Over the past few years, the increasing reliance of China’s commercial banks on wholesale funding markets, especially during a period of increasing interest rate volatility, has raised concerns about sustainability and potential risks for the broader Chinese economy. Fortunately, the People’s Bank of China (PBoC) and other regulators recently introduced new regulations to curtail issuance and place commercial bank funding on the path to a more solid foundation.
Commercial banks’ funding behavior driving market changes
Historically, China’s commercial banks have benefited from a wide spread between lending and deposit rates, regulated and protected by the PBoC, which encouraged lending to low risk state owned enterprises while allowing the commercial banks to benefit from a wide net interest spread at the expense of depositors. That foundation, combined with a high savings rate, strict capital controls and a limited range of investment alternatives, allowed commercial banks to benefit from a huge, low cost deposit base.
However, the introduction of interest rate liberalization, removal of implicit government deposit guarantees and rapid growth of money market funds has pummeled commercial banks’ funding bases, and reduced their interest rate margins at a time when investors are demanding higher profits and higher returns.
The PBoC unveiled a key component of interest rate liberalization when it introduced negotiated certificates of deposit (NCDs) in May 2015. These instruments, combined with negotiated time deposits (NTDs) have allowed commercial banks to access the wholesale markets and to diversify their funding base, more closely matching maturities and obtaining market-driven interest rates. In the two years since NCDs were launched, outstanding NCD issuance has rocketed to over CNY 8 trillion (Fig 1a) and has become a major funding source and driver of asset growth and profits. In 2015 and most of 2016, while interest rates were low and liquidity was ample, commercial banks were able to fund their growth via wholesale funding markets at very low costs (Fig 1b).
Chinese commercial banks became arguably the most important drivers of the onshore fixed income market, acting as both the largest investors (they held 48% of outstanding bonds at the end of June 2017) and the biggest borrowers (accounting for 57% of new issues in the first half of 2017).
To address the dilemma of ensuring stable economic growth while encouraging the deleveraging of the financial system, the PBoC started tightening liquidity in December 2016, pushing market driven yields higher, triggering increased interest rate volatility and sparking a funding shortage. However, this also exposed small and mid-sized banks’ unhealthy reliance on wholesale funding. While most corporate issuers could switch funding sources to avoid the unexpectedly higher funding costs in the capital markets, commercial banks’ assets were locked in, with longer tenors than their liabilities, leaving them no choice but to continue issuing NCDs. The yield spread for banks versus corporate debt widened sharply as banks incurred significantly higher wholesale funding costs (Fig 2a). Compounding these challenges were the mark-to-market losses suffered by existing investors, who also faced redemptions, causing forced selling and even higher NCD yields (Fig 2b).
Tightening policies provide a more stable banking environment
In late 2015 the PBoC introduced the Macro Prudential Assessment (MPA), a quarterly monitoring program designed to gradually tighten the regulation on commercial banks. In mid-2017, the central bank identified the rapid growth of NCDs as a systemic risk and redirected its extensive powers under the MPA toward curtailing wholesale bank funding. By capping banks’ asset growth, and including NCDs within the wholesale funding cap of one-third of a bank’s total liabilities, the PBoC achieved a substantial slowdown in commercial banks’ asset growth. In the near future, these measures may reduce banks’ reliance on wholesale funding and reduce the risk of an NCD selloff triggering a systemic crisis.
In our view, while many economic challenges remain, a prudent central bank and further regulatory reforms should create a more robust foundation for commercial bank funding, make financial risk more manageable and create a more favorable investment environment, which should improve the onshore bond market’s confidence and growth prospects.