Reliance of smaller Chinese banks on interbank funds raises credit worries

A growing reliance by smaller Chinese banks on cheap short-term funds from bigger peers is raising the risk of a credit crunch and prompting regulators to push the banks towards more stable funding.

China's mid-sized and smaller banks accounted for half of the trading value in the interbank market in each of the three quarters ended June, data from the China Foreign Exchange Trade System (CFETS) shows.

China's top four banks, including Agricultural Bank of China and Industrial and Commercial Bank of China, accounted for less than 20 percent even though they own 40 percent of China's $26 trillion in banking assets. Brokers and securities firms made up the rest.

While the larger commercial banks mainly use customer deposits - a stable and long-term funding source - to make loans, over the past year smaller Chinese lenders have been aggressively borrowing from local rivals to raise funds for investments and risky but lucrative shadow-bank loans.

Many of the banks classify the shadow-bank loans as investments to minimize the impact on their bank capital buffers.

"A lot of the credit is going into financial asset purchases. So the creditor is unfortunately being used to fund an investment," said Julian Evans-Pritchard, China economist at Capital Economics in Singapore.

If some of those bets turn bad and the small banks are faced with a liquidity crisis, the problem would reverberate across a banking system already concerned with the highest level of non-performing loans since the global financial crisis and a deterioration in asset quality.

"The smaller banks look more vulnerable at the moment. They have poured a lot of money into shadow banking sector where ... operating conditions have become tougher for a lot of firms," Evans-Pritchard said.

Although the smaller banks are not classified as systemic - able to bring down the entire banking system if they fail - some are quite large. For instance, China Minsheng Banking Corp, with a stock-market value of $49 billion and total assets of more than $793 billion, is bigger than Standard Chartered Plc.

Ninety-seven percent of the value of interbank trading was in overnight or seven-day funds in each of the last three quarters, CFETS data shows.

Citing figures from the People's Bank of China (PBOC), Moody's ratings agency said small and medium-sized banks had increased their reliance on interbank funding to 10.4 percent and 10.9 percent of their total funding respectively in the first two months of this year from 9 percent and 9.4 percent a year earlier.

Analysts said the concern is that a large portion of this debt is being used to increase investments, including shadow loans.

China Everbright Bank, for instance, boosted total investments in the first-half of 2016 by 39 percent from the end of 2015 to 1.3 trillion yuan ($194.70 billion) - roughly the same as Portugal's 2015 GDP. Its loan growth was 12.3 percent.