market, and pay the necessary premium to issue the TLACs.”
TLACs are an additional capital buffer on top of banks’ existing tier-1 and tier-2 capital. The instruments act as the first line of defence in the event increased losses or defaults.
The instruments only apply to 30 systemically important banks identified by the FSB as too big to fail. TLACs are designed to ensure they don’t.
“The reason why regulators want to put another layer of butter on the already-iced cake is to protect most of the depositors in the banks that are the blood of the economic system,” said Dominique Jooris, head of credit capital markets Asia ex-Japan at Goldman Sachs.
But the amounts of required TLAC capital raises problems of its own. Banks invest heavily in bonds but FSB rules punish them for holding the bonds of other banks; these don’t count as much, in the FSB’s eyes. Chinese banks are especially exposed to one another, due to the lack of alternative types of credit.
However, Beijing can direct flows of capital in ways that other governments cannot. It can ensure other state-owned financial institutions such as insurance companies and asset managers support bank TLACs. These remain small players relative to the major commercial banks in China, but are becoming bigger buyers of bank debt, as existing alternative tier-1 deals attest.
“A lot of non-traditional players came out,” one banker recalled of Bank of China’s $3.55 billion, multi-tranche “One Belt One Road” bond issue in May.
Most recently, on December 9, CCB completed a maiden AT1 offering that attracted a strong order book, topping $11 billion at its peak.
Many of that deal’s tranches are trading at par or above in the secondary market, indicating banks can meet TLAC-related capital needs.
“The moral of the story, particularly for the big-four Chinese banks, is that it’s doable,” the banker said.
While China’s banks should meet their targets, they cannot yet guarantee international investor support.
The key issue stems from corporate structures. Most large European banks like Credit Suisse, UBS and HSBC have holding-company bank structures. They issue debt at the holding company level, and use the capital across their operations. But Chinese banks all have an operating company bank structure, meaning individual branches raise capital and their creditworthiness is assessed as an issuing entity.
This difference has profound implications. Investors will have to weigh the creditworthiness of each particular China bank division issuing TLACs.
“In a few years time when the Chinese banks start issuing TLAC instruments investors will have to consider whether the securities have loss-absorbing features with principal risk,” one syndicate banker said.
China’s banks could solve the problem by setting themselves up as holding companies, as Swiss banks UBS and Credit Suisse have done. Or they could keep issuing at the operating level, as Spanish banks like BBVA do. However, this could be messy, as Chinese banks have many subsidiaries.
The banks – and their regulators – should embrace restructuring, painful as it may be. Passing financial risk from one state institution to another isn’t a wise long-term plan. For the health – and growth – of China’s financial system, foreign investors should support its key institutions.
China’s banks need capital. They also need reorganising.