- We estimate Chinese banks will still have RMB3 trillion in legacy "shadow" wealth-management products by end-2021, the deadline for resolving these exposures.
- By our calculations, recognizing these off-balance sheet assets could shave around 10% from the capital buffers of some national banks.
- Regulators might be flexible with balance-sheet deadlines but less tolerant on bailouts if any of the loan-like legacy products default.
Last year, as the pandemic gripped China's financial system, banks were granted an extension on the deadline to remove or recognize exposure to certain legacy wealth management products (WMPs). The banks now have until the end of this year to perform this formidable task--but will likely need more time. S&P Global Ratings believes a faster dash to the deadline would prove too disruptive, given the knock-on effects to regulatory capital and sector-lending caps.
While China's wealth management products continue to expand, both off and on balance sheet, the problematic WMPs have decreased by 55% to Chinese renminbi (RMB) 8.5 trillion (US$1.3 trillion) since the country first announced shadow-banking reforms in 2018. Some of the loan-like, implicitly guaranteed products have matured, and are increasingly being replaced by net asset value (NAV) funds.
We estimate RMB2.5 trillion-RMB 3.5 trillion of banks' non-NAV-type legacy WMPs could remain outstanding by the new deadline of end-2021. If moved onto bank balance sheets, these assets would consume a lot of capital for small and midsized banks. China's six "megabanks" account for the majority of such legacy instruments; however, they also have larger buffers to absorb the adjustment.
Other Than Balance Sheets, Where Will These Assets Go?
Banks will use their extended deadline to revamp legacy products, to avoid a huge hit to capital costs and provision charges if these assets are moved onto their balance sheets. We project 60%-70% of the legacy-style products (or RMB5 trillion-RMB5.9 trillion) will be revamped by end-2021. This compares to RMB5.7 trillion revamped in 2019, and RMB4.8 trillion last year.
Revamping could take the form of repackaging and reselling legacy products into NAV-type products, provided the maturity is matched and investors' appetites are aligned. In addition, some of these legacy products will naturally mature. With average corporate loan maturities of three to four years in China, we expect natural maturity to play a big role this year. Having said this, there may also be long dated loan-like products and assets backed by additional tier-1 (AT1) capital within the legacy WMPs. These will be harder to resolve because the new rules prohibit complex pooling and maturity mismatch of underlying assets and products.
For those products that can't be revamped or matured, banks will mostly likely move them onto their balance sheets, to reflect the risks. This can be capital consuming and we expect individual banks with weaker capitalization to establish a work-out plans with regulatory authorities. While reports say that these workarounds could go as long as 2025, we envisage most will be addressed in 2022. This is considering the additional transition timeframes given to individual banks in past reforms, such as recognition of 90-day overdue loans.
NAV-style products now predominate, however banks have continued to issue or sell other types of investment products. Newly issued WMP products in 2020 have average maturity of 228 days, with products of tenors exceeding a year accounting for just 13.12%, according to the wealth management development report of China banking industry in 2020. This reflects, in part, investor appetite, which is stronger for short-term products.
What Will Be The Capital Costs Of These Adjustments?
At a sector level, we estimate the overall regulatory capital burden for commercial banks would be around 33 basis points (bps). This would be the cost if the remaining RMB3 trillion (a roundoff of our range) of the legacy WMP products were moved onto balance sheets using financials for the third quarter of 2020 under a one time-transfer scenario. This is due to a two-fold effect of: (1) the capital cost associated with the larger balance-sheet; (2) the capital costs of higher provision coverage (see table 1).
|Two-Fold Impact Of Bringing Shadow Assets Onto Balance Sheets|
|Background||Breakdown on non-NAV WMPS|
|(1) Balance sheet (risk weightings)|
|The assets require increase capital adequacy based on risk-weightings, which vary according to sector||Government: 4%|
|Financial Institutions: 53%|
|Corporate counterparty exposure: 43%|
|(2) Provision charges|
|We assume the asset quality of these products are largely on par with their on-balance sheet corporate counterparts (excluding residential mortgages) in each banking group and banks maintain their latest provision coverage levels||On average, banks will allocate 180% provision coverage to the nonperforming section of the transferred legacy products|
|NAV--Net asset value. WMP--Wealth management products. Source: S&P Global Ratings estimates.|
Which banks will have a harder time adjusting?
China's six largest banks hold the bulk of the country's WMPs and thus will have the largest capital cost, in absolute terms. However, these banks also have ample buffers, and thus the adjustments will shave a smaller proportion of their capital cushions (see chart 2).
Capital buffers could thin for rural commercial banks. Their cushion above regulatory capital requirements would likely compress by about 12% (19 bps) if they moved the remainder of their non-NAV investment products onto their balance sheets in the second half of the year. This impact is outsized both due to thinner capital buffers, as well as their slower transition to NAV funds. As of end-September 2020, NAV products made up 51.28% of total WMPs, compared with the industry average of 57.97% (see chart 3).
The burden is also somewhat considerable for joint-stock banks (JSBs), which are generally national banks excluding the six megabanks. Our base case is a 12% reduction in the capital buffer. Moreover, this year China may classify banks in this group as domestic systemically important banks (D-SIBs), which would require them to increase their regulatory capital by 0.25-1.5 percentage points. JSCBs grew legacy products quickly before new asset management rule were implemented, to enhance their fee income growth. Wealth management and other fee-based services require less capital to boost revenues than traditional lending.
City commercial banks, in our view, are more progressed in the transition process, with NAV products making up 62.5% of the segment at end-September 2020. That said, these banks have less expertise and scope to develop fee-based business than other national banks.
We calculate that megabanks will hold 60% of the industry's legacy products at year-end. That translates into a capital burden of 41 bps, which is proportionally 9% of their buffers (moreover, these banks face rising capital costs as global systemically important banks, see "Credit FAQ: How Are China's Big Four Banks Addressing The RMB6 Trillion TLAC Gap?," Aug. 25, 2020). Consequently, should megabanks choose to absorb all their legacy products onto balance sheets by this year's deadline--setting a good regulatory-compliance example--the overall outstanding balance at end-2021 could drop materially to around RMB1 trillion-RMB1.5 trillion.
|Base Case Forecast Of Bank Capitalization Post-Migration Of Legacy Products|
|As of end-September 2020||Forecasts for Dec. 31, 2021|
|Base case (tril. RMB)||Non-NAV balance||Non-NAV balance (%)||Non-NAV as % of WMP||Total assets||Non-NAV as % of total assets||CAR||Non-NAV balance||Non-NAV balance(%)||CAR (%)||Revamp ratio (%) †||Expected capital burden (%)§|
|City commercial banks||1.68||15.94||37.50||40.3||4.17||12.44||0.27||8||12.21||(77)||0.23|
|Rural commercial banks||0.57||5.41||48.72||41.0||1.39||12.11||0.24||7||11.92||(50)||0.19|
|*S&P Global Rating estimates. §Impact of legacy products on capital adequacy ratio at end-September 2020. †Annualized percentage decrease of non-NAV products. tril.--Trillion. RMB--Chinese renminbi NAV--Net asset value. WMP--Wealth management product. CAR--Capital adequacy ratio. JSBs--Joint stock banks. Source: S&P Global, PY Standard, China Banking and Insurance Regulatory Commission.|
Implicit Guarantees May End. Is That Good Or Bad For Banks?
A key component of China's shadow-banking reform is to remove implicit guarantees on investment products. This has helped grow fee-based income, but such commitments are risky for individual banks. In our view, the new regulations reduce both system-wide and individual-bank risk.
We believe banks have preferred to make good on WMPs because such implicit guarantees play a big role in selling the products. Rather than endure reputational risk or lose business to competitors, they would compensate investors if products go sour. This means the banks need to change their selling habits. While this endeavor is already underway, bank hesitancy is also apparent. For example, in October 2020, Industrial and Commercial Bank of China Ltd. reportedly offered support on an asset management product that the bank distributed; the RMB4 billion in funds were managed by a third party, Penghua Asset Management Co. Ltd.
Other challenges remain, including improvements on transparency and standardizing valuations for project, risk reporting, and better maturity-matching of investor funds, which should aid with the investor-education process. In our view, the threat of regulatory fines or other punishment will help maintain discipline and reduce the market of products with false promises or implicit guarantees.
While regulators might grant additional grace periods on balance-sheet adjustments, less tolerance of implicit guarantees is probable.
The Contingent Costs Of Coming Out Of The Shadows
There are more than capital costs involved in meeting new asset-management rules. As loan-like WMPs move onto the balance sheet, this could create lending constraints. For example, a good proportion of legacy products will be backed by real estate and infrastructure assets, in our view, and recognizing them could breach lending caps by sector, as well as other thresholds. Another example is products backed by preference shares, which have higher risk weightings than traditional loans.
One key issue to watch for is the impact on funding costs. Banks have lured customers to WMPs by offering relatively high yields. Banks increasingly have to compete for deposits in China, and regulators discourage options such as interbank wholesale funding (e.g., a soft cap at 33% under macro-prudential settings).
We already count off-balance sheet WMPs when calculating our risk-adjusted capital (RAC) ratios. In other words, we have captured the risks in our credit profile for the banks, and the further transition of WMPs is likely to improve the ratio.
Editing: Cathy Holcombe
Digital design: Evy Cheung
- China GDP Recovery, Moratoriums, And Write-Offs Keep Banks' Bad Loans In Check, Feb. 1, 2021
- Credit FAQ: How Are China's Big Four Banks Addressing The RMB6 Trillion TLAC Gap?, Aug. 25, 2020).
- China Credit Spotlight: The Coming Exit Of Struggling Banks, Aug. 27, 2019
Appendix: China's Banking Groups
Megabanks in China are central government controlled commercial banks, and conduct a full range of commercial banking businesses and support certain government initiatives. These six banks are: Industrial and Commercial Bank of China Ltd. (ICBC; A/Stable/ A-1), China Construction Bank Corp. (CCB; A/Stable/ A-1), Agricultural Bank of China Ltd. (ABC; A/Stable/A-1), Bank of China Ltd. (BOC; A/Stable/A-1), Postal Savings Bank of China Co. Ltd. (PSBC; A/Stable/ A-1), Bank of Communications Co. Ltd. (BoCom; A-/Stable/A-2). We believe these banks have extremely high to very high likelihood of extraordinary government support.
Joint stock banks are partly owned by various level of governments directly or indirectly with nationwide presence. There are 12 JSBs in China, including these in the table below:
|Joint Stock Banks|
China Merchants Bank Co. Ltd.
Industrial Bank Co. Ltd.
Shanghai Pudong Development Bank Co. Ltd.
China Minsheng Banking Corp. Ltd.
China CITIC Bank Corp. Ltd.
China Everbright Bank Co. Ltd.
Ping An Bank Co. Ltd.
Hua Xia Bank Co. Ltd.
China Guangfa Bank Co. Ltd.
China Zheshang Bank Co. Ltd.
|Hengfeng Bank Co. Ltd.||Not rated|
China Bohai Bank Co. Ltd.
|Source: S&P Global Ratings.|
City commercial banks and rural commercial banks are regional banks operating in certain provinces or locations and generally have very high geographic concentration. As of end-2020, there are 133 city commercial banks and 1539 rural commercial banks in China.
This report does not constitute a rating action.
|Primary Credit Analyst:||Manqi Xie, CFA, Hong Kong + 85225328001;|
|Secondary Contacts:||Harry Hu, CFA, Hong Kong + 852 2533 3571;|
|Ryan Tsang, CFA, Hong Kong + 852 2533 3532;|
|Research Assistant:||Shaohua Guo, HANGZHOU|
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