Hidden Bad Loans Highlight Struggles of Rural Banks

China’s National Audit Office (NAO) has found that five financial institutions had hid a combined 1.3 billion yuan ($188.7 million) in nonperforming loans by misclassifying them as higher-quality assets.

The situation highlights the troubled financial state of rural banks in China as the economy slows and the government takes a tougher stance on tackling bad debt. As of the end of September, the nonperforming-loan ratio of rural banks reached 4.23%, higher than any other part of the banking sector, according to a report by the China Banking and Insurance Regulatory Commission (CBIRC) on Nov 11.

The nonperforming-loan ration — or bad-loan ratio — is a key measure of a bank’s health.

The five audited financial institutions were three rural commercial banks, a rural credit union and a collection of rural banks in East China’s Anhui province, all of which misclassified nonperforming loans as “passable assets.”

In China, financial regulators have five classifications for loans based on how likely they are to be repaid in full: “pass,” “special mention,” “substandard,” “doubtful” and “loss.” The last three classifications are considered nonperforming. In addition, regulators generally consider a loan that is more than nine months overdue as nonperforming.

In Anhui, the group of rural banks had misclassified 467 million yuan worth of bad loans as “pass” or “special mention” as of this June, according to the NAO’s audit report (link in Chinese) released on Tuesday.

Jiangxi Ganzhou Commercial Bank Co. Ltd., Jilin Tonghua Rural Commercial Bank Co. Ltd., and the rural credit union in Heilongjiang province each gave the classifications of “pass” or “special mention” to hundreds of millions of yuan in loans that were more than a year overdue, the report said.

And Sichuan Ziyang Rural Commercial Bank Co. Ltd. got caught transferring 168 million yuan in bad loans to an investment company that agreed to keep the loans on its books for the bank as long as Ziyang Rural remained liable for any losses, according to the audit report.

The overall asset quality of China’s rural commercial banks continued to deteriorate in the first nine months of 2018, even as it improved for national banks, global rating agency Moody’s said in a report Thursday. The divergence reflected the rural banks’ weaker risk management and poorer ability to adjust to tighter regulations.

In June, the CBIRC ordered city and rural commercial banks to classify all loans more than 90 days overdue as nonperforming by the end of next year, which has led to a surge in their nonperforming-loan ratios, according to CBIRC data. Analysts have attributed the rise in rural banks’ credit risk to their poor risk management and aggressive expansion over the past few years.

Contact reporter Liu Jiefei (jiefeiliu@caixin.com)

A previous version of this story incorrectly stated the amount of bad loans transferred by Sichuan Ziyang Rural Commercial Bank as 168 billion yuan. It was actually 168 million yuan.