Feuer Frei!
07-24-11, 06:26 AM
Investors are worried about the health of China’s banks. They’re afraid—with good reason—that the massive, state-directed lending binge that was instrumental in pumping up China’s GDP figures the past two and a half years will end up producing an equally massive pile of bad debt. Barely a week goes by without new word of a troubled project or impending default.
Never fear, say the banks and some analysts. They point to the extraordinarily low loan-to-deposit ratios of Chinese banks, averaging around 65%, as evidence that these banks have plenty of cash to cushion themselves against any future loan losses they might suffer. Everything is under control.
This argument is misleading, and offers a false sense of comfort.
First of all, the loan-to-deposit ratio is a measure of liquidity, not of solvency. A high ratio suggests that a bank may be relying too much on volatile short-term borrowing rather than stable long-term customers to fund its lending. It risks getting caught without enough cash reserves on hand to satisfy its creditors, forcing it to sell other assets at a loss, which could eventually cause the bank to fail. Having plenty of cash reserves on the left (asset) side of a bank’s balance sheet can help prevent such a crisis. But it has nothing to do with a bank’s capacity to absorb losses from bad loans without going bankrupt.
A bank’s solvency in the face of losses depends on the loan-loss provisions it has set aside and the capital it has built up on the right (equity) side of its balance sheet. Chinese banks like to boast that they have an average “loan-loss coverage ratio”—the amount of equity set aside, divided by the amount of nonperforming loans—of 220%, up from 80% at the end of 2008. Optimists argue this shows banks have set aside more than twice the amount of equity they would need to make up for all their bad loans.
But that ratio considers only those loans a bank has formally designated as nonperforming, and banks have hardly recognized any bad loans stemming from their recent bout of lending. China’s banks are required to set aside loan-loss reserves equivalent to 2.5% of their total loan portfolios. Yet based on the lessons of previous rounds of credit expansion, it’s more likely that up to 20% or even 30% of their loan portfolios will turn bad at some point in the wake of the latest expansion.
Indeed, estimates leaked by Chinese bank regulators suggest that 23% of loans to local government-sponsored infrastructure projects are an outright loss, with another 50% at risk of cash default. If Chinese banks made appropriate provision for these losses alone, it would reverse the record earnings they have been reporting and eat into their capital base. Apply these estimates across other risky loan categories, such as real-estate development and business lending diverted to speculation in stocks or property, and their capital is in real danger of being wiped out. The loan-to-deposit ratio doesn’t matter; they can have captive deposits and lots of cash, and still be bankrupt if they threw it all away on bad loans.
In fact, all that excess liquidity Chinese banks have on their balance sheets is really part of the problem. It isn’t there because the banks are cautious lenders, but because China’s external imbalances—the inflow of money from both the current and capital accounts, accumulated as foreign-exchange reserves—keeps driving up the domestic deposit base.
Unless this constant injection of money is sterilized and kept out of circulation, with cash reserves piling up and the loan-to-deposit ratio pushed ever lower, the result is runaway lending. That is precisely what happened when banks were allowed to draw on their reserves to fund the lending boom. The high levels of liquidity in China’s banks aren’t a cushion against bad debt. They are the reason those banks loaned money so recklessly in the first place.
SOURCE (http://www.businessinsider.com/wsj-chinese-banks-are-worse-off-than-you-think-2011-7#ixzz1T0u6WWWQ)
Never fear, say the banks and some analysts. They point to the extraordinarily low loan-to-deposit ratios of Chinese banks, averaging around 65%, as evidence that these banks have plenty of cash to cushion themselves against any future loan losses they might suffer. Everything is under control.
This argument is misleading, and offers a false sense of comfort.
First of all, the loan-to-deposit ratio is a measure of liquidity, not of solvency. A high ratio suggests that a bank may be relying too much on volatile short-term borrowing rather than stable long-term customers to fund its lending. It risks getting caught without enough cash reserves on hand to satisfy its creditors, forcing it to sell other assets at a loss, which could eventually cause the bank to fail. Having plenty of cash reserves on the left (asset) side of a bank’s balance sheet can help prevent such a crisis. But it has nothing to do with a bank’s capacity to absorb losses from bad loans without going bankrupt.
A bank’s solvency in the face of losses depends on the loan-loss provisions it has set aside and the capital it has built up on the right (equity) side of its balance sheet. Chinese banks like to boast that they have an average “loan-loss coverage ratio”—the amount of equity set aside, divided by the amount of nonperforming loans—of 220%, up from 80% at the end of 2008. Optimists argue this shows banks have set aside more than twice the amount of equity they would need to make up for all their bad loans.
But that ratio considers only those loans a bank has formally designated as nonperforming, and banks have hardly recognized any bad loans stemming from their recent bout of lending. China’s banks are required to set aside loan-loss reserves equivalent to 2.5% of their total loan portfolios. Yet based on the lessons of previous rounds of credit expansion, it’s more likely that up to 20% or even 30% of their loan portfolios will turn bad at some point in the wake of the latest expansion.
Indeed, estimates leaked by Chinese bank regulators suggest that 23% of loans to local government-sponsored infrastructure projects are an outright loss, with another 50% at risk of cash default. If Chinese banks made appropriate provision for these losses alone, it would reverse the record earnings they have been reporting and eat into their capital base. Apply these estimates across other risky loan categories, such as real-estate development and business lending diverted to speculation in stocks or property, and their capital is in real danger of being wiped out. The loan-to-deposit ratio doesn’t matter; they can have captive deposits and lots of cash, and still be bankrupt if they threw it all away on bad loans.
In fact, all that excess liquidity Chinese banks have on their balance sheets is really part of the problem. It isn’t there because the banks are cautious lenders, but because China’s external imbalances—the inflow of money from both the current and capital accounts, accumulated as foreign-exchange reserves—keeps driving up the domestic deposit base.
Unless this constant injection of money is sterilized and kept out of circulation, with cash reserves piling up and the loan-to-deposit ratio pushed ever lower, the result is runaway lending. That is precisely what happened when banks were allowed to draw on their reserves to fund the lending boom. The high levels of liquidity in China’s banks aren’t a cushion against bad debt. They are the reason those banks loaned money so recklessly in the first place.
SOURCE (http://www.businessinsider.com/wsj-chinese-banks-are-worse-off-than-you-think-2011-7#ixzz1T0u6WWWQ)