• China’s pledge to recapitalize banks is surprising for two reasons: it’s been two decades since the last large-scale capital injection of the banks, and, on paper, China’s banks are not undercapitalized.
• Capital is needed because China’s large banks face competing demands: lend to troubled borrowers, serve as a financial bulwark, and continue to pay dividends.
• Increased liquidity, rather than improved solvency, may be one of the most important outcomes of the bank recapitalization.

Prevailing Winds is a China-focused blog written by Nicholas Borst, Director of China Research at Seafarer. The blog tracks the economic and financial developments shaping the world’s largest emerging market.

Of the many stimulus policies China has announced this fall, the pledge to recapitalize banks is amongst the most important. In September, the chief banking regulator stated that the government would increase capital levels at six large state-owned banks. In October, the Ministry of Finance (MoF) announced that the government would “issue special treasury bonds to support large state-owned commercial banks to supplement their core tier one capital, enhance their risk resistance and credit lending capabilities, and better serve the development of the real economy.”¹ In November, the bank recapitalization was again confirmed by the National People’s Congress.

The capital announcement was surprising for two reasons. First, China’s MoF has not used this method to undertake a large-scale capital injection of the banks for decades. The last time it did so was in the late 1990s when the entire banking system was struggling under high levels of bad debt. Back then, the MoF issued 270 billion renminbi (RMB) in special government bonds. The proceeds from those bonds were injected into China’s four largest state-owned banks, more than doubling their capital base.² The capital injection was the start of a wider banking sector cleanup, in which large amounts of non-performing loans (NPLs) were transferred off banks’ balance sheets and housed at newly created “bad banks,” euphemistically called asset management companies (AMCs). Many analysts have interpreted the proposal for another capital injection as an indication that the problem facing banks today may be significant.

The second reason the announcement was surprising is that, on paper, China’s large banks are not undercapitalized. According to official statistics, as shown in Figure 1, these banks have capital adequacy ratios well in excess of their Basel regulatory requirements and the additional capital requirements for banks that Chinese regulators have designated as G-SIB (global systemically important banks).

Source: China’s National Administration of Financial Regulation.

So why would the Chinese government propose a capital injection for banks that have capital levels well above regulatory requirements? The answer is linked to the growing demands on Chinese bank balance sheets. China’s banks, especially the large banks, are critical for implementing government policy for the financial sector and economy. The government instructs banks to lend to troubled borrowers, serve as a financial bulwark, and continue to pay dividends. Each of these activities puts pressure on bank capital . Therefore, the recapitalization is a tacit admission that large banks are struggling to meet the demands placed on their balance sheets.

Source: Seafarer.

Lend to Troubled Borrowers: Chinese authorities have directed banks to continue lending to troubled borrowers and industries to prevent financial and economic disruption. The most prominent example is the White List for real estate projects. Starting in January 2024, local governments across China have identified more than 5,000 different property projects to which banks are “encouraged” to lend.³ Many of these projects are stalled-out construction projects where the developer is in financial distress. This directed lending is intended to provide developers with the funding necessary to restart construction and complete these projects. This has become a major issue for the housing market as many apartments in China are pre-sold before completion. Many homebuyers have been in limbo for years while waiting for their homes to be finished. Such delays have contributed to a crisis in confidence that has led many potential buyers to stay out of the market.

Directed lending is not limited to real estate. The government has also directed banks to lend to troubled small and medium enterprises and local government financing vehicles (LGFVs). While reported NPLs have remained low, write-offs and other methods of bad loan disposal have skyrocketed. According to an IMF estimate, the NPL ratio would be substantially higher absent these write-offs and disposals.⁴

In addition to write-offs and disposals, loan restructuring appears to be becoming more common. In one infamous example last year, banks agreed to lower interest rates and extend loans to a struggling LGFV in Guizhou province for twenty years, including no principal repayments for the first ten years.⁵

Directed lending to troubled borrowers negatively impacts bank balance sheets. Loan write-offs and restructurings come at the expense of banks’ profits. Fewer bank profits mean less retained earnings that can be used to bolster capital. As shown in Figure 3, China’s large banks have experienced a steady decline in their return on assets (ROA). While the decline in ROA is multi-causal, the increase in directed lending to distressed borrowers is an important factor.

Source: China’s National Administration of Financial Regulation.

Serve As Financial Bulwark: Since the “Regulatory Windstorm” of 2016-18, China’s regulators have pushed banks to boost their capital levels. This is part of an effort to stamp out risks in the financial system and have the largest banks serve as a bulwark against financial instability. A key focus of this effort has been adopting new prudential measures developed by the Basel Committee, an international working group that formulates new banking regulations. Primarily focused on the largest banks, China has adopted a slew of new Basel-proposed measures designed to increase bank capital levels and liquidity. This process is ongoing, with China on track to adopt new Total Loss Absorbing Capital (TLAC) standards that will increase bank capital requirements to 16 percent in 2025 and 18 percent in 2028.

Whereas the large banks have increased capital and liquidity, China’s thousands of regional, city, and rural banks have not kept pace. As shown in Figure 4, large Chinese banks have boosted their capital adequacy ratios by around four percentage points since 2017, in contrast to the rest of the banking system where capital levels have remained flat.

Source: China’s National Administration of Financial Regulation.

This divergence between large and smaller banks is intentional. Large banks remain central to China’s financial system, accounting for nearly half of total banking assets. Their strong balance sheets allow them to act as shock absorbers for the financial system. For example, in 2019, the Bank of Jinzhou, a regional bank in northeast China, was on the verge of failure. The investment arm of ICBC, China’s largest bank, provided a capital injection for the Bank of Jinzhou and became its largest shareholder.⁶

China’s large banks are also an important liquidity backstop for the rest of the financial system. As shown in Figure 5, China’s large banks provide trillions of renminbi in interbank loans and repurchase agreements to smaller banks and non-bank financial institutions. When liquidity pressures mount within the system, such as when small banks faced liquidity shortages after the failure of Baoshang Bank in 2019, regulators direct the large banks to provide additional support through the interbank market.⁷ The ability of the large banks to provide liquidity support to other financial institutions is an important release valve for liquidity pressures within the system.

Pay Dividends: The other major source of pressure on bank capital is dividends. If banks want to replenish capital, they can lower dividend payments. Figure 6 shows the opposite has occurred, with aggregate bank dividends continuing to grow despite significant economic pressures. Banks are a major source of dividends in China. In 2023, the top 15 banks paid over 560 billion RMB in dividends, around 25% of the total of all A-share listed companies.⁹ Many of these bank dividends ultimately flow to the government through its majority ownership of the large banks. In this sense, bank dividends contribute directly to the government’s fiscal resources, and thus, the government may be reluctant to authorize a reduction.

Source: Wind Information.

Another significant reason banks will not cut dividends is that doing so would undermine a major government campaign to boost share prices. Last year, the securities regulator announced a plan calling on listed companies to pay more dividends.¹⁰ The motivation behind this push is a belief that increasing dividends and buybacks will help boost the valuation of Chinese stocks, which sit well below other major global markets. Many of China’s banks are currently below the 30% dividend payout ratio guideline by the securities regulator. Lowering payout ratios further would undermine the campaign to boost dividends. Rather than cut dividends, the large banks are being pressured to increase the frequency of dividend payments to twice a year.¹¹ All of this means that Chinese banks are unlikely to be permitted to cut dividends by their largest shareholder, the government.

Keep an Eye on Liquidity

When a bank runs into financial problems, it is typically a solvency issue, a liquidity issue, or a combination of the two. As mentioned above, increasing NPLs at the large banks are putting pressure on capital. However, these banks are not facing immediate solvency problems because high capital levels allow them to absorb the growing losses from bad loans.

Liquidity pressures, however, are more challenging to predict and faster moving. The large banks face two competing demands for liquidity. The first is the ongoing liquidity demands for their own businesses, such as satisfying depositor withdrawal requests and regulatory requirements. The second is the “national service” directed by the government, where the large banks serve as a liquidity backstop to the rest of the financial system.

Currently, China’s small and medium-sized banks face clear liquidity problems. These banks often have weak deposit bases, concentrated exposures to distressed borrowers, and rely on wholesale financing through the interbank market. Their problems would likely be much worse without the liquidity support provided by the large banks through interbank lending and financial bailouts.

The main question is whether the large banks can continue to play this role. As large banks continue to restructure loans for distressed borrowers, it comes at a cost to liquidity. While restructuring a loan may avoid the immediate hit to capital from recognizing a loss, it comes at the expense of making a bank’s balance sheet less liquid. A loan that is extended or changed to interest-only payments extends the maturity of a bank’s assets. Meanwhile, the maturity of a bank’s liabilities remains the same. This becomes even more damaging if banks “evergreen” loans, that is continually rolling over loans that would otherwise default. A growing portion of a bank’s income may shift from actual cash flows to accrued interest that will never be paid. Taken to an extreme, a bank’s balance sheet may become riddled with illiquid assets that produce no real cash flows, even as losses remain unrecognized and capital intact in a bank’s financial statements. The accumulation of these hidden illiquid assets is how a bank with healthy capital levels might experience a sudden liquidity crisis.

Thus, increased liquidity, rather than improved solvency, may be one of the most important outcomes of the bank recapitalization. More capital means more liquidity. A capital injection provides banks with cash, the most liquid instrument of all. This liquidity will be essential for the large banks to continue to serve as a backstop for the financial system and to meet growing liquidity challenges on their own balance sheets. Correspondingly, if liquidity pressures at the large banks increase, it may be an early indicator of deeper solvency issues to come.

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

As of September 30, 2024, the Seafarer Funds did not own shares in the securities referenced in this commentary.

1. “Intensify Countercyclical Fiscal Policy Adjustments and Promote High-quality Economic Development, Transcript of the State Council Information Office Press Conference (加大财政政策逆周期调节力度, 推动经济高质量发展 国新办新闻发布会文字实录).” Ministry of Finance of the People’s Republic of China (中华人民共和国财政部). October 12, 2024.
2. Mo, YK. “A Review of Recent Banking Reforms in China.” Bank for International Settlements, 1999.
3. Cash, Joe, and Liangping Gao. “China Boosts Funds for Housing Projects to Support Embattled Sector.” Reuters, October 17, 2024.
4. “Global Financial Stability Report, October 2024 - Steadying the Course: Uncertainty, Artificial Intelligence, and Financial Stability.” International Monetary Fund, October 22, 2024.
5. Wang, Juanjuan, and Ziyu Zhang. “Debt-plagued Local Financing Vehicle in China Gets ‘Unprecedented’ Extension to Repay Loans Within 20 Years.” Caixin Global, January 4, 2023.
6. “Unit of China’s ICBC Bank to take 10.82% Stake of Troubled Bank of Jinzhou.” Reuters, July 28, 2019.
7. “China’s Financial Authority Stresses Stable Interbank Lending to Small Banks” China Daily, June 9, 2019.
8. “China Monetary Policy Report Q3 2024 (中国货币政策执行报告).” The People’s Bank of China, November 8, 2024.
9. Author’s calculation based on Wind Information data.
10. “Regulatory Guidelines for Listed Companies No. 3 - Cash Dividends of Listed Companies (Revised in 2023) (上市公司监管指引第3号——上市公司现金分红（2023年修订)).” People’s Republic of China Central People’s Government (中华人民共和国中央人民政府), December 15, 2023.
11. Wu, John, and Cheska Lozano. “Chinese Megabanks to Adopt Semiannual Dividends, Keeping Payout Rates Steady.” S&P Global, August 18, 2024.