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China’s Big Problem with Small Banks

Starting in April 2022, thousands of customers of six rural village and town banks in China’s Henan and neighboring Anhui province found that they could not withdraw funds from their online accounts. The frozen deposits, worth a total of 40 billion yuan ($6 billion), and affecting some 400,000 depositors, triggered China’s first major wave of bank runs since the onset of the Covid-19 pandemic. The bank runs, which did not result in the customers gaining access to their deposits, were followed by angry localized protests and nationwide worries over the solvency of small banks. The event ultimately culminated in intervention by China’s highest-level financial regulator, the Banking and Insurance Regulatory Commission (CBIRC). Investigators determined that the head of the parent company of four of the troubled banks used third-party platforms and money brokers to absorb public funds, and that criminal activity had occurred. As of August, the police have issued arrest orders and have put local officials under investigation. Meanwhile, the banks in Henan have started to distribute advance payments to some of the customers whose deposits had been frozen.

This incident exemplifies the grim prospect for thousands of China’s small banks, bringing to light a serious problem in the country’s financial sector. The impact of this banking incident has rippled far beyond the villages and towns in Henan and Anhui.

China’s Three-Tiered Structure for Reserve Requirements

The Chinese economy is fraught with no shortage of risks, and Beijing is keenly aware of it. In July 2017, at a conference with officials in charge of financial works, Xi Jinping, the Chair of Chinese Communist Party (CCP), urged attendees to “place more importance on proactively preventing and resolving systemic financial risks. … Make efforts to improve the financial security defense and [financial] risk emergency response mechanisms.” One such financial security defense mechanism is China’s three-tiered system for bank reserve ratio requirements.

The Chinese government, like many other governments that use a central bank to regulate money supply, employs a “reserve ratio” to mandate the portion of deposits that commercial banks must hold onto (rather than lend out or invest). The Chinese government applies a different reserve requirement to banks of different sizes, with smaller banks being subject to a less stringent reserve requirement than larger banks.

To give an example of such a “reserve ratio requirement” in practice, if a bank is holding a total of $100 million in deposits, a government-mandated reserve ratio of 10% means that the bank must put aside $10 million and can use at most $90 million of the $100 million to make investments or to issue loans. Such a reserve requirement is employed by a given country’s financial authorities to mitigate the chance of bank collapse and to adjust the money supply of the country’s economy. The country’s central bank will lowers the reserve ratio if it desires to boost the economy by allowing commercial banks to lend out more cash, and will increase the reserve ratio when it’s time to control inflation by syphoning money off from the circulating money supply, forcing banks to issue fewer loans. The “reserve funds”, i.e. the portion of deposits that a commercial bank keeps on hand in cash, are normally deposited at the central bank by the commercial bank. In the event of an economic downturn or mass customer withdrawals, these reserve funds offer a level of protection against possible bank failure.

China implements a three-tiered reserve ratio requirement for banks of different sizes. The larger banks are required to keep a higher portion of reserve funds, with a higher reserve ratio, while smaller banks generally have lower reserve ratio requirements.

The six largest banks in China are subject to the highest reserve ratio requirement, which is normally 13.5%. These six banks are the Industrial and Commercial Bank of China (ICBC), the Bank of China (BOC), the Agricultural Bank of China (ABC), the Bank of Communications (BoComm), China Construction Bank (CCB), and the Postal Savings Bank of China (PSBC). This means these banks have to set aside 13.5% of their total deposits as a safety measure.

The medium sized banks — joint-stock commercial banks, urban commercial banks, and foreign operated banks — face a reserve ratio requirement of 11.5%. Meanwhile, the vast number of small-sized banks — rural credit cooperatives, rural cooperative banks, village and town banks, and rural commercial banks — are required to maintain a reserve ratio of only 8%. These ratios of 13.5%, 11.5% and 8% are standard requirements; they can be dialed up or down slightly by the central bank (the People’s Bank of China, or PBOC) when necessary. Despite any minor adjustment to these ratios, the notable differences between the ratios always remains. Behind such a setup is a carefully calculated consideration for societal control.

Societal Control Through the Three-Tiered Banking System

The assets of the six largest banks, which are overwhelmingly owned by the state, constitute 71% of China’s banking industry. These banks’ branches and offices spread throughout the entire country, and some of the large banks have tapped into overseas markets as well. If any of these large banks were to go belly up, the impact would be catastrophic, with trillions of dollars of capital at stake and with tens of millions of customers at risk. Consider the millions of people who would run on banks or protest in the streets at the same time across multiple cities in China, turning the country upside town and posing a nightmarish threat to CCP’s grip on power. To mitigate such risks, the authorities strive to regulate the six major banks rigorously, imposing a high reserve ratio requirement.

At the other end of the spectrum, the ownership of China’s small banks is more diverse. As of 2022, China’s 4,000 small and medium-sized banks have a total of 96 trillion yuan in assets, comprising only 29% of the country’s banking sector, in sharp contrast to the top six largest banks that sit on the other 71% of the sector’s assets.

Because of their smaller size, these banks are much less of a headache for the CCP. The operations of a small bank are confined to a small geographic region – normally within a town, a village, or a county. A small bank’s customer base is only a tiny fraction of that of a large bank. If any one small bank goes belly up, the direct impact is local and controllable. The provincial government, assisted by a moderately-sized police force, can put a lid on any potential unrest.

Out of fear of political instability caused by economic slowdown, China has obsessively pursued an expansionary monetary policy to continuously stimulate growth over the past twenty years (although the effectiveness of the expansionary strategy seems to be waning). China’s three-tiered banking system allows the central bank to pump money into the economy by relaxing the reserve requirement for small and medium-sized banks, all the while maintaining a conservative reserve ratio for the larger state-owned banks. This means the risks inherent in the banking industry cascade down to the small banks that are most easily sacrificed. If widespread economic fallout takes place, the small banks are the first ones to take the hit.

A Risky Business Model

China’s large banks have numerous advantages over the small banks, including access to diversified streams of revenue, broad scopes of operations, and immense customer bases. Most importantly, China’s big banks are “too big to fail,” meaning that the government would almost certainly rescue them if they were in serious financial trouble. Meanwhile, small banks have an absolute disadvantage in terms of brand reputation, size of capital, and quality of customers. While large banks deal in low-risk loans to top-performing state enterprises and profitable private companies, small banks mainly do financing for small local businesses via small and micro-sized loans.

Loans to small businesses are often of high risk. Small businesses are usually more vulnerable than large businesses; they typically face fierce market competition, have a narrower scope of operations, and have access to only modest amounts of capital. As such, small companies are more likely to fail than big ones. Most small companies in China are family-owned businesses, which usually have relatively informal operation management, imperfect governance, and poor long-term planning. Commonly they do not keep formal financial and accounting records, not to mention having such records audited by an independent accountant. Issuing loans to such businesses is highly risky; these businesses have a high demand for financing but have few asset to put up as collateral. Such small business loans often carry a high-risk premium, meaning that the businesses face high interest rates.

On the other hand, as deposit-taking financial institutions, small banks face full-scale competition with large commercial banks. Small banks depend on attracting customer deposits so that they can make income from using those deposits to issue loans, but it is difficult for small banks to gain the public’s trust due to their scale and lack of brand-name recognition. To attract depositors, many small banks resort to “luring” depositors with high deposit rates. Paying higher deposit rates, these banks must issue loans at even higher interest rates. This has the effect of increasing borrowers’ interest costs, exacerbating the risk of loan defaults and lowering bank profitability.

While fighting for survival with their peers, these banks discovered an ally: online deposit platforms offered by financial technology companies. These fintech companies were typically not licensed as banks and thus were not subject to the same stringent legal requirements that regulate the banking industry.

Small banks, by partnering with these deposit platforms to offer banking products online and selling them to users across the country, were able to access a constant inflow of funds over a short period of time. Many of these online platforms made inflated claims about the returns they offered, and some have proven to be outright frauds. By the end of 2020, 89 Chinese commercial banks (84 of them small and medium-sized banks) attracted about 550 billion yuan ($81 billion) in deposits via such internet platforms, an increase of 127% from 2019. Some high-risk small banks collected as much as 70% of their deposits by deploying such online, out-of-region deposit products offered by third-party platforms.

In January 2021, Chinese regulators forbid commercial banks from offering deposit products through internet marketplaces, citing worries about increasing hidden risks and the possibility of financial contagion. The small banks, losing their life support as a result of the crackdown on online deposit products, were left with few other options for capital replenishment.

A Perfect Storm

In the second quarter of 2021, the Chinese central bank conducted a study that designated over 10% of China’s small and medium-sized bank as “highly risky institutions.” Of the 4,400 banking and financial institutions surveyed, including 24 large banks, 3,999 small and medium-sized banks, and 377 non-bank institutions, there were 13 urban commercial banks (medium sized banks) and 393 small banks that appeared to be in serious financial trouble. These hundreds of small banks included rural commercial banks, rural cooperative banks, rural credit cooperatives, and village and town banks.

Entering 2022, the Chinese economy has been pounded by multiple adverse factors. Xi Jinping’s zero-tolerance Covid policy has led to never-ending lockdowns in megacities like Shanghai, Beijing, Xi’an, and Chengdu, leaving tens of millions of people unable to work for extended periods of time. Serious trouble haunts the real estate sector, which accounts for almost 30% of the country’s economy and almost 70% of household wealth; growing numbers of households refuse to make mortgage payments on uncompleted properties, with mortgage boycotts occurring in more than 100 cities across China. Beijing’s aggressive military exercises near Taiwan have discouraged foreign investment in China as other countries seek to reduce their reliance on the Chinese exports as a key base of the global supply chain. A wave of extreme heat and drought, unprecedented in modern history, roasted southern China for 70 days straight starting in June, adversely affected energy-intensive industries and downstream sectors.

The interplay of these forces has precipitated a slowdown of the Chinese economic engine, creating a perfect storm for thousands of small banks across the country. Recipients of small and medium banks’ loans, be they local businesses, local governments, or end consumers, are all having a hard time. The housing slump has left local governments, which rely heavily on land sales, in dire financial straits. Small businesses are barely surviving, if not gone, after years of relentless societal control measures enacted in the name of Covid mitigation. Record high unemployment and widespread pay cuts are hurting middle class households and their ability to pay mortgages and car loans.

In July 2022, China’s Banking and Insurance Regulatory Commission (CBIRC) said that, in the first half of this year, small and medium-sized banks disposed of non-performing loans worth 594.5 billion yuan ($86 billion), an annual increase of 25%.

For the last few years, the Chinese authorities have been concerned about small bank failures. Beginning in 2018, regulators have required some 627 high-risk rural small banks to dispose of nonperforming loans in the amount of 2.6 trillion yuan ($385 billion). This figure exceeds the total amount of disposed loans over the previous decade. The CBIRC, the Finance Ministry, and the Central Bank have together injected some 133.4 billion yuan ($19.7 billion) into 289 of the small rural banks. The CBIRC has also encouraged high-quality banks, insurance companies, and other qualified institutions to participate in mergers or restructuring to absorb troubled small banks. Since 2020, more than 20 small and medium-sized banks have either completed or are undergoing a merger or restructuring.

Despite the CBIRC’s efforts to stay the troubles affecting small banks and lending institutions, a rural commercial bank and a village-and-town bank in Liaoning Province entered into bankruptcy proceedings in August 2022, the CBIRC announced. The significance of this event cannot be understated; in the 22 years between 1998 and 2020, there have been only a total of four cases of Chinese bank insolvency.

The runs on six village and town banks in Henan and Anhui, and the bankruptcy of the two small banks in Liaoning, seem to foreshadow the coming failures of a large number of small banks. The impact of such a wave of bank failures would be systemic. Risk would move up towards large banks, as loans that cannot be undertaken by small and medium-sized banks would fall upon the larger banks. Small bank failures would deal a serious blow to the numerous small private enterprises in China, depriving them of a key funding channel. Most importantly, a large number of small bank failures would rock people’s confidence in the Chinese financial sector, triggering massive social unrests and throwing the country into a state of crisis not seen since 1949.