Battling to Bring China's Bad Loans Under Control

It is the smaller banks in China that are the most affected. The country's numerous local banks have been struggling to raise the capital needed to be able to offer more loans, particularly to the SME sector, to drive new, innovative growth to combat a slowing economy. This is bad news for the government, which is particularly trying to boost SME lending to help stabilize economic growth.

A troubled picture started to emerge when the operation of Inner Mongolia-based Baoshang Bank was taken over for the first time by the regulators in May, citing serious "credit risks". Despite the tiny size of the bank book (Baoshang Bank had only about $83 billion on its books compared with Industrial and Commercial Bank of China, or ICBC, China's biggest bank, with assets of more than $4 trillion), the unexpected takeover shook the foundations of Chinese banking, and immediately set off a crisis of confidence, weakening small banks. With mounting fears that it could cause the entire banking system to seize up, the People's Bank of China, stepped in and injected about Rmb2 trillion into the interbank market to ease the lack of liquidity.

Another small bank soon followed. In July, according to a report by the Shanghai Securities News, Yantai-based regional lender HengFeng Bank was taken over by Central Huijin Investment, a government-owned investment fund. Then at the end of July, Hong Kong-listed Bank of Jinzhou, whose shares had been suspended from trading in April, announced it was being bailed out with capital injections from ICBC and two of China's largest state-controlled distressed debt managers.

Aiming to counter a dangerous credit crunch extending across the broader financial sector, the central bank directed large state-owned banks to lend short-term cash to troubled securities brokers and other nonbank financial institutions. However, tensions in the money market remain high as other banks watch closely for signs that more small banks are on the brink of failure.

To reassure markets, CBIRC vice chairman Zhou Liang has said that because small and medium-sized banks are irreplaceable in China's financial system, the central government will continue to support them to better serve their local communities. Market analysts have said, however, that the likelihood of another government takeover of a smaller bank in the near future remains high. Despite government assurances, this is making many banks very cautious about lending to smaller players in the industry.