Small banks in China are more prone to weak governance than larger peers. This known problem has been dramatically highlighted of late with protests outside of "village" banks and regulatory offices in Henan province. Bank customers are worried after some faced barriers to withdrawing funds at four village banks in Henan province and another two in Anhui province. If there is contagion, deposits leaving small banks would likely land at larger peers.

Flight-to-quality scenarios hinge on public perception of the deposit-protection system and whether an institution has backing from the government. Earlier this week officials announced plans to pay Chinese renminbi (RMB) 50,000 to "affected customers"—which may be clients who made online purchases of "deposit-like" financial products.

As negative narratives and complaints rise, we expect more regulatory intervention to manage this incident before it gets out of hand. Any special regulatory response would have to balance financial stability and market discipline (see "China's Baoshang Bank Subordinated Debt Write-Off Strengthens Market Discipline," Nov. 16, 2020; and "Baoshang's Upcoming Tier-2 Debt Payment Will Shed Light On Banking Reform In China," Nov 14, 2019).

We believe prudential regulators are assessing potential financial gaps and trying to strike a delicate balance between protecting depositor confidence without being seen to guarantee investment-like products and other concessions that give rise to moral hazard. In light of the small size of these private banks, the foul play involved, reputation damage suffered, and ordinary deposits becoming affected, a regulatory takeover could be on the table.

Perceptions Matter Most

A police report from the city of Xuchang (in Henan) cited related-party dealings, undue influence on senior bank managers--and outright fraud at the involved banks (see Appendix for details). The report is incident specific yet cites some practices that are found elsewhere; most notably, the use of third-party internet finance platforms to market "deposit-like" products, a practice regulators curbed from January 2021.

This fuse for contagion risk could be lit by an adverse turn in public perception rather than strengths or weakness in banking metrics. Banks most vulnerable to panic are those with legacy internet platform dealings with participating non-bank financial institutions. In a contagion scenario, customers may indiscriminately withdraw deposits and investment products.

Banks are inherently confidence-sensitive, and the fear of "being last out" could significantly disrupt deposit stability for affected banks.

Deposits Or Not? This Is Important…

The affected funds may not be typical customer deposits, but rather investments in wealth management products. While not definitive at this stage, there are some clear indications. The banking regulator referred to these funds as being part of the off-balance sheet business of the banks. Moreover, the promised interim payout of RMB50,000 is not being referred as deposit insurance payout, which has a RMB500,000 cap under the deposit insurance scheme. In addition, the police report made reference to 'deposit-like' product marketing practices.

Determining the nature of the misappropriated funds is important because investment funds are not covered under the deposit insurance fund. Some reports are even saying these funds never registered with the bank due to fraud. That could impose legal complications on the victims.

Given charges of stolen assets, we believe regulators are also assessing potential financial gaps. We note that ordinary deposits at the affected banks are becoming affected as well based on reports, and this could accelerate remedial regulatory actions.

The Comparison With Baoshang Bank

Depositors were protected in the case of bankrupt Baoshang Bank in 2020. Its banking services – including deposit services-- were custodially transferred to a megabank.

The deposit protection worked because the takeover was necessitated by prudential matters and the regulator came in prepared. This village banks case is more complex because it involves fraud and other criminal activities, rather than just mismanagement. This incident has dragged on for several months already, without resolution.

At end 2021, the national deposit insurance fund had RMB94 billion. This is quite small at only 0.04% of system deposits; however, in our opinion, the central government is likely to step in when the deposit-protection mechanism falls short.

Thus far, the village-bank issue is being managed by local authorities, including the Henan arm of China Banking and Insurance Regulatory Commission (CBIRC). We view Henan's credit profile as average among provinces. Nonetheless, it has a large and weak state-owned enterprise sector, which can limit its capability to support troubled SOEs--let alone privately run institutions (see "China LRGs In Focus: Henan Province—Update," June 29, 2021).

The Interim Payment: What This Means

We believe this action was motivated by a need to maintain a financial stability. To some extent, it also quells a build-up of local social tensions.

At this stage, the ultimate source of this funding for this payment is unknown. We believe the first point of call would be local resources coordinated by the local government.

At the national level, a potential source is the recently established financial stability fund-- used to pre-emptively stem financial stability risks versus the post-mortem use of the deposit insurance fund (the latter is used if a bank is taken over by regulators, subject to license revocation or bankruptcy, or other situations approved by the State Council). The financial stability fund is reported at RMB64.5 billion as at May 2022. The total cost of this interim payment can be up to RMB20bn, based on the 400,000 people affected reported by the Chinese magazine Lifeweek.

Enhancing Banking Sector Governance And Controls

In recent years, Chinese banking regulators have put bank governance and controls at the forefront of their supervision. Governance is much weaker at smaller banks. According to People's Bank of China (PBOC)'s latest financial-stability report, 422 banking institutions were in the high-risk category as, of which most were small. Aggregate assets for these high-risk banks were RMB4.6 trillion or 1.4% of the total banking assets as of mid-2021.

The PBOC more recently stated that high-risk banks have reduced to 316 as of end-2021, accounting for around 1% of banking assets.

Rural cooperatives (rural commercial banks, rural cooperative banks, rural credit union) make up 64% of this high-risk group, and village banks 29%. Geographically, Henan has a high representation of financial institutions in the high-risk category. Other provinces include Liaoning, Gansu, Inner Mongolia, Shanxi, Jilin and Heilongjiang.

The financial stability report cited the risk of deposits sourced from internet finance platforms. About RMB550 billion were sourced from these platforms by end 2020--and close to half of this volume was connected to banks in the high-risk category. These practices skirt geographic restrictions for local banks. Soliciting deposits without approval and other breaches made by these internet platforms were also cited by the regulator.

Undue influence from large shareholders is another area of recent regulatory attention, with detailed rules on this topic released in September 2021. If on the regulatory radar, it still takes time to implement and enforce on the country's thousands of small banks. The implementation and enforcement leg of regulatory supervision is particularly important for small banks. This is because they are more inclined to look externally for guidance in setting governance protocols and are typically less capable in setting their own proactive risk management systems and frameworks.

According to the police investigating the village banks in Henan and Anhui, shareholder-related governance issues have continued for more than a decade. Media outlets, including Caixin and China Daily, also reported changes in health codes in COVID-related apps that restricted travel and the ability for some affected customers to physically seek fund withdrawals. This is peculiar and signals broader governance issues.

Failures Can Happen, In A Controlled Manner

Small banks are more prone to failure due to weak governance and controls, high loan concentrations, poor asset quality, less stable funding profiles and declining profitability. These institutions are already on regulators' radar to de-risk. Individually, they are not systemically important, but they are numerous and widespread closures can potentially spark a panic.

For the banking sector as a whole we continue to see a strong tendency for the Chinese government to provide direct or indirect support to troubled financial institutions that are government-related or systemically important.

This external support can come in several forms, including loans and capital infusions from SOEs, from other banks and financial institutions where a local government has control or influence. The local government could step in themselves and if needed and the financial institution is important enough, the central government could be called upon. However, the bankruptcy of the privately owned Baoshang Bank is a reminder that bank failures are not impossible in China, if the government believes the effect of the closure to the financial system is manageable.

Related Research

• China LRGs In Focus: Henan Province—Update, June 29, 2021
• China's Baoshang Bank Subordinated Debt Write-Off Strengthens Market Discipline, Nov. 16, 2020
• Baoshang's Upcoming Tier-2 Debt Payment Will Shed Light On Banking Reform In China, Nov. 14, 2019

Appendix: Timeline Of Events On Village Bank Incident

Table 1