Rising risk for Chinese banks: Asset growth buoyed by wholesale funds, not deposits

Banks are now more sensitive to potential counterparty failure.

Moody's Investors Service says that the significantly faster pace of asset growth for Chinese banks other than the country's big four, suggests that much of the current asset growth in the Chinese banking system is supported by 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," says Christine Kuo, a Moody's 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," adds Kuo.

Moody's also explains that the banks' most liquid assets are largely in the form of interbank assets, which means they will need to withdraw funds from other banks to meet their own funding needs, which could in turn cause contagion.

Moody's analysis is contained in its just-released report on Chinese banks titled "Banks - China: Increasing Reliance on Wholesale Funds Makes Midsize and Small Chinese Banks More Vulnerable to Confidence Shocks," and is authored by Kuo.

Here's more from Moody's:

Moody's report points out that a rising credit risk among many mid- and small-sized Chinese banks is their deteriorating funding profile, a reflection of the fact that their usage of wholesale funds — in particular short-term funds — has been increasing in recent years.

In contrast, the big four banks in China (Aa3 negative) are not dependent on the interbank market and are mostly fund suppliers, reflecting their strong deposit franchises and more prudent growth strategy.

Moody's explains that for individual banks, the increased use of short-term wholesale funds will expose the banks to the higher risk of tenor mismatches and funding disruptions. 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.

Moody's says that investments in loans and receivables are a growing asset class on the banks' balance sheets, and carries significant risks of their own. Aside from balance-sheet volatility, the costs of funding these liabilities also tend to be higher for smaller banks, reflecting their higher risk premium, which is also a negative from a profitability perspective.

Moody's says that while China's central bank will likely inject the needed liquidity into the market to address systemic risk — should a bank's funding problem become contagious — banks that are more dependent on confidence-sensitive wholesale funds could still be vulnerable to a spike in funding costs and substantial roll-over risks, which could in turn undermine their credit standing.