China's endless moral hazard

Right now it looks like no bank is too big or too small to fail in China. With auto bailout systems for banks at every level, it doesn't matter how much a local bank may be underperforming -- the government has got its back.

Associate Professor Victor Shih from Northwestern University in the US spoke at the second Annual Global Recovery Investment Summit that was arranged by AsianInvestor and FinanceAsia in Hong Kong this week to discuss more closely this dilemma and the issue of what he called, "China's endless moral hazard".

Shih refers to the situation as a moral hazard because he believes that no matter how much trouble a bank may get itself into, or whether it is in the wrong, the central bank will bail it out. This differs from Western markets, where there is much more accountability in the governance system and it is still possible for a big bank to go bankrupt.

In the short-term, Shih believes it is difficult to imagine a financial crisis in China. "Crises are caused by a sudden withdrawal of liquidity due to the lack of confidence in the market," Shih said. "With common knowledge of this ultimate backstop, actors in the system will rarely panic."

Under such a system, if all goes according to plan, it is expected that regulators will guide banks towards sensible lending policies, which would lead to a stop in the build-up of risk in the system. However, the system is not perfect.

Shih noted that local investment companies in China have received over Rmb11 trillion ($1.6 trillion) in loans on the basis of what he said were "illegal government guarantees and shaky collateral". And regulators turned a blind eye to the widespread ever-greening of loans.

As well as this, he noted that local governments have openly given bank managers 'special bonuses' for lending to local projects.

One example of this became known in 2008 when it emerged that Liu Changming, head of Bank of Communications (Guangdong), had made Rmb10 billion of loans over four years. This was almost a sixth of all loans that were payable at the branch.

Changming formed shell companies to borrow large sums from the bank, which he then lent to various businesses at high interest. In the end, he racked up almost Rmb5 billion in non-performing loans. The peculiar twist to this story is that when a Ministry of Finance (MOF) auditor found the irregularities in Bocom's books, the local prosecutor's office arrested the auditor for taking a bribe. 

Eventually, the central government stepped in and ordered the MOF and the police to pursue the case. In the long-run though, it had very little impact on the tightening of accountabilities.

Shih noted that regulators now allow Bocom to roll over the bad loans and value seized assets optimistically to cover up the non-performing loans. What this demonstrates is that when a safety net is all-encompassing it can lead to a misallocation of capital as the state guides cash flows in order to satisfy policy objectives.

Therefore, the market might be instilled with confidence due to the safety net in the short-term, but if the timeline is extended, it is expected that a build-up of risk will crop up as borrower-banker-regulator collusions multiply.

"Regulators manage to uncover some collusion, but the temptation of shared rent will always undermine strict regulatory efforts," said Shih.

Shih makes the point that the Chinese system can be improved to become more transparent and accountable.

"Basically, the market has to be allowed to monitor bank behaviour in addition to the regulators," said Shih. He also recommended that listed banks should be made to publicly disclose top borrowers at the city level. And minority shareholders need more power to look through the banks' balance sheets.

Currently, regulations like non-performing loan ceilings that are imposed on the banks and on the China Banking Regulatory Commission only encourage these parties to collude -- thus making it easier to hide non-performing loans on the books.

The main problem, Shih said, is that regulators are trying to put everything in one basket instead of focusing on a few measures of bank safety, one at a time. Banks also need more autonomy so that risks can be digested by the market in a decentralised way and so that they can sell distressed debt directly to investors.

However, with a system that is currently supporting an endless moral hazard, the changes that Shih recommends realistically won't be implemented until China reaches a tipping point that sways it towards an absolute financial crisis.

Victor Shih is a political economist at Northwestern University specialising in China. He is the author of a new book published by Cambridge University Press titled Factions and Finance in China: Elite Conflict and Inflation.