Killing Bank Profits Is a Pretty Desperate Move

(Bloomberg Opinion) -- China’s banks are once again being asked to martyr themselves to the economy, forgoing profits to redirect funds toward capital-starved businesses. This won’t resolve the web of problems the financial system is caught up in.

The State Council has urged banks to return 1.5 trillion yuan ($211 billion) to the real economy in the form of low-cost loans to small and medium companies. That’s a big ask, amounting to about 75% of net profit, almost a quarter of revenue and 9% of capital buffers, according to Goldman Sachs Group Inc. In theory, it will save billions of dollars of interest expense for companies by pushing down implied lending rates. In reality, Beijing is acknowledging the deep dysfunction in its financial system and smacks of desperation.

The latest demands follow a host of aggressive measures by regulators in recent weeks, including moratoriums on repayments and buying new loans from banks, which will help free up a corner of their balance sheets. That Beijing is now asking financial institutions to effectively forego top-line growth to get money where it should be going anyway points to the ineffectiveness of small lenders, one of the largest direct suppliers of credit to the economy.

That’s nowhere more apparent than in the Chinese hinterland, where these regional institutions are a major source of financing for small and medium companies. They have overextended themselves and become warehouses of bad risk. On Thursday, Caixin reported regulators were planning to allow local governments to replenish the capital of small and midsize lenders by as much as 200 billion yuan, citing people familiar with the matter. Of the 4,005 such banks in China, 15% didn’t meet minimum capital requirements. Authorities are aware that some lenders won’t be able to comply with the latest edict — the ones that can are those with enough liquidity and capital, not those they’ve had to bail out.

The problem isn’t the price or quantity of credit, though. It’s the persistent and well-known challenge of transmission, getting each yuan where it’s needed most. Beijing has always controlled borrowing costs and been able to inject (or suck out) gobs of money when necessary. It has moved rates up when leverage starts rising, and lowered them when it wants to stimulate borrowing. With the hit from Covid-19, the ratio of credit to gross domestic product could go as high as 286%, HSBC Holdings Plc estimates. In May, so-called total social financing grew 12.5% from a year earlier. Rates have been pushed so low that they have encouraged arbitrage and a buildup of leverage.

But measures to make transmission more effective haven’t done much and the financial plumbing remains clogged. The central bank’s various tools, including cutting the reserve ratio requirement, haven’t been able to lower rates. In fact, they have become less effective over the last few years in bringing down lending costs. The loan prime rate, for instance, which has become a de facto benchmark, hasn’t had the desired effect, even though officials have tweaked it in recent months.

Things will only get worse from here. Bank balance sheets, the main channel between the financial system and the real economy, aren’t being strengthened or cleaned up. In fact, asset quality is deteriorating and the ability to digest the non-performing loans is shrinking as capital buffers are eroded.

For investors, all the bank capital and preferred shares coming to market as these institutions try to safeguard their cushions will have a new layer of risk – one they can’t quantify. Those hefty Chinese bank dividends may also come into question as profit growth is compromised. For Beijing, pulling on the same levers again and again won’t work. Cleaning up balance sheets will.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Anjani Trivedi is a Bloomberg Opinion columnist covering industrial companies in Asia. She previously worked for the Wall Street Journal.

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