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S&P Global Ratings

China's Bailout of a Troubled Bank Isn't Surprising

S&P Global Ratings

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China's Bailout of a Troubled Bank Isn't Surprising

Hong Kong, May. 27 2019 — China's recent bailout of a troubled commercial bank is a clear signal that it remains highly supportive of the banking sector. The central bank and banking regulator took control over Baoshang Bank (unrated)--a small to midsized regional bank, with a strong connection to a private group--because of severe credit risks. It's the first such action for about 20 years. S&P Global Ratings anticipates high regulatory discretion in managing troubled banks, and believes that financial stability will remain a paramount consideration.

"Aggressive and small to midsized banks like Baoshang are susceptible to an economic slowdown because their risk management capability can't keep up with their breakneck pace of growth," said S&P Global Ratings credit analyst Ryan Tsang. "In certain cases, questionable governance intensify the risks a bank faces when aggressive private shareholders exert significant influence over the institution's credit decisions."

The bailout is also a good test of how regulatory tier-2 capital instruments (term subordinated debts) would function under a regulatory takeover scenario. In Baoshang's case, the risk of these instruments being called upon to absorb losses could have heightened. The People's Bank of China and China Banking Insurance Regulatory Commission indicated on May 26, 2019, that corporate or financial institutions' exposure of more than Chinese renminbi (RMB) 50 million (US$7.3 million) as of May 24, 2019, would be protected, subject to negotiation with administrators. The authorities also stated that any new corporate and interbank balance after May 24, 2019, would be fully protected.

The gap continues to widen between strong and weak Chinese banks, given the slowdown in economic growth, regulatory crackdowns, and varying risk management practices (see "Deleveraging While Disseminating: The Task Facing China's Banks," published on RatingsDirect on Nov. 8, 2018). We recently revised our view on the importance of selected Chinese mega banks to the Chinese government and their likelihood of receiving government support (see "What Drives Chinese Megabanks' Stand-Alone Credit Profiles And Their Likelihood Of Receiving Government Support," on March 26, 2019). In our opinion, these banks are critical to the Chinese government and have an extremely high likelihood of receiving extraordinary government support.

Earlier this year, senior regulatory officials stated that risky financial institutions could exit the market. The central bank and other regulators also published a policy guideline on domestic systemically important financial institutions, and further details are expected to be released later this year (see "Too Big To Fail? China Strengthens FI Risk Buffers With New Framework," published Nov. 30, 2018). This development follows the establishment of a deposit guarantee scheme in 2015. As of end-2018, the scheme has accumulated only RMB82.12 billion of funds, which is still small compared with the RMB182.52 trillion of deposits in the system.

"We believe the resolution framework will develop in a way that leaves plenty of flexibility for the government to bail out banks at its discretion," said S&P Global Ratings credit analyst Liang Yu. "Our ratings continue to factor in our expectation of strong support from the government for the banking industry and individual banks."

China Construction Bank Corp. (A/Stable/A-1), the second largest state-owned commercial bank, is entrusted to ensure the smooth running of Baoshang's operations, thereby maintaining depositors' confidence and minimizing the disruption.

Investors maintain high interest in the loss-absorption abilities of the Basel III-compliant tier-2 instrument issued by Baoshang in late 2015. The instrument contains a mandatory nonviability contingent capital (NVCC) feature, which provides for a write-down of the principal upon the occurrence of a trigger event.

For similar rated instruments issued by mega banks, we apply our notching from the issuer credit rating rather than the stand-alone credit profile because we believe the likelihood of extraordinary government support is extremely high. In our view, the Chinese government is very unlikely to declare these mega banks nonviable and trigger the NVCC clause in these instruments.

Based on the recent regulatory takeover of Anbang Insurance Group Co. Ltd., the shareholders' interest at Baoshang could be significantly, if not completely, written down to absorb losses. It's uncertain whether the investors of the bank's tier-2 capital instruments will have to bear losses at this point.

"It's difficult to envision that investors in Baoshang's subordinated regulatory capital would receive more favorable treatment than senior corporate or interbank creditors with exposure of over RMB50 million, unless the senior unsecured debt were associated with irregularities," said S&P Global Ratings credit analyst Harry Hu. "But we don't rule this out as the regulator seeks to negotiate with relevant parties, balancing moral hazard issues and market confidence."

Baoshang reported assets of RMB431.6 billion in 2016. It did not publish its 2017 and 2018 annual reports. The bank's assets at end-2016 were 3.8x that of end-2010. Baoshang was one of the top 40 Chinese banks by total assets at the end of 2016. It is the third bank to have been administered by the regulator for around the past 20 years, following Hainan Development Bank in 1998 and Shantou Commercial Bank in 2001.