Among the more incredible remarks made in the rather incredible year of 2008 was the John Thain quip: “Right now we believe that we are in a very comfortable spot in terms of our capital.”
It quickly became evident to the (then) Merrill Lynch boss that he was in anything but a ‘comfortable spot’ and his firm needed to be saved by Bank of America.
Indeed, if last year’s financial crisis has taught us anything, it’s the importance of bank capital. China is now taking the lesson to heart.
Beijing’s banking regulator is suddenly about how much of this year’s Rmb8.9 trillion ($1.3 trillion) of new lending might go bad – particularly among loans made to local governments for infrastructure that may not pay its way.
With this in mind, the regulator is calling for banks to ensure that they have kept enough money aside. And when it comes to declaring capital, it has made clear there shall be no more cutting corners.
That explains the recent clampdown on banks selling their subordinated debt among themselves – a practice that has artificially inflated capital bases.
The holders of this debt have long counted it towards their supplementary capital. This in turn contributes towards their capital adequacy ratio, the key measure used by governments to check that banks have enough capital to cushion themselves against potential losses.
The practice is problematic because it takes the risk of an individual bank and turns it into systemic risk for the sector. Instead of bringing new capital into the system, the issuance of subordinated debt between banks creates a chain of cross-held loans – with potentially dangerous consequences.
“The higher the cross-holding rate, the bigger the corresponding systemic risk,” is how Caijing magazine puts it. “Once one bank in the debt-chain defaults, the risk will quickly spread to other banks, causing a financial panic.” Sound eerily familiar?
The data points to the scale of the problem. The total balance of subordinated debt held by listed banks will reach Rmb376 billion by the end of the year, according to research by CICC. According to another survey, approximately half this debt is cross-held between the banks.
For a number of banks, including the Bank of Communications and Minsheng Bank, subordinated debt accounted for more than 25% of their core capital.
It was all too much for the CBRC: in August, the bank regulator issued a circular calling for capital replenishment schemes. One of its main proposals was that the total amount of subordinated debt cross-held by the banks should be subtracted from their supplementary capital.
But when a decision was finally made in late October, the new rules were somewhat weaker than originally envisaged: if a bank held subordinated debt that was issued before June 2009 it will still count towards supplementary capital. Debt issued after that date will not.
So why the compromise? When the original circular was published, analysts pointed out that discounting all the subordinated debt could reduce local banks’ capital adequacy ratio by as much as 1%. This might not sound like a lot, but several banks (such as Minsheng Bank and Shenzhen Development Bank) were already struggling to meet the 7% minimum tier-1 capital adequacy ratio set by the planners. An extra percentage point would only exacerbate their difficulties.
It should also come as no surprise that several banks have announced plans to seek capital through other means. Equity financing is a popular option: Minsheng Bank has plumped for an IPO to raise as much as $4 .2 billion in Hong Kong.
The circular will discourage banks from issuing new sub-debt to each other. The outcome: to choke off runaway lending. And tellingly enough, new lending in October – at Rmb253 billion – was the lowest monthly amount so far this year.
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