Analysis: China cash squeeze exposes risks from short-term funding


The mirror that China's central bank is holding up in front of the country's banks is providing uncomfortable viewing. Too many banks are reliant on short-term funding markets to survive, and a shake up in the sector is needed.

The central bank has engineered the current cash crunch as a warning to overextended banks but a growing concern, analysts say, is of a miscalculation that sets off a full-blown crisis.

Continue Reading Below

The central bank's determination to rein in rapid credit growth has sent interbank lending rates soaring to record highs, sparking panic and swirling speculation that banks are defaulting on deals as they scramble to secure short-term funds.

Analysts suspect a particular target of the central bank is non-bank lending, or shadow banking, which has boomed in recent years.

"A more structural factor behind this squeeze is that banks are using liquidity tools to support their long-term business. That should be a strong warning sign for the industry," said Hu Bin, senior China banking analyst at Moody's Investor Service in Hong Kong.

In particular, Hu says, some banks are relying on short-term interbank borrowing to come up with the cash necessary to meet repayment obligations on high-yielding investment products, a similar reliance that caused problems for some Western banks during the global financial crisis.

"Everyone in the system is impacted by this, even all the way at the top in terms of the largest banks in the country," said Charlene Chu, senior director at Fitch Ratings.

"It's certainly a lot more swift and arguably more effective in reining in the growth of shadow credit. But it does create a lot of repayment risk within the system between financial institutions and there is potential for unintended consequences."

Overall financing in the Chinese economy increased 52 percent in the first five months of 2013 compared to the same period last year, which analysts say was led by a surge in shadow banking activity and wealth management products that promised investors high returns.

Fitch estimated that total sales of wealth management products reached 13 trillion yuan by the end of the 2012, more than 16 percent of total bank deposits.

More immediately, it estimated that more than 1.5 trillion yuan in wealth management products will mature in the last 10 days of June. That may explain the scramble by some banks to secure short-term funds, which are often used to meet the repayment obligations.


Banks have created wealth products by packaging various assets like money market deposits, corporate bonds and informally securitized loans.

Many of these products are held off-balance-sheet, which allows banks to meet state-mandated loan-to-deposit ratios and still create new loans.

Many are also based on long-dated assets, so when payouts are due to investors, banks often raise cash by issuing new products - or by borrowing in the interbank market.

Authorities have tried to regulate the shadow banking sector and in particular these wealth management products but with little impact on the sector's growth. Now the central bank is playing hard ball with the banks by refusing to provide liquidity to the money markets, which this week drove the interest rate for some banks to borrow short-term funds to 25 percent or higher.

"The critical question now is how long is this going to go on," said Fitch's Chu on the sidelines of a conference in Sydney. "If this is going on for quite a while and we really start to get a shake out of institutions, the question is what potentially would they do to try and address some of that and would consolidation be on the radar screen."

Smaller banks, whose less extensive branch networks give them less access to customer deposits, are especially vulnerable to the credit squeeze.

At the end of 2012, interbank assets accounted for 25 percent of the total assets of mid-sized banks examined by Michael Werner, senior bank analyst at Bernstein Research. That compared with 15 percent in 2009, he said in a report this month.

Therefore, a wave of defaults on interbank loans could seriously threaten the solvency of smaller banks, he said.

"Speaking with a lot of Chinese banks, you often hear, 'this is not a risk because these loans always get repaid.' I think that type of mentality is going to get thrown out the door," Werner said.

At the end of 2012, mid-sized Minsheng Bank's <600016.SS> <1988.HK> interbank funding of less than one year accounted for 29 percent of its non-equity liabilities, the highest among the Chinese banks that Bernstein covers.

Werner says other mid-sized banks like Everbright Bank <0165.HK><601818.SS>, Industrial Bank <601166.SS>, and Ping An Bank <000001.SZ> are also highly dependent on short-term borrowing.

To be sure, the level of reliance on short-term funding is no where near the levels of some Western banks before the global credit crunch. Short-term funding may have accounted for more than half of such liabilities at Lehman Brothers at the end of 2007, a research paper by staff economists at the Federal Reserve Bank of New York showed in 2010. Lehman's collapse set off the global financial tsunami.


Banks that find themselves overly reliant on short-term funding face a choice: they can shrink their balance sheets so that more assets are funded by deposits, or they find other more stable funding sources.

If they choose the latter, equity and long-term debt are possibilities. But resorting to these more expensive funding sources would pressure banks' net interest margins, hurting profitability.

China's central bank appears to prefer de-leveraging.

"The central bank appears to be determined to force banks and other financial institutions, such as funds, brokerages and asset managers, to de-leverage," said a trader at a major Chinese state-owned bank in Shanghai.

"That hardline stance suits the recent government policy of clamping down on non-essential businesses by financial institutions, such as shadow banking, wealth management, trust operations and even arbitrage," he said.

An article in a China central-bank backed newspaper called the Financial Times suggested the cash crunch and a rumored default had provided impetus for China to accelerate the roll-out of a new deposit insurance system.

Such a system would eliminate the need for authorities to bail out individual banks by ensuring that depositors were protected even if a bank found itself short of funds.

(Additional reporting by Lu Jianxin: Editing by Neil Fullick)