When a Bad Loan Isn’t Really a Bad Loan

Balding's World

I recently finished a report on Chinese banks and one of the most surprising discoveries are how Chinese banks think about bad loans and data.  In most of the world, definitely those with large financial markets, the definition of a non-performing loan is taken for granted.

What is probably the most surprising revelation in recent IPO prospectuses is just how honest Chinese banks are being in admitting that their definition of a non-performing loan differs significantly from international standards.  Huishang Bank in their prospectus states that a major regulatory risk is that “our loan classification and provisioning policies may be different in certain respects from those applicable to banks in certain other countries or regions.”  The Bank of Chongqing says nearly the same thing noting that “our loan classification and impairment loss provisioning policies may be different in certain respects from those applicable to other commercial banks and banks in certain other jurisdictions.”   Harbin Bank take this warning one step further writing in their recent IPO prospectus “…profits of our Bank may decrease significantly, and our business financial condition, results of operations and prospects could be materially (emphasis added) and adversely affected…” due to non-standard non-performing loan definitions.  In short, Chinese banks are telling you that their non-performing loan classifications are not standard or accepted outside of China.

Chinese banks go to great lengths to avoid classifying a loan as non-performing with very different standards.  A 2012 NBER paper led by Franklin Allen from the Wharton School noted that “…the classification of NPLs has been problematic in China.  The Basle Committee for Bank Supervision classifies a loan as “doubtful” or bad when any interest payment is overdue by 180 days or more (in the U.S. it is 90 days); whereas in China, this step has not typically been taken until the principal payment is delayed beyond the loan maturity date or an extended due date, and in many cases, until the borrower has declared bankruptcy and/or gone through liquidation.”

Amazingly, Chinese banks not only admit their loan classification standards leave something to be desired but give specific examples.  Let me give you a couple of especially egregious examples.  Harbin Bank classifies a loan as doubtful if after a loan restructuring still cannot pay back the loan.  Bank of Chongqing classifies a loan as substandard if a building project has had no activity for at least one year and doubtful if the business has not been operational for at least 6 months.  Huishang classifies a loan as substandard, with at least a 40% loss, if the borrower is unable to obtain new funding to service their debt obligations. To summarize Chinese loans are classified as non-performing if after restructuring a firm still can’t pay, you have been out of business for at least six months, and your situation is so dire you can’t find another lender to roll over your loans.

Chinese banks however are not just defining away the problem of NPLs does arise they play accounting merry-go-round to make them disappear.  The Wall Street Journal recently wrote about a plan by large Chinese banks with investment banking arms to sell bad loans to the investment banking arm, taking the troubled off the traditional banks books, and then let the IB arm try to turn it around.  The bank does not have to report the NPL, even with incredibly loose definitions, and gets a higher than market price for the loan.  The investment bank get deal flow to boost numbers.  This however, continues to push the risk further down the road and continue the build up.

There are three final points.  First, banks appear to structure products to avoid NPL classification.  When lending for advances, the first payment will not be due for an extended period of time allowing the very real possibility for very real delays.  How long exactly?  To use a recent example, when Shanxi Zhenfu Energy roiled global financial markets with the possibility of a default on a product created by China Credit Trust, this overlooked a key fact.  Shanxi Zhenfu Energy had been bankrupt for nearly a year when the technical default occurred due to the fact that the original loan was made in the second half of 2010 but the first payment was not due until February 1, 2014.  This means that much of the debt incurred during the worst excesses of the credit expansion may not even require repayment yet, further masking loan quality.

Second, amusingly, for me anyway who has written about GDP and inflation irregularities, a major risk identified by Huishang is that “we cannot assure you of the accuracy of facts, forecasts, and statistics derived from official government publications contained in this prospectus with respect to China, its economy, or its banking industry.”  In other words, Chinese banks don’t believe official statistics.

Third, this is the reason the Chinese market and international analysts are so worried about finances in China.  For quite some time, Chinese banks stocks have hovered around P/E between 4 and 5 because the market doesn’t believe the NPL data. Banks with secondary offerings have been accepting large discounts with IPO’s cheaply priced to traditional models and falling post-IPO due to the large doubts about the accuracy of NPL data.

There are enormous financial risks and one of the largest is the lack of reliable data as described by Chinese banks about their own finances and the overall Chinese economy.

Note: This is the first post in a series of posts about the Chinese banking industry based on my paper.