Spooked customers of Chinese village banks may jump ship to bigger lenders

Problems at six private "village" banks in China could spread to other smaller institutions and trigger a flight of deposits and investment funds, according to S&P Global Ratings.

The discovery of irregularities at four village banks in Henan province and two in Anhui have "spooked" customers, who may now try to shift their money to bigger lenders or to those perceived to be backed by the government, Ratings said in a July 14 report. Customers have battled to withdraw their funds from the banks, prompting protests.

"Small banks in China are more prone to weak governance than larger peers," said Harry Hu, senior director at Ratings. "This known problem has been dramatically highlighted of late with protests outside of village banks and regulatory offices in Henan province."

After the protests, which are a rarity in China, authorities announced some relief measures, including a payment of 50,000 yuan each to affected customers who made online purchases of deposit-like products. The payments do not fall under the deposit insurance system, which covers customers up to 500,000 yuan in deposits but not for investment products.

Tighter regulation

The affected funds may not be typical customer deposits, but rather investments in wealth management products. Chinese lenders had been selling such investment products by calling them deposits, though the practice has declined after regulators tightened rules on the sector.

Regulators are also assessing potential financial gaps, given the charges that assets were stolen, Ratings said, noting reports that say even ordinary deposits at the affected banks are being hit. That could accelerate remedial regulatory actions, it said.

"Prudential regulators will try to strike a delicate balance between protecting depositor confidence without being seen to guarantee investment-like products and giving other concessions that gives rise to moral hazard," Hu added.

Ratings estimates the interim relief to cost about 20 billion yuan, though it is not clear who is funding the payments.

"Poor internal control should be the main reason behind these incidences," said Michael Zeng, Hong Kong-based banking analyst at Daiwa Capital Markets. It is not likely to be a widespread phenomenon, as larger, public or government-owned peers would have more sophisticated controls, Zeng said.

While the incident may not pose a systemic risk to China's banking system, it would trigger more stringent regulatory actions by authorities, Zeng said.