It is time to add another credit indicator to the financial warning signs flashing in China.
The adjusted loan-to-deposit ratio, which includes a range of off-balance sheet items and is an indicator of the banking system’s ability to weather stress, climbed to 80 per cent as of June 30, according to SP Global Ratings.
For some smaller lenders, the ratio – is used to help calculate a bank’s ability to cover customers’ withdrawals – has already topped 100 per cent, SP has estimated.
SP’s adjusted measure is rising much faster than the official loan-to-deposit ratio as banks pile into off-balance sheet lending, sidestepping government efforts to rein in credit.
At the current pace, overall credit could surpass deposits on an adjusted basis within a few years – a level that would give China little leeway to stave off financial turmoil, SP said.
“The next two to three years is a crucial window for China to rein in the ratio, or we will be in serious trouble,” said SP’s Beijing-based director Liao Qiang.
“Reaching 100 per cent doesn’t mean a crisis will ensue immediately, but it shows China’s entire deposit base is used up and any loss of confidence from savers will severely destabilise the banking system.”
Even after SP’s adjustments, the ratio in China remains lower than in many other countries. Yet the country’s rapid loan growth, diminishing returns on credit and rising bad debts combined to make deposits a particularly important buffer against future financial distress, Liao said.
Deposit-taking has formed a cornerstone of China’s banking system as it expanded in tandem with the economy, providing lenders with a stable, low-cost funding base to fuel credit growth.
Chinese households and companies hold US$22 trillion of bank deposits – more than anywhere else in the world. That cushion has made lenders less dependent on short-term wholesale funding than banks elsewhere.
For two decades, China imposed a cap that limited loans to a maximum of 75 per cent of deposits as part of measures to contain risks. That ceiling was abolished in October 2015, in part because it was seen as a blunt tool that encouraged illicit deposit-hoarding and moving loans off balance sheets.
The official loan-to-deposit ratio among Chinese lenders stood at 67 per cent at the end of September, up only slightly from 66 per cent when the cap was lifted.
But that measure has become less relevant as Chinese banks – especially small and mid-sized ones – have stepped up shadow lending and sales of savings-like offerings called wealth management products, which do not get carried on their balance sheets.
The shift is captured in SP’s adjusted ratio, based on the country’s 50 largest banks, which stood at 70 per cent in 2013 and rose by 10 percentage points over the following two years.
SP came up with its adjusted ratio by treating all loan-like assets and corporate bond investments on banks’ balance sheets, as well as corporate credit made off-balance sheet, as loans. On the other side of the equation, it added wealth management products to deposits.
Jonathan Cornish, the Hong Kong-based head of bank ratings for North Asia at Fitch Ratings, said adjusting the loan-to-deposit ratio to capture items such as interbank borrowing, wealth management products and other assets could contribute to “a more comprehensive assessment of liquidity across the system and for individual banks”.
Fitch did not calculate its own adjusted ratio, he said.
A nine-year credit expansion meant to protect economic growth has prompted numerous warnings of impending financial trouble.
China’s debt-to-gross domestic ratio reached 247 per cent after expanding at the fastest pace among the Group of 20 nations, according to the economists Tom Orlik and Fielding Chen at Bloomberg Intelligence. They said such sharp increases had been known to trigger crises in other countries.
The Bank for International Settlements in September used data comparing credit and gross domestic product to warn of looming risks in China.
“Targeting economic growth and continued heavy reliance on credit to support growth means that economic leverage is unlikely to abate soon,” Cornish said.
“This will increase the risks for the financial sector.”
When loans exceed deposits, banks were forced to rely on wholesale funding that can quickly vanish during market dislocations, Cornish said.
In such an event, the central bank – which sets benchmark rates for deposits as well as loans – would be forced to raise interest rates to draw in deposits, Liao said.
That, in turn, would make it harder for companies coping with slower economic growth to repay loans, putting further stress on banks, he said.
The fragile nature of interbank funding was revealed in June 2013, when a credit crunch drove the one-day repurchase rate to a record and the central bank was forced to inject cash amid rumours of lenders missing payments.
The episode exposed “deficiencies” in commercial banks’ liquidity management, the chairman of the banking regulator said at the time.
China’s bad loans likely underestimated, says central bank adviser
Some banks are already pushing into dangerous territory. Bank of Jinzhou’s adjusted loan-to-deposit ratio stood at 153 per cent at the end of 2015 and the lender got 43 per cent of its funding from interbank borrowings last year, SP has estimated.
At mid-sized Industrial Bank, the broadly adjusted ratio was 115 per cent while 39 per cent of its funding came from the interbank market, according to SP.
Industrial Bank declined to comment.
A press officer at Bank of Jinzhou did not respond to phone calls.
In April Wang Tao, head of China economics at UBS Group, compiled her own adjusted loan-to-deposit ratio for China and came up with an estimate closer to 90 per cent.
“Once the LDR [loan-to-deposit ratio] visibly exceeds 100 per cent, banks may become more vulnerable to credit market sentiment,” she wrote in a report at the time.