Bank NPL crisis in China | China Accounting Blog | Paul Gillis

Bank NPL crisis in China

This is another post by Martin Miszerak (martin@miszerakassociates.pl). He is teaching at Remnin University next semester.

Long time readers have seen that I have not posted much lately. I had turned by efforts more to radio and TV. But with recent developments in the areas I cover, I plan to return with some new posts soon.

Over the course of 2019, much of the financial news out of China has centered on the condition of China’s smaller banks. The most recent resolution of Hengfeng Bank is only the latest in a procession of smaller bank rescues, including Baoshang Bank Co. Ltd and Bank of Jinzhou Co. Ltd. What we don’t know yet is whether such rescues are isolated incidents, often triggered by corruption, or symptoms of a systemic NPL crisis in China’s smaller bank sector, which is said to number over 3.000 lenders. No financial information on these failed lenders has been released, while some of them have not published annual reports for years, such as Hengfeng Bank.

Last July, Jason Bedford, a former UBS research analyst specialized in China’s banks, predicted that the 250 institutions he was covering were facing a capital shortfall of about RMB 2.4 trillion, concentrated, however, in the smaller banks. Bedford questioned the integrity of many bank accounts, claiming that loans were often disguised in their accounts as “investments” and consequently the “true” NPL ratio of the entire banking sector was much higher than the official 1.74% at the end of 2017, as published by the People’s Bank of China in the most recent Financial Stability Report. However, we may be able to gain a better insight into loan quality trends in China’s smaller banks early next year, as all mainland-only listed banks were required to transition on January 1, 2019 from IAS 39 to IFRS 9. These banks will be fully disclosing the impact of that transition on their net loans and total equity in their 2019 annual reports.

Under IAS 39, also known as the “incurred loss model,” banks recognized credit losses only when they occurred by means of a 5-tier loan classification. IAS 39 came under fire in wake of the Great Recession for allegedly allowing banks to delay recognition of loan impairment. In response to this criticism, IASB, initially working together with FASB, developed IFRS 9 (“expected loss model”) and published it July 2014. While modifying the accounting standards for various financial assets, the most significant impact of IFRS 9 on Chinese banks lies in the measurement of asset impairment. The new standard requires an additional allowance against amortized cost of financial assets, based on present value of future credit losses. Any increase in that allowance is a debit to the income statement and a credit to net loans.

As IFRS 9 requires banks to make subjective assessments of credit risk and future credit losses, with uncertain impact on their balance sheets, the People’s Bank of China was visibly concerned prior to the beginning of the transition from IAS 39 to IFRS 9 on January 1, 2018. That day, all 23 Hong Kong-listed Chinese banks, including the Big Four, made the transition by means of a one-time remeasurement of impairment allowance against their net loans as of December 31, 2017. The remeasurement was a credit to net loans and a debit to total equity. Historical financial statements were not restated.

As the transition from IAS 39 to IFRS 9 went unnoticed by the Chinese financial press, it can be deduced that the adoption of IFRS 9 by the 23 banks also failed to generate evidence of any significant additional impairment. The impact on the balance sheets of the Big Four is summarized in the table below (all data from their 2018 annual reports):

While the Big Four and presumably the other 19 Hong Kong-listed banks transitioned to IFRS 9 on January 1, 2018 with “flying colors,” this may not be case of the next wave of transitions on January 1, 2019. We’ll see.

Copyright 2020 Paul L. Gillis all rights reserved