Banking on Moral Hazard

China’s banking system has experienced exceptionally rapid asset growth over the last two years, driven by joint-stock banks and city commercial banks. Total banking system assets have risen by 45.3 trillion yuan or US$6.8 trillion since the end of 2014. Our examination of the financial statements of 23 of China’s largest banks suggests that the surge in assets has been funded by increasingly unstable liabilities, primarily consisting of issuance of wealth management products (WMPs) and short-term wholesale funding.

Moral hazard remains the key factor powering asset growth. The credit quality of the assets underlying banks’ marginal growth is deteriorating in an environment of slowing economic growth and softer credit demand, but asset growth remains strong as the prospect of credit risk or outright defaults appears remote. Banks’ claims on non-bank financial institutions (NBFIs) are a key driver of new asset generation, which feature underlying credit exposure to unproductive industries, the property sector, and other speculative markets.

Recent liquidity stress in the repo market suggests non-loan asset growth is weakening as the result of changing PBOC guidance of short-term interest rates. China’s recent pattern of rapid asset growth funded by WMPs may reverse should credit risks materialize and the central bank’s stinginess with short-term liquidity persist.

Posted August 1, 2017
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