Small- and Mid-Size Chinese Banks Grow Systemic Risk to Sector

China’s banking system is facing “systemic risk” as banks outside the nation’s largest four institutions increasingly grow their assets on the backs of wholesale funds and not deposits.

"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,” said Christine Kuo, a Moody's Investors Service senior vice president. "With an increasingly larger number of banks now more actively engaged in the interbank financial product business, the banks 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.”

Further, Moody’s said that Chinese banks’ most liquid assets are mostly interbank assets, requiring them to withdraw funds from other banks in order to conduct their own financing, and leaving them more open to financial contagion. By comparison, China’s big four banks are predominantly fund suppliers and are strong deposit franchises.

For small- and mid-size Chinese banks, using short-term wholesale funds exposes them to “tenor mismatches and funding disruptions” that raise credit risks, Moody’s analysts said. “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,” Kuo said.

Loans and receivables are growing as an asset class on these Chinese banks’ books and bring on added risk in terms of volatility, higher risk premium and lower profitability, Moody’s said.

- Nicholas Stern, editorial associate

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