The Island of Misfit Toys: Deleveraging and the Evolution of Credit Committees

China’s financial system is a little like the Island of Misfit Toys.[1] From a distance everything looks familiar, but up close it becomes apparent that things aren’t built the way you might expect. Take the country’s money-market funds: they aren’t managed by institutional investors like Vanguard and Fidelity but by internet giants Alibaba and Tencent. Meanwhile, trusts don’t help preserve intergenerational wealth as they do in other countries but operate as a conduit through which banks and high-net-worth individuals make loans. Similarly, creditors’ committees—vehicles used globally to restructure debt at distressed companies—have evolved to serve a role in China far beyond how they’re typically used overseas.

Around the world, creditors’ committees have long been used as a way to rehabilitate struggling companies by restructuring their debt without getting the courts involved. They’re a way for a company’s creditors to come together and collectively determine if they should change the terms of their loans or take other steps to ensure the company’s survival. Elsewhere in the world, the decision to set up a creditors’ committee usually rests with the creditors themselves, but in 2016 the China Banking Regulatory Commission (CBRC) decreed that the creditors of all heavily indebted Chinese companies must convene creditors’ committees (债权人委员会).

By year end, 12,836 firms had followed CBRC’s decree and established such committees, overseeing 14.8 trillion yuan worth of outstanding loans.[2] At the time, those figures seemed a fair indication, and an implicit government acknowledgement, of just how widespread distress among Chinese firms had become. That would have been a reasonable assessment if creditors’ committees had been used much as international experience dictated, and as the central CBRC had intended.[3]

Instead, in their implementation of Beijing’s new regulations, local authorities massively broadened the scope of companies required to set up creditors’ committees. Far from being a vehicle that deals solely with distress, local authorities required healthy firms to also set up these committees (see Figure 1), deploying the committees as a way to uncover hidden financial risks and as a tool to rein in the pace of debt accumulation at Chinese firms. Although the CBRC hasn’t disclosed national-level data on the number of credit committees established by the end of 2017, there are signs that the number of committees has continued to increase, not in response to a rise in corporate distress, but as a result of provincial authorities expanding the criteria governing what firms must set them up.

For example, 119 creditors’ committees had been set up in Sichuan at the end of August 2017–the earliest period for which we have data for the province–overseeing 273 billion yuan worth of loans.[4] By the end of 2017 those figures had ballooned to 2,425 creditors’ committees overseeing 2.67 trillion yuan worth of loans.[5] The rapid expansion was largely the result of the Sichuan branch of the CBRC lowering the minimum threshold at which firms are required to set up a committee from 300 million yuan to 100 million yuan worth of outstanding loans, regardless of whether the firms are having financial difficulties.[6]

Figure 1. Widening the Net
Minimum level of outstanding liabilities at which companies are required to set up creditor committees, regardless of whether they’re in distress. The list is only partial, based on publicly available data.
Source: CBRC; provincial state media.

This report looks at how the role of creditors’ committees has evolved. Firstly, it will look at how creditors’ committees are used in distressed firms, as the central CBRC originally intended. Secondly, it will examine how local authorities have expanded the application of creditors’ committees and the problems they’re supposed to resolve. Finally, it will look at how the China Banking and Insurance Regulatory Commission (CBIRC)—the CBRC’s successor—has decided to embrace the local innovations. Because this report is based on government statements and state media articles about creditors’ committees, it doesn’t offer much insight into the problems or challenges involved in managing these committees or just how successful they’ve been in meeting the authorities’ lofty goals. Instead it’s an effort to understand the role authorities hope creditors’ committees will play in de-risking the financial system.

From Bankruptcy to Debt Workouts to…Something Else

Creditors’ committees are a common part of bankruptcy proceedings around the world. In the United States, for example, after a company files for Chapter 11 protection, a judge will typically order that a creditors’ committee be formed to give unsecured creditors a say in negotiating the debtor company’s restructuring or liquidation. In China, creditors’ committees were first granted a role in bankruptcy as part of trial regulations published in 1986. They played an important part in a number of high profile bankruptcies during the early 2000s and recently have been used in the bankruptcy proceedings of major state-owned firms like Dongbei Special Steel.

However, it wasn’t until July 2016, when the CBRC published Notice 1196,[7] that creditors’ committees’ role in negotiating debt workouts independent of legal bankruptcy proceedings was formalized. Eschewing a government imposed, one-size-fits-all approach to dealing with distressed companies, the CBRC is using creditors’ committees as a way to generate bottom-up solutions tailored to each individual firm—what the CBRC calls “one policy for one firm” (一企一策). Given that the solution is designed by commercial lenders, it is also a nominally market-based solution, though the government does have an active role. The CBRC refers to creditors’ committees as an example of government-bank-firm cooperation (政银企合作). For example, a 2016 notice from the Shandong CBRC says that the head of creditors’ committees have to coordinate with the provincial government, the local finance office, the National Development and Reform Commission, and the Ministry of Industry and Information Technology.[8]

The committees are expected to determine:

• whether a company is beyond help and should be wound down. At the time the rules were issued, the Chinese media made much of how creditors’ committees were expected to help close down zombie companies that were kept alive only by the willingness of banks to extend credit to them.
• whether a company should be saved but requires active help on the part of the creditors. If so, creditors might reduce the interest rate or extend the maturity on outstanding loans, agree to convert some of the debt into equity, or engage in more creative solutions, like splitting the company in two as a way to ring-fence good assets from some of the debt.
• whether the company is struggling with “liquidity” problems only and merely requires ongoing support from creditors rather than a restructuring of its debts.[9] At the heart of this approach is the idea that many companies are fundamentally sound and will turn around given enough time. For companies in such a situation, the risk is that individual creditors might decide to withdraw their loans, sparking the sudden onset of distress that eventually forces the company to collapse. Beijing hopes to avoid such disruption by forcing creditors’ committees to decide whether to maintain debt levels or allow debtor companies to borrow more, and if so, how much. The strength of creditors’ committees is that their decisions bind members, precluding individual creditors from unilaterally withdrawing credit from the borrower.[10] Those who break rank face punishment. The People’s Daily put it this way:

“Banking institutions that don’t execute the creditors’ committee’s decisions…or pursue measures that disrupt the debtor company’s smooth restructuring will face disciplinary measures from the banking association. The regulator will also take appropriate measures.”[11]

Information Asymmetry: What the Banks Don’t Know Can Hurt Them—and the Entire Economy

Local authorities, however, have pushed the function of creditors’ committees far beyond what the central government originally intended. Rather than just being a tool for dealing with distress, local authorities have seized upon the committeesas a way to improve the ability of banks to monitor and discipline their borrowers. Such a move is necessary because banks have traditionally lacked sufficient insight into the financial situation of their borrowers to be able to fully grasp the risks involved. Henan CBRC deputy chairman, Zhang Chun, put it this way:

“Asymmetry of information has worsened the relationship between banks and firms, causing great damage to the local financial ecosystem. Creditors’ committees have emerged at just the right time to [repair] the relationship between banks and firms and build a new order of bank competition.”[12]

In other words, creditors’ information deficit can be redressed by having them pool their insights, and by leveraging their collective influence to extract useful information that might otherwise not be forthcoming from the debtor firm’s management.

Asymmetry of information isn’t unique to China. In any economy, banks will always know less about the financial health of the companies they lend to than executives at those companies. But in China the problem has some unique characteristics. An old adage has it that Chinese companies keep three sets of books: one for the taxman, one for their bankers, and an accurate one for themselves. That resulted in banks’ bias toward lending to state firms, not because they were necessarily more transparent than private borrowers, but because in an environment of significant information asymmetry, it was politically–if not financially safer–to lend to a state firm.

Banks mitigated the risks from unreliable and often scarce information by ensuring they had sufficient collateral to cover the value of the loans. With sufficient collateral, a bank’s inability to fully appraise a borrower’s capacity to repay the loan became less important because the loan is effectively insured. Traditionally, however, private companies haven’t had the sort of collateral that banks want, specifically land and property. So, in response to government prodding to lend more to the private sector, banks accepted third-party guarantees instead. In other words, some other company would promise to repay the loan if the borrower defaulted.

Guaranteed Financial Contagion 

The problem with this arrangement is that complicated chains of interlocking guarantees emerged—one private company would be guaranteed by another, which in turn would have its own loans guaranteed by a third, and so on—causing situations in which a default at one company resulted in a chain reaction of defaults, as distress at one company was transmitted to others via guarantees.[13] This phenomenon has taken a serious toll on regional economies, resulting in the collapse of dozens of private companies in places like Jiangyin in Jiangsu province[14] and Dezhou in Shandong province.[15] However, individual banks have very little insight into these complicated guarantee chains, giving rise to serious risks for the banks. On one hand, what might appear to be a healthy borrower might actually be in a far more precarious financial position given the guarantees it has made. On the other, a bank might inadvertently trigger a wave of defaults by withdrawing credit from a single firm.

By having creditors share information with each other, the idea is that they will have a better sense of borrowers’ guarantees and will even be able to negotiate with the creditors’ committees of other firms in the guarantee chain. But that’s just one part of the picture. By acting in concert, creditors should, in theory, also be able to better understand the financial risks related to a company’s relationship with its parent and subsidiaries. Moreover, given the proliferation of new types of financial institutions in recent years, a firm might have loans from banks, asset management companies, leasing firms, trusts, bonds, and even online lending platforms. Coordination between creditors will give them better insight into a company’s overall debt burden. A People’s Dailyarticle from February 2018 explained the situation in Chongqing like this:

“Currently, some firms have complicated debt and guarantee relationships, and it’s difficult for a single bank to fully grasp the situation. They have no way of effectively managing risks, they often move in a herd in assuming a firm is a ‘good company,’ and they lack a grasp of the overall scale of corporate groupings’ leverage and liabilities, leading to a situation of excessive credit, increasing the risk to both companies and bank.”[16]

Collective Credit Decisions Made by the Market

Finally, creditors’ committees have emerged not just as a tool to prevent banks from inadvertently triggering localized financial crises, but also for limiting the expansion of credit. A number of provinces have empowered creditors’ committee with the authority to purse what they call “joint credit management,” which, in effect, allows the committees to place a cap on any additional borrowing by the debtor, regardless of whether the firm is in distress. The rationale is that the inability of banks to individually assess a borrower’s risk has resulted in companies borrowing far more than they should. And while that may not have resulted in outright distress, it now needs to be curtailed, in part to ensure that credit isn’t disproportionately concentrated in a handful of large firms but is better distributed across smaller, entrepreneurial companies.

That has been happening in certain provinces for some time already. The Shandong provincial CBRC, for example, has been promoting such joint arrangements at large firms since at least 2013. According to figures disclosed the following year in the province’s 2014 annual report, 212 companies practiced “joint credit management” that year. The report singled out four creditors’ committees from the city of Dongying for using such a structure to collectively reduce outstanding debt at their respective debtor companies by 10.5%. Shandong was also an early mover when it came to setting up creditors’ committees, initially calling them 债权人联席会, or “creditors’ joint committees” (see Figure 2).

Figure 2. Trailblazing in Shandong
Number of creditor committees operating in Shandong province at year endSource: Shandong CBRC.

On June 1, the national-level CBIRC issued trial regulations that will see large firms (i.e. those with three or more banking system creditors and more than 500 million yuan in outstanding debt) form “joint credit committees” (联合授信委员会). In effect, the banking regulator seems to be trying to draw a distinction between what it originally designed creditors’ committees for—a body convened to ensure the smooth restructuring of troubled firms—and what they evolved into at the provincial level. Those expanded functions will now properly belong to the joint credit committees. In a Q&A posted on its website, CBIRC explained the role of the new body like this:

“The ‘joint credit mechanism’ makes up for the failing of the banking industry to monitor and control firms’ excess borrowing from multiple sources and helps the banking sector properly grasp the actual state of firms’ fundraising.”[17]

According to the Q&A, joint credit committees will be required to assess debtor companies’ financial situation and then sign an agreement with the debtors that limits how much they can borrow. The debtor companies are then free to raise those funds as they see fit, but they can’t exceed the limit. How that plays out in practice remains to be seen.

Conclusion

Creditors’ committees and joint credit committees are best understood as part of Beijing’s double pronged strategy to clean up the financial system. On one hand, Beijing wants banks to gradually dispose of their bad loans. On the other, it is aiming to improve the quality of those assets that remain on the banks’ books. And it wants to achieve both at a minimal cost to the state.

As part of that process—one that will be drawn out over a long period of time—creditors’ committees can potentially help minimize economic disruption, force the cost of adjustment onto the banks, and gradually impose discipline on banks and companies and so prevent a repeat of the waste and excess that accumulated over the past decade. At least, that seems to be the theory behind the mass deployment of these committees. Whether they are up to the task or will simply end up preserving the status quo is something we hope to explore in the future.

Endnotes