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Morningstar | Relaxation of Debt-to-Equity Swap Won't Change Our Outlooks for Chinese Banks

Recently, China’s Banking and Insurance Regulatory Commission issued new rules for asset-investment companies, or AICs, set up by banks, in order to speed up the debt-to-equity swap program. The government has been regarding DES as one of the major tools to accelerate bad-debt disposal for banks and reduce leverage ratios in the highly indebted corporate sector. However, we believe it’s unlikely to reach sufficiently meaningful scale to address China's debt problem. We retain our fair value estimates for banks we cover and will revisit our assumptions if further details are material enough to change our forecast. Our top picks are narrow-moat Agricultural Bank of China and Industrial and Commercial Bank of China, trading at three-year lows of 0.75 and 0.68 times 2018 price/book, respectively, representing 30% discounts to our fair value estimates. With our other assumptions unchanged, current prices imply bad-debt ratios reaching about 11% for these two banks. We believe risks for these banks are manageable, as their prudent operations and cheap funding costs enable high profitability and a strong ability to absorb credit losses gradually.

Given the limited exposure, we expect a slight negative impact on large banks in our coverage, while significant implementation uncertainties remain for AICs regarding funding source, equity pricing, and capital impact for banks’ AIC subsidiaries. The negative impact on net profits will be partially offset by the central bank’s liquidity injection, leading to different bottom-line impacts hinging on how banks use the capital released by the reserve requirement ratio cut. If 100% of capital released by the 50-basis-point RRR cut were to be transferred as equity holdings by AICs via the DES program, this would lead to a 0.4% net profit decline and a 35-basis-point reduction in core Tier 1 capital for SOE banks. However, if 100% of the released capital were to be lent out as bank loans, this would boost net profit by about 0.7%.

The positives of the new rules include higher flexibility in terms of how AICs dispose of debts after purchasing them from banks, as well as banks' capital requirement regarding their AIC businesses. We believe capital risks for banks has declined, as the risk weight for AICs’ equity holding is now 150%, versus 400% and 1,250% in the past. Moreover, allowing banks to hold noncontrolling stakes in AICs also enables banks to not consolidate AICs into their books and thus avoid additional capital consumption.

Despite recent relaxed rules, we don’t expect DES will achieve a meaningful impact on both the banking industry and the economy. SOE banks and large joint-stock banks are likely to be major participants in the DES program. Since the resumption of DES in 2016, total DES deals announced amounted to about CNY 1.6 trillion; however, less than 20% of the deals have been implemented. Even under our optimistic expectation for around CNY 1 trillion DES implementation over the next three years, or CNY 330 billion implementation per year, this represents less than 0.6% of total bank loans per year, lower than the average of 0.95% credit costs at large banks in 2017.

After digging into the new rules and recent DES deals, we believe the direct impact on banks will be limited, as all DES are only conducted on the AIC level after banks sell the loans to these firms at a negotiated price. Transfer prices for bad debts from the most recent DES cases look fair in general, with recovery ratios ranging from 0.2 to 0.4, in line with the banks' own assumptions on loan recovery. Other DES cases appeared risky from the perspective of AICs, as they purchased loans at book value, though they are treated as performing on a bank’s loan book. Recent relaxed rules benefit banks, helping the banks to accelerate bad-debt disposal, introduce the bad-asset management market, and soften the capital impact for banks. However, we remain concerned about potential implementation risks in the long run, given the lack of clear guidelines, including the creation of strict viability and eligibility criteria for corporations, sound corporate governance, limiting the time of equity holding, how to swap debts at fair value, and so on.