China’s Major Banks Turn Inward to Deal With Bad Loans

For China’s major banks, 2018 saw a shift in the way they dealt with nonperforming loans (NPLs). Even as they massively increased their write-offs of bad loans, the amount of distressed debt they sold to asset management companies (AMCs) plunged. This development should provide some comfort that the big banks are becoming more self-reliant in controlling bad debt.

Based on our calculations, China’s Big Five state-owned commercial banks collectively wrote off $81.2 billion of NPLs in 2018, 74% more than they did in 2017 (see Figure 1). That represents a significant ramp up from 2017 when those same banks increased their write-offs by only 6% from 2016 (note that write-offs include what the banks refer to as “transfers out,” which are losses from distressed loans sold to third parties). The banks’ huge increase in bad loan disposals in 2018 allowed them to marginally reduce their NPL ratios, even as the NPL ratio for the banking sector as a whole actually rose (see Figure 2).

Figure 1. A Massive Surge in Write-offs by Big Five Banks (billions of yuan) Note: The “Big Five” includes ICBC, BoC, ABC, CCB, and BoCom.

Source: The banks.

Figure 2. Big Five Banks’ NPL Ratios Marginally Safer Than Before Source: The banks.

The enormous write-offs last year should’ve shown up in AMC purchases of those bad loans, since they are the main channel through which banks dispose of their bad loans. Except that wasn’t the case, at least according to figures disclosed by Huarong and Cinda, the only two of the Big Four AMCs to disclose their 2018 earnings.

Huarong, for example, spent just $2.9 billion acquiring loans from the Big Five banks, down 66% from $8.6 billion in 2017 (see Figure 3). In fact, Huarong’s purchase of NPLs declined across the board as its operations contracted following the company chairman’s detention on corruption charges. But the bad loans it bought from the Big Five banks fell disproportionately from 47% of total NPL purchases in 2017 to 30% in 2018. Meanwhile, Cinda also cut back on NPL purchases from the Big Five from $6.33 billion in 2017 to $3.3 billion. It instead increased its bad loan purchases from joint stock banks and city and rural commercial banks.

Figure 3. AMCs Cut Back on NPL Purchases from Big Five Banks in 2018 (billions of yuan)Source: Cinda, Huarong.

So, what explains the major banks’ declining reliance on AMCs? Certainly, the Big Five increased their securitization of NPLs last year, packaging $6.7 billion into asset-backed securities, up 29% from 2017. But the impact of securitization on the flow of NPLs to the AMCs is marginal at best, since banks mainly securitize loans to individuals that are not allowed to be sold in bulk to the AMCs.

A more plausible explanation may be found in a report on local AMCs from the Southwestern University of Finance and Economics in Chengdu. The report says the rise of asset investment companies (AICs)—subsidiaries of commercial banks that are specifically tasked with facilitating debt-for-equity swaps—has “slashed the flow of NPLs” to AMCs. So far, only the Big Five have set up AICs.

Data isn’t sufficiently available to calculate how many bad loans the banks converted into equity last year. However, based on limited disclosures by the banks, activity at the AICs has surged. For instance, ABC’s AIC executed $13.3 billion worth of debt-for-equity swaps in 2018, more than twice what it did in 2017. ICBC didn’t disclose the value of the swaps it carried out, but the assets of its AIC quadrupled and its net profit quintupled. Meanwhile, BoCom’s AIC did $1.5 billion worth of swaps in 2018, its first year in operation.

It’s unclear the degree to which debt-for-equity swaps are redirecting bad loans away from the AMCs. Most swaps seem to involve large, politically influential state firms with whom banks are likely to maintain good relations. Hence, banks might be reluctant to relinquish control of their loans to a third party, even if they’ve gone bad.

Still, regardless of whether the AICs’ activities entirely account for the AMCs’ anemic NPL purchases, it’s clear that the major commercial banks are increasingly dealing with their bad loans in-house. That’s a good thing for both the banks and the AMCs. By developing alternative channels for NPL disposals, it reduces the supply of NPLs being sold onto the secondary market, thereby supporting prices and, by extension, the value banks can extract from their bad loans. Moreover, by reducing the volume of bad loans the AMCs need to absorb each year, it reduces the amount of fresh capital AMCs need to raise.

China’s NPL landscape is constantly changing, but one thing is clear: Beijing is providing the financial system with the tools to deal with the bad loan problem without having to step in with its own money. Diversifying the channels for NPL disposals is an important development in maintaining that balance.