Up to one-fifth of China's regional lenders may need to address a capital shortfall. Some regional banks are heavily exposed to local government financing vehicles (LGFVs), many of which are faltering due to liquidity strains. S&P Global Ratings believes the capital hit on the regional banking sector in our downside scenario would be Chinese renminbi (RMB) 2.2 trillion, likely spread over many years.

We take the extreme distress case of Baoshang Bank Co. Ltd. as an example. The mid-sized Inner Mongolian lender collapsed in May 2019. In the aftermath of the bank's failure, and then takeover, the net issuance of interbank negotiable certificates of deposit dried up. This raised wholesale funding costs for all banks, making loans more expensive. This was hard on the small enterprises that relied on bank funding (see "China Credit Outlook: Liquidity Crunch Just The Latest Headache For Corporate Issuers," July 8, 2019).

A swath of local governments have limited fiscal resources to support troubled regional banks, in our view. Support from the central government would likely be the ultimate resort if local governments ran out of reasonable options. The central government would put together a program to prevent the situation snowballing into a systemic risk. At the same time, controlling potential moral hazard is important. Investors would share the pain as some LGFVs and banks fail.

This report is built on a sensitivity analysis. We calculate the top regional banks' capital adequacy ratio (CAR) for varying degrees of LGFV distress. We focus on two aspects of this downside scenario: the ratio of LGFV exposure under pressure for restructuring, and loss rate for banks' LGFV exposure post-restructuring. Our data show the hit on CAR when both risk factors escalate.

Quantifying The Downside Risks For Regional Banks

The rising risk of debt restructuring among LGFVs will burden China's regional banks. In our view, the institutions could feel more pain than peers given their concentrated local exposure. Chinese regional banks, including city commercial banks and rural commercial banks, primarily run at the local level, as opposed to the 18 megabanks and joint-stock commercial banks (JSCBs) that operate nationwide. The regional banking sector (that is, banks that are tied to a region in China) is smaller than the national peers, accounting for about 30% of commercial bank total assets as of end-2022.

Regional lenders generally have upheld their headline capital ratios amid the rising credit risks of LGFVs. However, there's a possibility that these risks could spread. Certain distressed LGFVs may need to restructure their loans, involving interest rate cuts and loan extensions. Such steps will likely form part of the government's "package of plans" to alleviate LGFVs' liquidity strains (see "China Policy Patches Alone Won't Fix LGFVs' Fraying Liquidity," Sept. 7, 2023).

We expect pressure will be most apparent within regions where local government resources are constrained by the high leverage or poor liquidity of state-owned enterprises' (SOEs) high leverage or poor liquidity.

LGFV debt restructurings will weigh on Chinese regional banks, in our view. In our downside scenario, about one-fifth of regional banks could fall below the 8% capital adequacy ratio (CAR) requirement, necessitating recapitalization, if the hit is a one-off. Regional banks with concentrated exposure in resource-constrained regions, most of them in lower-tier cities, will likely feel the most pain. And for some of these banks, the pain could be too much to bear by themselves.

Chart 1

In our test, we identified 80 regional banks among the top-100 Chinese commercial lenders, ranked by common equity Tier 1 (CET1) capital as of end-2022. These 80 institutions account for 56% of the regional banking sector's total assets. Note that our sample may overstate the strength of the wider group: the top regional banks are typically better capitalized than their peers.

The potential capital hit to the sector is sizable, by our estimate, amounting to RMB2.2 trillion in the most adverse scenario. This is 4.7x the collective net profit of regional banks (of RMB463 billion) in 2022.

Our key assumptions are:

• 74% of regional banks' LGFV debts may be restructured, versus a national average of 60%.
• A 34% pretax loss rate. This is based on our assessment of the potential loss in the recent loan restructuring for Zunyi Road Bridge Construction (Group) Ltd. In this case creditors accepted a haircut in the present value of cash flows with the average interest rate of debt halved to 3.75%; lenders also let the issuer delay principal repayments.

Table 1

To be clear, we expect the China's regional banks as a whole to maintain capital adequacy, even in the downside scenario. This sub-sector's CAR could fall 3.6 percentage points (ppt) as a result of LGFV debt restructurings, while staying above the regulatory threshold.

Broadening the analysis to all types of Chinese commercial banks, the hit from LGFVs in our downside scenario would be more manageable: it would cut CAR by about 2.6 ppts.

Close Ties Between Regional Banks And LGFVs Will Continue

Chinese regional banks will likely maintain their strong ties to LGFVs, for better or worse. This is partly due to regional banks' close linkage with local governments, and lenders' commitment to support local-government policies and their roles to develop the economy of a given region. Both LGFVs and regional banks are committed to these goals, and these banks will likely keep lending to LGFVs in furtherance of these goals.

Regional banks have an above-average loan exposure to LGFVs. Risks could spread for these banks if LGFV distress escalated. We estimate that Chinese regional banks have about RMB12 trillion exposure to the LGFVs, compared with total assets of RMB97 trillion, as of end-2022.

Regional banks tend to have greater exposure to LGFVs linked to lower-tier governments. The liquidity profiles of many LGFVs linked to lower-tier governments have deteriorated markedly in recent years due to the pandemic and the property sector downturn. At the same time, some of these lower-tier governments are fiscally constrained to provide support to their LGFVs. As a result, regional banks operating primarily in those weaker regions bear higher credit risks than their peers in wealthy regions.

Chart 2

Government Support Will Be Selective

Local governments are a likely first line of defense whenever regional banks become stressed. The governments view the regional banks as important to the development in the region in which they are based.

Nevertheless, we expect local-government support to strained lenders will be selective. Tighter financial discipline at local governments, including our expectation that a newly established financial services super-regulator will push back on noncommercial lending practices, may reduce the likelihood of extraordinary support for certain government-related entities.

The increasingly tight capacity of local governments to support government-related enterprises is another factor, in our view. Highly indebted regions have few resources to rescue the entities they own. Likewise, investors' perception of the health of a local economy and government resources will influence their willingness to buy bonds from LGFVs in that region (see "China Tier-One Local Government Risk Indicators Chartbook," July 23, 2023, "China Tier-One Local Government Risk Indicators Databook," July 23, 2023, and "Skewed Funding Amplifies Default Risks For China LGFVs," July 7, 2023).

In a more extreme scenario where local governments are out of resources and credit events present spillover risks across China, central government would likely step in. Maintaining financial stability is paramount to Chinese authorities, in our view. The Chinese government continues to be highly supportive of the banking system. However, such support would be aimed at containing systemic risks, and would not likely be entity-focused. Select credit events remain possible and could be painful.

Chart 3

Regional Banks Can Bear LGFV Pain

While the stress on some regional banks with concentrated LGFV exposure could weigh on their capital and risk profiles, the broader Chinese banking industry has reasonable financial buffers, and the system's credit profile remains sound.

The picture is of a broadly stable and reasonably supervised banking sector, and of a central government with the will and the means to address systemic risk, as well as a decent track record of managing financial system stresses.

Nevertheless, within that, there are pockets of weakness. China's regional banks are heavily exposed to LGFVs, many of which are faltering. Furthermore, many of the local governments backing the banks and their LGFVs may themselves be fiscally strained.

Finally, we see more instances of the Chinese authorities' "tough love"--to act to prevent the worst, but to let weaker institutions fail or be absorbed. The bankruptcy of Baoshang Bank was an example of the latter. Such moves may translate into a willingness among policy-setters to let one or more regional bank fail as the LGFV distress cases build.

Editor: Jasper Moiseiwitsch

Digital designer: Halie Mustow

Related Research

• China Policy Patches Alone Won't Fix LGFVs' Fraying Liquidity, Sept. 7, 2023
• Banking Industry Country Risk Assessment: China, Aug. 16, 2023
• Credit FAQ: What Are China's Options To Resolve Local-Government SOE Debt Risk, Aug. 3, 2023
• China Tier-One Local Government Risk Indicators Databook, July 23, 2023
• Zunyi Road's Loan Deal Won't Fix Its Debt Problems, Jan. 10, 2023
• China Banks' Property NPLs To Peak At RMB660 Billion In 2024, April 20, 2023