Chinese banks warned of asset quality shocks as market for wealth management products expands

Around US$2.9t worth of WMPs are off-balance sheet at end-1H16.

China's expanding market for bank-issued wealth management products (WMPs) makes lenders increasingly vulnerable to asset-quality shocks and strains on funding and liquidity, necessitating higher capital levels, says Fitch Ratings in a Special Report.

More than three-quarters of outstanding WMPs, totalling CNY20.2trn (US$2.9t), resided off-balance sheet at end-1H16. These WMPs are, in effect, bank contingent liabilities as there is a widely held expectation that issuing banks will stand behind their products, and it is exceedingly rare for banks to pass on losses to investors.

Here's more from Fitch:

Issuance of off-balance sheet WMPs has grown so large for some banks that they are in effect second balance sheets, but with poor disclosure, and little to no reserves or capital to cushion losses. Importantly, reported capital and leverage ratios do not incorporate risk from off-balance sheet WMPs.

We estimate that if non-guaranteed WMPs were accounted for as on-balance sheet assets, average common equity Tier 1 (CET1) regulatory capital ratios would drop by 1.4pp for state banks and by 2.5pp for mid-tier banks. We also looked at the Fitch Core Capital/unreserved credit exposure (FCC ratio).

If WMPs are taken into account, average FCC ratios would fall from 12.2% to 10.7% for state banks and from 7.3% to 5.7% for mid-tier banks. This means that mid-tier banks can on average sustain credit losses of only 5.7% before their capital is depleted.

China's bank regulators have recently proposed tighter rules on WMPs. We believe these are positive moves, and imply a greater recognition by the authorities of the moral hazard that exists between banks and their WMPs. The new rules will create additional costs to banks at a time when profitability is under pressure. However, we believe the impact is too marginal to lead to a reduction in total issuance, as banks still have strong incentives to expand off-balance sheet activity.

Fitch also believes the regulators have not taken more stringent measures to rein in shadow banking activities because they represent an important alternative source of credit for the real economy. Significantly tighter regulation of WMPs would have the potential to trigger a disorderly deleveraging cycle.

Banks do not provide delinquency data on WMPs or other forms of non-loan credit, but there are reasons to doubt asset quality. Issuance may be used to get around prudential restrictions on lending and to offload assets from the loan book. Media reports suggest that WMPs are a preferred form of financing for companies in pressured industries, and we believe a portion of WMPs is likely to be invested in non-cash-generating assets.

It is unlikely that higher WMP fee income compensates banks adequately for the additional risk. By our estimates, impairment of just 2% of outstanding products would be enough to wipe out all profit accumulated from WMP business over the life of the industry.

The increase in WMP issuance and the shortening in duration make banks more susceptible to strains on funding and liquidity due to the increased mobility of WMP investors, the pressure to meet cash pay-outs at maturity, and potentially poor liquidity of underlying assets. Systemic risk is rising as more parts of the financial sector become involved in extending, rolling over, hiding, or funding credit.

The growing interconnectedness between a range of financial institutions adds to the risk that a disruption in WMP issuance could quickly spread through the financial system. This contagion risk is partially mitigated by the authorities' ability to provide liquidity support.