Risks mount for Chinese banks on back of rising investments in loans and receivables

Exposure to these asset classes more than quadrupled since 2012.

Chinese banks have developed a strong appetite for investments in loans and receivables, which boost earnings and capital generation in the short-term. However, Moody’s warned that this trend raises asset quality, liquidity and interest rate risks in the long term.

Moody’s study of 26 listed banks showed that investments in these asset classes jumped to RMB10.5 trillion at end-2015 from RMB2.5 trillion at end-2012, led by joint-stock commercial banks and regional banks.

"The high yields and low provisioning costs of these investments have enabled continued earnings growth for these banks in an environment of rising credit costs and declining net interest margins," noted David Yin, a Moody's assistant vice president and analyst.

However, Yin warned that the specific features of these investments mean they may obscure the true extent of the banks' exposure to the ultimate borrowers, while the lower provisioning and capital requirements reduces the banks' resilience to potential credit shocks.

Of the RMB10.5 trillion balance of these investments at end-2015, 68% comprised trust and asset management schemes established by non-bank financial institutions, 13% wealth management products, and 19% bonds issued by governments, financial institutions and corporates.

The bulk of the banks' investments in loans and receivables are for trust and management schemes, which banks can use to re-package their existing loans into financial investment products.

At the same time, banks can treat investments with credit enhancement measures from other financial institutions as interbank assets, and assess the credit risk based on the credit profiles of the financial institution counterparties, rather than on those of the ultimate borrowers.

Apart from these risks, Moody’s noted that the widespread use of credit enhancement increases interconnectedness of financial institutions, and thus the risk that a single institution's failure triggers concerns over broader system stability.

Finally, Moody's also flagged risks to the banks' liquidity positions—with them funding their longer-term investments from short-term interbank borrowings—and interest-rate risk in case of an unexpected liquidity crunch.

Among the 26 banks that have disclosed data on their investments in loans and receivables, Moody's reckons that joint-stock commercial banks and regional banks are most exposed, given their active participation as both investors and originators.