Inside China: Fixing the NPL problem

Bank-held NPLs are protected as state assets, and rules are hindering the development of a market-based mechanism for their disposal

China's loss provision coverage ratios follow a five-bucket classification of loans: pass (0%), special mention (2%), sub-standard (25%), doubtful (50%), and loss (100%). The last three classes cover non-performing loans (NPLs). From January to October 2015, NPLs increased from RMB1.42 billion ($218 million) to RMB1.92 billion, and China's NPL ratio increased from 1.29% to 2.07%. Also, loans worth RMB2.8 billion were classified as special mention, which constituted 3.91% of all loans as of October 2015. These rapidly worsening statistics reveal the risk-taking and relaxed underwriting standards during the lending boom that accompanied China's economic boom. As China's economy cools, these bad loans are revealing themselves.

Although China's NPL ratio and loss provision coverage ratios appear healthy under both Chinese and international standards, market participants and China's financial regulators are nervous because they believe banks are underreporting their NPLs. Due to internal performance pressure and external competition in the banking industry, banks have regularly concealed their NPLs by including them in the special mention category or by burying them under sham balance-sheet transactions. This has further resulted in insufficient loan loss coverage ratio for the concealed NPLs. Moreover, regulatory-based, non-market NPL disposal mechanisms have motivated banks to whitewash their accounting statements.

For the past decade, high bank profits and wide discretion in provisioning loan losses gave bank managers the tools to create the impression of smooth and stable bank income. They could shift income from a good quarter to a bad quarter by taking large provisions when income was high and small provisions when income was low. By managing earnings this way, the bank manager could help maintain a higher stock price for the bank, and ensure personal compensation targets were met.

However, as defaults become more common and the economic downturn erodes bank profits, banks have insufficient means to meet their increasing loan loss provisioning and NPL write-off requirements. Also, by requiring banks to increase reserves and hasten write-offs at a time when bank profits are strained, regulatory authorities have created an environment where banks are further compelled to reduce their lending activities. And this reduced lending activity exacerbates the credit crunch and puts further pressure on bank earnings.

"As China’s economy cools, these bad loans are revealing themselves"

Another complication is that banks have to comply with the 5% NPL ratio imposed by the China Banking Regulatory Commission (CBRC) as a core indicator for risk supervision of commercial banks. In practice, the CRBC and its local bureaus closely monitor banks whose NPL ratios exceed 2% and may intervene in the management of those banks. As such, banks are being pushed in two directions: profit pressure demands fewer write-offs and less provisioning of NPLs, while regulatory pressure demands more write-offs and more provisioning of NPLs. When a bank reaches the point where it cannot meet its profit targets and the CBRC's NPL ratio requirements, the bank conceals its NPLs elsewhere.

Even if bank profits allow for a write-off, the process is onerous. The Ministry of Finance (MOF) requires a bank to exhaust all judicial claims procedures before it can write off an NPL. Due to these strict, complicated and time-consuming court procedures, the bank has less autonomy in disposing of its NPLs. Even when the bank obtains a favourable judgment, it must have the judgement enforced by courts first. And the bank might not be able to write off the NPL simply because the debtor's assets went unsold in a court auction. Also, the bank may not be able to deduct write-offs before tax due to strict State Tax Bureau requirements.

Commercial banks may not invest in non-banking financial institutions or enterprises according to the Commercial Banking Law. Essentially, this restriction prevents banks from converting debt into equity, or participating in any asset restructuring. As a result, besides write-offs, the only NPL disposal option available to banks is transferring the loans to third parties.

Moreover, banks generally may not bundle and sell personal NPLs such as residential mortgage loans, auto loans, student loans, credit card loans and other consumer loans. Although this requirement was designed to prevent debt evasion, it has proved ineffective and counterproductive in practice. Due to China's lack of a sound personal credit information system, debtors can still easily evade debts by concealing assets.

When a bank bundles and sells NPLs, the bundle can be sold only to a licensed financial asset management company (AMC) if the bundle contains more than 10 debtors or 10 loans. Smaller bundles can be sold to investors other than AMCs.

Today, four national AMCs operate in China; Cinda, Orient, Great Wall and Huarong, and they are all supervised by the CBRC. Fifteen provincial AMCs were approved by local governments and have operated since 2013 to expedite the NPL disposal process. A provincial AMC can only operate within the province in which it was established.

Although some AMCs have minority shareholders from the private sector, all of them remain state-owned. Maintaining state-owned status allows them to receive NPLs from state-owned banks, which can sell NPLs involving state assets only to state-owned AMCs.

As China's economy has slowed, the NPL market has shifted from a seller's to a buyer's market. When the economy was good, it was a seller's market because it was easy to dispose of NPLs and banks did not want to take the valuation discount for selling NPLs to AMCs. In fact, the longer debtor assets were held, the more valuable the assets would become.

When the economic boom ended, the NPL market reversed into a buyer's market. But the buyers are no longer buying. Plummeting asset prices not only make it difficult for the AMCs and banks to agree on an NPL market rate but also make disposal of even the cheapest asset pools difficult due to less desire for investment and restructuring on the part of downstream investors.

From the AMC perspective, asset prices have not bottomed yet because the slowing economy has not landed. Also, the cost of funding for AMCs and the expected asset prices do not justify a slow disposal process.

From the bank perspective, AMCs are controlling the NPL market and unreasonably pushing down NPL prices. For instance, the weighted average valuation discount in Zhejiang province was 43% in 2014 but sharply decreased to 32% in 2015. As the NPL market shifted into a buyer's market, selling NPLs to AMCs has become the last resort of banks.

As a result of these difficulties in traditional NPL disposal methods, banks have a strong incentive to find alternative ways to clear the mounting NPL pressure from their balance sheets. One common new practice is to use an AMC as a channel to take over an NPL and then have it resell the NPL to a fund or third-party financed by the bank. Sometimes, it can be just as simple as a sale-and-buyback arrangement between a bank and an AMC. Under this structure, the AMC receives a channeling fee of about 0.5% without incurring any asset risks. Meanwhile, the bank avoids a huge valuation discount that comes with a true NPL sale. Essentially, in these deals, the bank is buying time.

Unlike the provincial AMCs which cannot resell NPLs, the four national AMCs can resell bundled NPLs to third parties, including local or foreign private investors. Many private asset management companies have been established by trust companies, banks, securities firms and fund managers to purchase NPLs from the national AMCs and have become the major investors in the NPL secondary market.

Disposal methods available to the big four AMCs are almost unlimited. They may lease, restructure, transfer, swap, securitise, convert into equity or entrust a third party to dispose of the NPLs or the debtor assets. When an AMC transfers an NPL, the AMC generally must do so through a public auction. Without a public auction procedure, the AMC cannot sell an NPL to non-state owned purchaser by contract.

From a downstream investor perspective, major legal restrictions, especially those in the Supreme Court's NPL working minutes in 2009, discourage participation in the secondary NPL market.

First, according to the Supreme Court, an investor who purchases an NPL from an AMC cannot sue the state-owned originating bank on the grounds of flawed creditor rights. This immunity could encourage state-owned banks to sell defective NPLs with impunity.

Second, when an AMC prepares to assign an NPL to a non-state-owned investor, the parent company or the local government of the state-owned debtor company has the right of first refusal. This requirement is controversial because it amounts to granting the parent company or the local government a substantive civil right. But the Supreme Court does not technically have the power to grant a right of this type.

Third, during a lawsuit between an NPL investor and state-owned debtor company, the latter may file a countersuit that claims the transfer of the original creditor rights infringes the state's interests and is therefore invalid. When dealing with an infringement of state interest claim, the court would have to suspend the original lawsuit pending the outcome of the countersuit. Regardless of the countersuit's outcome, the debtor company can effectively delay its payment obligations by forcing the loan back to the original creditor if the claim succeeds or by stalling the original lawsuit while the countersuit is pending even if the claim ultimately fails.

China's foray into securitisation began with a pilot period from 2005 to 2014, during which four NPL securitisations were completed (one by Cinda, one by Orient and two by China Construction Bank). But in early 2009, the CBRC stopped approving NPL securitisations due to concerns about the global financial crisis. As China's economy slows and the number of NPLs increases, banks remain highly interested in securitising NPLs. The banks believe that, by not permitting the securitisation of NPLs, the CBRC has undermined the overall usefulness of the asset class.

Since 2015, the People's Bank of China and CBRC have publicly expressed support for studying how to develop the NPL securitisation market. However, this would provide only minor relief rather than a fundamental solution to the NPL issue for banks. Even if the policy door is reopened for NPL securitisation, it would initially be on a trial basis; the size of which would remain small for the near future. And for a number of reasons, there is no guarantee that the trial programme can successfully resolve the difficult technical issues impeding effective NPL securitisation.

Inside China

Inside China, written by FenXun Partners’ Xusheng Yang and Sue Liu, is an insight into aspects of the China market that often elude the naked eye. Yang is a specialist in China’s financial markets and institutions, having started his career at the China Securities Regulatory Commission and then co-founding FenXun in 2009. Liu’s practice focuses primarily on the asset management industry, and has previously worked as an associate at Skadden Arps Slate Meagher & Flom in New York.

First, to derecognise NPLs from an originator's balance sheet, who should take the first loss piece? Due to the lack of appropriate investors, AMCs or other banks will have to hold the subordinated notes. In some cases, originating banks have to sponsor a wealth management plan to purchase the subordinated notes. In most cases, it is still the originating banks that will have to bear the transaction structure cost as well as the asset risks. However, according to accounting rules, originators may not be able to derecognise the securitised assets under those sham arrangements.

Second, what type of assets should be included in the asset pool? Pure NPLs may not generate predictable cash flows and provide sufficient credit support for the senior securitisation notes. Therefore, depending on the party who leads the NPL disposal work, be it the originator, the servicer or the subordinated noteholders, a portfolio mixing NPLs with performing loans should be put together to create adequate cash flow.

Third, how can the difficulty in determining the valuation discount for a true balance sheet transaction be solved? Although securitisation through its disclosure system can greatly reduce information asymmetry risks, it would not disrupt the AMC oligopoly in the primary and secondary markets or provide new tools for disposal of NPLs. As a result, under the current market structure, securitisation pricing is no different from that of a traditional sale or purchase of NPLs.

By Xusheng Yang, partner at FenXun Partners in Beijing