Linkages between China's banks and insurers are strengthening. Major banks are set to raise large amounts of capital over the next 18 months. Insurers are natural buyers of their capital instruments, which offer yield, duration, and supportive regulatory settings. While the relationship has mutual benefits, S&P Global Ratings thinks growing cross-holdings in the financial sector could multiply systemic risk.

China's insurers are short on investment options. The country's evolving capital markets still lack depth, overseas investments are restricted, and the supply of long-dated central-government bonds is not sufficient to meet demand. Bank capital instruments expand the investment scope for insurers, and this exposure comes on top of deposits and equity stakes in banks. The result is high sectorial and obligor concentration toward financial institutions. Moreover, this year regulators eased investment limitations for the insurance sector, which we believe could further exacerbate this concentration.

We expect the concentration risks will persist. This year's introduction of perpetual bonds issuance among domestic banks is one example; we've already seen Chinese renminbi (RMB) 673 billion (US$95 billion) in announced and completed deals. We also anticipate active fundraising in offshore preference shares to continue. In light of strong investor interest in bank-capitalization tools, we recently held a webcast to share our views on this burgeoning market. See the Appendix for a Q&A derived from that event.

China's Banks Need Capital

In our view, the pipeline for hybrid-capital instruments will remain strong as China's major banks seek to support credit growth and cushion against future losses. At the start of this year, Bank of China Ltd. (BOC) issued the first-ever perpetual bond by a Chinese bank. Since then, some RMB 230 billion of such instruments have hit the market, and a further RMB443 billion are in the pipeline (see tables 1-2).

Chart 1

Perpetual bonds provide a new channel at relatively low costs for banks to raise additional tier-1 (AT1) capital. These securities include several supports. The bonds can, for example, be used as collateral for accessing central-bank liquidity facilities. Most issues launched this year have been oversubscribed, in some cases by more than 2x (see table 1). At the same time, we expect further issuance of preference shares, the other key source of AT1 capital for China's banks.

Table 1

Table 2

Banks are issuing capital instruments to meet regulatory requirements in the face of limited ability to accumulate capital internally. More broadly, the largest domestic banks are encouraged to support GDP growth by providing funds and liquidity to favored sectors--private and small and micro enterprises.

Chart 2

And Insurers Need Investable Assets

Recent issuance of bank-issued hybrid capital presents additional investment opportunities for China's insurers. This follows a regulatory announcement in January 2019 permitting insurers to investment in commercial banks' perpetual bonds and Tier 2 capital bonds.

Insurers are starved for long-term investable assets, given declining investment yields and stricter portfolio rules in recent trends (see chart 4). Banks' hybrid capital instruments can also help life insurers match their long-duration liabilities. Moreover, we view bank capital instruments as having better liquidity than alternative investments. Nevertheless, we expect the uptake of these investments by insurers to be market-driven. Particularly, the embedded writedown provisions--which expose investors to potential losses--may prompt insurers to seek higher yield when investing in hybrid instruments.

The sector's investment decisions are also influenced by regulatory guidance, in our view. For example, regulators have encouraged insurers to support "real-economy" investments. These include infrastructure-related investments, which are often long-duration like bank-issued hybrid capital; however, in our assessment, they are less liquid.

The strong pipeline for hybrid issuances will not likely be enough to meet insurers' need for good-quality assets of long duration. Chinese insurers continue to grow assets at a rapid clip (see chart 3) mainly supported by life insurers. This comes at a time when regulators are requiring insurers to increase oversight on managing interest-rate risk. Insurers have also returned their business focus back to providing protection, which should elevate the demand for long-duration assets.

Chart 3

Table 3

Chart 4

Chart 5

What are the downsides?

While bank-capitalization instruments should help boost investment returns for insurers, there are risks. The main one is concentrated holdings in financial sector assets (via direct equity as well as capital instruments). Moreover, many banks hold each other's capital instruments, and such cross-holding structures can raise systemic risks, including insurers' exposure to banks. In February 2019, regulators eased concentration limits for insurers' investments; nevertheless regulatory risk charges (see table 6) and other limits remain in place to discourage excessive concentration among financial institutions.

China's regulators have been fairly explicit in their view that the insurance industry can and should play a role in stabilizing economic cycles and managing risks. As such, insurers may be tasked to provide additional capital to support national interests. In extreme cases, there could be pressure for insurers to maintain holdings in bank securities in the event of crisis. That said while intensifying cross-sector holdings multiply systemic risks, they may increase the odds of extraordinary government support in the case of distress.

Table 4

Both preference shares and perpetual bonds are subordinate debt. If issuing banks' fail, or their common equity tier-1 capital (CET-1) falls below 5.125%, then noteholders effectively lose out (see table 4). That said, given that most of these AT1 securities are issued by China's largest banks, many investors consider these instruments to be "too big to fail," i.e., authorities would not allow premiere banks to get weak enough to trigger the point of non-viability.

Together For Better Or Worse

We believe the bank-insurer relationship is one of mutual benefit. In the event of a bank failure or crisis, however, systemic risks would multiply.

Another complication is that most Chinese banks and major insurance companies are government-owned. This means they benefit from state support, but also face obligations to carry out broader economic goals.

This year's development of a market for bank-issued perpetual bonds highlights the dynamics. Policymakers offered a number of cushions and incentives to attract participation, and boost banks' funding options. In our view, these sugar-coated initiatives come with the obligation for banks to meet broader economic objectives with their loan policies. For example, increased credit to private, small and midsized enterprises could turn out to be a successful economic policy; however, it comes with risks for banks given the susceptibility of the sector to economic downturns. Insurers, in turn, would be exposed to those risks, given their outsized holdings.

Long ago, S&P Global Ratings wrote about a similar concentration risk in Japan. In the early 2000s, insurers suffered significant losses on their investments in the bank sector after the failure of Resona Bank Ltd. and other stress during that period (see "Capital Double Gearing Creating Concentration Risk For Japanese Financial Institutions," Sept. 9, 2002).

Related Research

• China's Regulators Pave New Path For Bank Recapitalization, And Encourage Insurer Participation, Jan. 29, 2019
• Japan's Life Insurers' Diverging Attitudes To Bank Exposure, May 5, 2003.
• Capital Double Gearing Creating Concentration Risk For Japanese Financial Institutions, Sept. 9, 2002.

APPENDIX: Q&A On Perpetual Bonds And Preference Shares

In July 2019, S&P Global Ratings held a webcast in which we discussed Chinese banks' capital instruments, and insurers investment in such products. Eunice Tan moderated and Liang Yu and WenWen Chen fielded questions from participants.  

Why are banks issuing perpetual bonds?

They need the capital, which they began raising in large amounts in 2018. We expect the banks' recapitalization efforts to press on over the next few years, due a combination of several factors:

• Mega banks are facing global peer pressure and pending total loss-absorbing capacity (TLAC) regulatory requirements to increase the level of capital.
• Banks are encouraged to lend more to support economic growth. This, combined with banks having to move "shadow banking" assets onto their balance sheets by 2020 under new asset management rules, has increased capital consumption.
• Slowing growth and rising defaults, and more stringent loan classification requirements will also constrain banks' capital ratios.
• Banks are refining their capital structure and lowering the cost of capital.

Redemption of earlier issued capital instruments (from five years ago) will need to be replenished. As required by regulation, banks need to refinance with the same or better quality of capital.

Perpetual bonds provide a new channel for recapitalization at a relatively lower cost given a number of supportive policies, a less-complicated approval process than preference shares, and coupon payments that can be interest deductible.

What are the difference between preference shares and perpetual bonds issued by Chinese banks?

Both instruments have common Basel III additional tier-1 capital features, i.e., they are subordinated to most other bondholders; have loss-absorption triggers if the issuer bank becomes nonviable or its CET-1 ratio falls below a certain level (5.125%); issuers have full discretion to cancel coupon; are perpetual in nature and have the option to call after about five years (see table 5).

Table 5

Beyond this, we also see some differences for such instruments issued by China context:

• Preference shares issued are issued in China's exchange market and some offshore, and perpetual in the domestic interbank market. Given they are different markets they are subject to different approval processes.
• Coupon payment for perpetual bonds are deductible before tax, whereas dividends for preference shares are paid after tax.
• Issuance of perpetual bonds are supported by central bank bill swap program (CBS) and can be used as collateral to access central bank liquidity facilities under certain requirements. There are no similar arrangements for preference shares.

Do Chinese banks really buy each other's perpetual bonds or capital instruments? What are the regulatory risk weight for banks' holding of capital instruments?

The short answer is yes, banks are one of the major investors for hybrid capital instruments. They also buy each other's tier-2 bonds. However, there are certain limitations: holding perpetual bonds or preference shares on balance sheet requires 250% risk weight in calculating capital charges and if holdings get too high any excessive amount needs be deducted from capital; the exposure to single counterparty cannot exceed 25% of a bank's tier-1 capital. Most capital instruments held by banks are through wealth management products and thus not subject to the above constraints.

In general, crossholdings can raise systemic risk. We think the regulators know this, which is why they are trying to broaden the investor base open the market for example through China interbank bond market, the qualified foreign institutional investor (QFII) and renminbi QFII programs, and the Bond Connect.

What are the different features of such capital instruments issued globally compared to China?

The features are standardized to global practices and meet Basel III requirements for AT1. In terms of the AT1 capital ratio trigger, some countries such as the U.K. or Switzerland adopt more stringent requirement (i.e., a CET-1 ratio of 7% rather than 5.125%). Many countries also allow temporary writedowns. In principle, this is less risky than permanent writedowns for investors because it leaves open the possibility for loss recovery. So far, we haven't seen such features allowed in China, but expect they may in future to allow for more flexibility and attract a wider base of investors.

What are the non-call risk and do you expect issuers to call back after five years?

We expect most Chinese issuers will exercise their option to redeem their preference shares, given that they are likely to refinance at lower costs. In general, issuers of hybrid capital have the contractual right to call back after five years. Although there is no obligation, in some markets redemption is expected. If non-call becomes prevalent or widely expected, this could lead to a change in pricing and higher premium due to expected longer holding maturity. In some cases, the market may interpret a non-call as a sign that an individual bank's capital position is stressed due to weakened credit standing, and it may face refinancing difficulties.

What are the risk charges for insurers on these types of assets?

See table below:

Table 6