Let China’s small banks fail– analyst

China should follow Spain's footsteps and establish a fund pool against bankruptcies.

The Chinese government should learn from Spain and allow its small banks to fail– provided they have a guaranteed fund pool as a buffer when bankruptcies occur.

Betty Huang, an economist at BBVA Research, said that authorities should take a leaf out of Spain and create a credit guaranteed fund pool and fund debt banks.

Feasibility analyses should be made for the financial institutions who are unable to resolve their financial difficulties independently.

“Banks passing the feasibility test can seek central bank approval for assistance, whilst those failing may be allowed to fail,” Huang told Asian Banking & Finance, when asked on what ways China’s banking system can be strengthened.

China is facing a decade-long clean-up of its embattled rural banks. In just one week in July, 40 banks disappeared in China. Of these, 36 were absorbed by Liaoning Rural Commercial Bank, whilst Jiangxi Bank collapsed according to reports by local media.

As of December 2023, mainland China has a total of 3,796 rural financial institutions, of which 1,607 are rural commercial banks. This makes up 84% of all of China’s financial institutions.

In contrast, their total assets amounted to only RMB56.8t, at an average of RMB15b per institution– just 3% of the average asset value of city commercial banks. Some of these banks’ nonperforming loans (NPL) ratio go as high as 40% versus the industry average of 1.6%, according to BBVA Research.

Huang’s suggestion takes inspiration from Spain’s Fondo de Reestructuración Ordenada Bancaria (FROB). The FROB is the entity that managed the restructuring process of Spain’s credit institutions and helped strengthen the banking sector following the 2008 financial crisis.

Private sector, third party help
Huang also suggested introducing the private sector to resolve bad debt, and to hire independent third-party auditors for crisis audits.

Introducing the private sector to resolve bad debt can offer higher returns and better asset allocation quality than state-owned institutions due to the sector’s “inherent profit maximisation drive”, according to Huang.

“Compared to Spain's bad debt banks, which are funded by both government and market investment institutions, China's banking industry restructuring funds are exclusively government-backed. These state-owned banks have traditionally focused on policy objectives rather than profit maximization,” she said.

BBVA also recommends hiring independent auditors for crisis audits. 

“To manage risks associated with acquiring troubled banks, we advise treating different risk-level problem banks differently and carefully selecting state-owned and local asset management companies for seamless bankruptcy processing,” it added.

Accelerating mergers is another suggestion to prevent public trust from disintegrating.

“Crucially, timely acquisition of significant regional banks prevents bank runs and panics,” Huang said.

The central bank should refrain from internal management involvement, gradually divesting shares and re-privatizing banks post-economic recovery, she added.