China: The Baoshang Backlash

Key sectors: finance

Key risks: liquidity risks; credit risks

On 24 May the People’s Bank of China (PBoC) announced that Inner Mongolia-based Baoshang Bank will be taken into receivership for one year due to “serious credit risks”. The move is a rare one; Baoshang is the first commercial bank in China to be taken over by regulators in the past two decades. The PBoC called it an isolated case, maintaining that Baoshang’s issues are not systemic. However, the takeover irked the interbank market, spooking lenders and caused a credit crunch that resulted in corporate defaults.

Baoshang Bank was already on Beijing’s naughty list due to its links with Tomorrow Holding, a conglomerate controlled by financier Xiao Jianhua, who is known to have helped elite individuals illicitly move money out of the country. Xiao disappeared in Hong Kong in early 2017 and is reportedly under investigation in mainland China for graft. In taking over Baoshang Bank when it collapsed, regulators sent ripples throughout the financial system. The prospect of further defaults in interbank borrowing as well as more bête noire banks caused an increase in borrowing costs for smaller banks and non-banking financial institutions (NBFIs). On 12 June, the Beijing-based New China Fund Management, told clients it needed to sell assets after defaulting on several products because it failed to secure loans.

Liquidity issues and structural issues in the interbank market, while brought to the fore by the Baoshang takeover, are primarily a result of President Xi Jinping’s financial de-risking campaign. The tighter financing environment forced many small and medium enterprises (SMEs) to raise capital through the practice of structured bond issuance. Structured issuance is a practice wherein bond issuers buy a portion of their own offerings, which is pledged as collateral in the interbank market to inflate issuance sizes and attract investors. It became a way for entities with unsatisfactory credit ratings to secure low-cost loans from the interbank market, which they otherwise would not have access to. The scale of this type of issuance remains unclear, but Citic Securities estimates that structured debt may account for up to 8 per cent of the total non-government bond issuance. The result is that the interbank bond market became flooded with SME corporate credit risk. New China Fund Management is one of several NBFIs that had benefitted from the structured bond practice to secure funding.

Structured bonds worked well when liquidity was not an issue, but when market confidence fell in the wake of the Baoshang takeover, risk aversion to the practice permeated the system. Unable to distinguish which bonds are structured or involve unqualified counterparties, banks are tightening controls. The PBoC is desperately trying to prevent further fallout from the Baoshang takeover by injecting liquidity into the interbank market. On 26 June, regulators gave their approval for China’s big securities brokers to issue financial bonds in the interbank market for the first time, indicating a regulatory shift towards longer term solutions.

The funding crunch will only be temporary – the market will eventually reintroduce risk control mechanisms – but the Baoshang takeover has caused jitters that are proving difficult to eliminate. While a Chinese banking crisis remains far off, the fallout from the Baoshang Bank case has left its mark on the country’s financial system, which will no longer see channelling business as risk-free.