China’s banks are in a tight spot: They are expected to issue US$2.2 trillion in new loans over the next five years, but face increasingly stringent capital adequacy requirements.
The lenders’ first port of call is the capital markets and 2010 looks to be a bumper year for fundraising; Industrial and Commercial Bank of China (ICBC; 601398.SH, 1398.HK), Bank of China (601988.SH, 3988.HK), and China Construction Bank (601939.SH, 0939.HK) have already initiated multi-billion-dollar plans to issue shares and convertible bonds in Shanghai and Hong Kong.
But this still might not be enough. Yang Kaisheng, president of ICBC, predicted that China’s four largest publicly traded banks would need to raise a further US$70 billion over the next five years to meet capital adequacy ratios of 11.5%. "We need to carve a new path for sustainable growth yet limiting the need for capital," said Yang.
Among his proposals: selling loans to third-party purchasers and further progress on asset-backed securities. Ironically, one cure for China’s banking woes may in fact be the instrument that nearly brought down the global financial system.
Securitization is currently a four-letter word, shorthand for letting mathematical models get in the way of common sense, but it has a few notable advantages. Selling loans to third-party purchasers replaces liabilities with new capital, magnifying a bank’s ability to extend credit as well as its revenues from issuance fees. Asset-backed securities (ABSs) are also a useful alternative investment, especially in a market as limited as China’s.
There are, of course, risks and complications. First of all, securitization weakens the incentive for lenders to properly evaluate and vet customers. Concerns about moral hazards are complicated by China’s already poor reputation for discriminating worthy borrowers. For this reason above all others, the Chinese government should be wary of embracing securitization without an established legal and regulatory framework in place.
Another key question is who would purchase these securitized products. Buyers of ABSs in more developed markets tend to be large funds with long investment horizons, but Beijing places strict limits on securities investments by institutional investors like insurers. As such, the target customer base for Chinese ABSs remains unclear.
Attracting investors of any stripe hinges on solid credit ratings for the products involved; but in China questions must first be asked of the domestic ratings agencies that provide credit assessments. Due to some spectacular misjudgments in the local corporate bond market, ratings agencies struggle for credibility. Securitization comes with a lot of baggage – the financial shenanigans enabled by ABSs tarnished the reputation of international stalwarts like Moody’s and Fitch – and so experience and consistency count for a lot.
The first rules concerning asset-backed securitization came into being five years ago as the Administrative Measures on Pilot Projects of Credit Assets Securitization. In the pilot ABS issuances in December 2005, China Construction Bank issued US$360 million in residential mortgage-backed securities, while China Development Bank offered US$500 million in securities backed with unsecured credit from various state industries.
The China Banking Regulatory Commission released guidelines in February to govern securitized capital in banks’ risk measurement, but the country still lacks a mature legal process for securitization and a system to track legal ownership of securitized assets. It would be in the regulator’s interests, therefore, to live up to its reputation for knuckle-dragging on financial issues. For now, attention is focused on developing basic derivative instruments for equity markets, and there it should stay. Complicated fixed-income securities are a long way off.
As for the banks, using undercapitalization as an excuse for securitization suggests their situation is dire. It is not. The government may squeeze financial institutions at both ends, calling for responsible commercial behavior one moment and a lending spree the next; but the same government will come to the rescue should the money run out.