Potential Tighter Regulations On Interbank Exposure Will Squeeze Chinese Banks

The author is Michael Werner, senior research analyst covering the Chinese and Hong Kong banks at Sanford Bernstein & Co.

The Growth of interbank exposures at the Chinese Banks has been Alarming. Interbank exposures
more than tripled at joint-stock banks over the past 4.5 years, and now make up 21% of their total assets vs. just 8% at large banks.

Out of the four major categories of interbank exposure, resale agreements collateralized by credit assets have seen the fastest growth. In our opinion, these are the riskiest.

The interbank market is less regulated and less capital intensive than the traditional loan and deposit market. As a result, it has been increasingly used by the small and mid-sized banks to boost their bottom-lines.

In particular, the small and mid-sized banks have generated higher margins by running duration mismatches in their interbank books (relying on short-term funding to support long-dated assets).

The rise to interbank exposures in recent years has led to higher credit, liquidity, interest rate and regulatory risks at the banks.

The lax regulatory treatment of these exposures has led to 1) under-provisioning 2) insufficient capital reserves 3) an under-stated loan-to deposit ratio and 4) potential liquidity problems arising from the duration mismatches in their interbank books.

The liquidity squeeze in June (which led short-term interbank interest rates to rise to all-time highs) represented a market-driven mechanism adopted by the PBOC to encourage banks to de-leverage their interbank activities.

While this is a step in the right direction (we saw evidence of de-leveraging in the third quarter this year), more needs to be done to address the risks from these assets.

We expect the CBRC to respond by announcing tighter regulations on interbank exposures, with a
handful of options available to them. The CBRC could:

– Increase Risk Weighting. If the CBRC increases the risk weighting on interbank exposures by 20%
(currently they are risk-weighted ~25%), this would lower the tier 1 capital ratios by 20-30bp for the state-owned banks, by 40bp for CITIC and CMB, and by more than 65bp for Minsheng

– Increase Credit Provisions. If the CBRC forces the banks to take a 30bp provision for certain
interbank exposures that are collateralized by credit assets (currently the banks take no provisions), the negative earnings impact would be < 1% for the all the banks we cover except Minsheng (-4%). - Count Certain Interbank Exposures Towards LDR – the CBRC could choose to force the banks to count interbank exposures collateralized by credit assets towards the calculation of their LDRs. If this were the case, BOCOM, CMB and Minsheng would breach the 75% regulatory ceiling by 200bp, 400bp and 3300bp, respectively. We expect the small banks to mitigate the negative capital and profitability impact of new regulations by further deleveraging their interbank exposures, a process they started in the third quarter. We expect the CBRC will announce regulations that tighten regulation on banks' exposures to the interbank market. Any announcement made prior to year-end (even if new regulations are not implemented until after year-end) will lead to banks scrambling to re-position their balance sheets before year-end. (The article has been edited for clarity)

China Expert network