China’s Banking System at Risk from Growing Dependence on Wholesale Funds

Moody’s new report looks at the consequences of the faster pace of asset growth experienced by Chinese banks.

Moody’s has issued a report revealing that the significantly faster pace of asset growth for Chinese banks, other than the country’s big four, suggests that much of the current asset growth in the Chinese banking system is supported by wholesale funds rather than deposits.

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Christine Kuo, a Moody’s Senior Vice President, said: “The increasing use of wholesale funds constitutes a systemic risk because it raises interconnectedness in the system and makes transmission of unexpected shocks more pronounced.”

Counterparty Failure

She added that with an increasing number of banks now more actively engaged in the interbank financial product business, they are becoming more sensitive to the risk of potential counterparty failure, which could magnify any collective reaction to negative news and trigger a sharp tightening in system liquidity.

In its report, Moody’s explained that the banks’ most liquid assets are largely in the form of interbank assets, meaning they will need to withdraw funds from other banks to meet their own funding needs, which could in turn cause contagion.

Moody’s report also pointed out that a rising credit risk among many mid- and small-sized Chinese banks is their deteriorating funding profile, a reflection of the fact that their usage of wholesale funds, particularly short-term funds, has been increasing in recent years.

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China’s Four Big Banks

By contrast, the big four banks in China (Industrial & Commercial Bank of China, China Construction Bank Corporation,  Agricultural Bank of China and Bank of China) are not dependent on the interbank market and are mostly fund suppliers, reflecting their strong deposit franchises and more prudent growth strategy.

Moody’s went on to explain that for individual banks, the increased use of short-term wholesale funds would expose the banks to the higher risk of tenor mismatches and funding disruptions.

The situation is exacerbated by the fact that many banks channel these short-term, confidence-sensitive funds to support illiquid assets, including loans as well as investments in loans and receivables.

Growing Asset Class

Furthermore, Moody’s said that investments in loans and receivables are a growing asset class on the banks’ balance sheets, and carry significant risks of their own. Aside from balance-sheet volatility, the costs of funding these liabilities also tend to be higher for smaller banks, reflecting their higher risk premium, which is also a negative from a profitability perspective.

Moody’s concluded in its findings that while China’s central bank will likely inject the needed liquidity into the market to address systemic risk, in the event that a bank’s funding problem becomes contagious, banks which are more dependent on confidence-sensitive wholesale funds could still be vulnerable to a spike in funding costs and substantial roll-over risks, which could in turn undermine their credit standing.

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