Increased Interbank Borrowing Causes Concern

(Beijing) — It’s common for banks to lend to each other, but when taken to extremes, the economy suffers and risks pile up.

This is what worried China’s central bank regulators when they found out that many banks had been using borrowed money to buy other banks’ wealth management products. Rather than going to make loans to companies, funds are flowing through the wealth management departments of several banks, then piling into the bond market, inflating bond prices and fanning speculation.

The People’s Bank of China set out last year to control the financial risk by tightening the supply of short-term, cheap funds, creating an incentive for banks to hold more cash. The idea was that this would force many bond traders to gradually deleverage as banks reduce lending to them. In practice, however, it triggered a bond market rout in December. 

A subsequent investigation to find out what caused the crash revealed that the regulator may have underestimated the extent to which banks invest their wealth management funds with each other, according to sources with knowledge of the matter.

This is particularly worrisome because it means the whole economy, not only the bond market, may be facing trouble. The country is counting on banks to make loans to the so-called “real economy,” which the government uses to distinguish firms that produce actual goods and services from those making money by trading securities.

Lending instead to bond traders indicated the loans were not serving that purpose. This spells trouble for the economy because it may render monetary easing ineffective.

“No one in the banks knows where the money they invested in other banks’ wealth management plans ended up,” an official from the central bank said. “They could not tell because the selling bank itself used the funds to buy other banks’ wealth management plans.”

Taken together, it means banks were trading with each other. To the extent that their investments did not benefit the real economy at all, they were like engines unattached to any weight — “idling,” the official called it.

“We did not pay much attention to interbank wealth management in the past because it did not seem like there was much risk,” he said.

China’s national banking regulator does not allow banks to invest their wealth management funds into its own or other banks’ wealth management plans. But the ban has remained on paper because there is no effective mechanism to enforce it.

That has begun to change. The central bank is already applying more scrutiny to most interbank dealings with its Macro Prudential Assessment (MPA) framework, a comprehensive financial risk monitoring and mitigation system implemented last year.

A recent update has expanded the scope of monitoring for interbank investment to cover new interbank wealth management plans and certificates of deposit (CDs), according to several bankers and sources close to the central bank.

These interbank CDs, unlike their Western counterparts, are sold to banks and investment funds in the interbank market and function as a tool for depository institutions to borrow money, often in large sums, without having to worry about early repayments.

According to the sources, the central bank is also mulling revising an old regulation for interbank transactions to close a loophole that allowed banks to circumvent restrictions on interbank loans by using CDs.

Under the 2014 policy, the amount of loans one bank can borrow from other banking institutions — through deposits or repurchase agreement, for example — was reduced to one-third of its total debt.

But it left out interbank CDs because back then not many banks used the tool.

In 2016, banks in China issued CDs worth a total of 13 trillion yuan ($1.9 trillion), up 145% from a year ago. After maturing contracts were paid off, the net increase was 3.3 trillion yuan, a 35% increase from that for the previous year.

The growth was accompanied by a surge in interbank investment in wealth management plans. As of mid-2016, about 15% of banks’ wealth management products were sold to another bank. Three years ago, the ratio was almost zero.

Based on the central bank investigation, many banks have issued CDs to borrow funds only to reinvest them into other banks’ wealth management products. This is more prevalent among small banks compared with the big ones, which have more deposits from people and companies.

Inside the banks, many workers thought of CDs and interbank wealth management as intrinsically linked, but they should not be, a source close to the central bank said.

Treating CDs the same as other interbank loans would force many banks to scale back on interbank lending and put further pressure on the bond market, analysts say.

This is dangerous when the regulators do not have a firm grip on the complexity of networks that channel funds from one bank to another, and ultimately to the bond market, analysts say.

In general, the more intermediaries involved, the greater the implied leverage ratio for the bond investment, and the greater the risk.

The central bank needs to take this into consideration when making regulations about interbank CDs and wealth management, the central bank official said. “No one knows for sure how much leverage the bond market has really taken on. If the real leverage ratios are higher than expected, the impact will be shocking.”

Contact reporter Wang Yuqian (yuqianwang@caixin.com)