Stricter China rules on banks’ asset classification to improve transparency

New rules in China on asset classification will improve transparency by making it tougher for the country’s banks to hide problem loans, S&P Global Ratings said in a Feb. 14 note.

The updated financial asset risk classification methods for commercial banks, announced by the People’s Bank of China on Feb. 11, will widen the assets that must be officially reported as nonperforming, Ratings said. The revised rules will apply to all new businesses from July 1. There is a grace period until 2025-end for existing portfolios.

“China’s risk classification of problem assets will get stricter under the new rules,” S&P Global Ratings credit analyst Ming Tan said in the note. “This will minimize opportunities for regulatory arbitrage.”

Chinese banks’ reported nonperforming loans, or NPLs, will likely rise under the new framework. Using the rating agency’s own methodology, which includes a portion of the so-called special mention loans and estimates of forborne and other problem loans, such as loans to distressed property developers or subject to restructuring plans, it estimates Chinese banks’ aggregate NPA ratio to be at 7.6% as of the end of 2022, well above the reported 1.7%.

Asset quality

Industrial and Commercial Bank of China Ltd., the largest lender in the country by assets, reported an NPL ratio of 1.40% as of the end of the 2022 third quarter. The aggregate ratio for rural commercial banks, according to China Banking and Insurance Regulatory Commission data, was as high as 3.29%. According to Chinese government estimates, the country’s economy, weighed by the COVID-19 pandemic and troubles in the property sector, is estimated to have expanded 3.0% in 2022, missing the government’s target.

“The new measures could improve asset quality indicators for banks, by making them more reflective of macroeconomic trends and corporate health,” Tan said. “They could reduce the somewhat counter-intuitive phenomenon of asset quality improving through periods of economic stress.”

Restructured loans are currently classified as special mention loans in China, a more relaxed definition than the category of NPLs in the matured banking systems, Ratings said.

The new rules would also require a borrowers’ entire exposure to be classified as nonperforming if more than 10% of the exposure defaulted, which could have implications for banks’ exposure to distressed developers whose project loans could be performing even though some debt defaulted at the parent holding company level, the rating agency said.

The new rules will also cover all non-loan credit assets that are on and off balance sheet, such as bonds, other investments or guarantees.

The stress in China’s property sector, as well as risks among local government financing vehicles, could take time to be fully reflected in banks’ reported numbers, especially for the more aggressive regional banks, Ratings said.

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