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The RMB727 billion drop in deposits in the banking system this past month may further limit the ability of credit-strapped banks to make loans. The fall in deposits is another example of the impact of distorted interest rates.
Negative real interest rates on deposits (averaging -.5 percent since 2004) has slowed the accumulation of new deposits and in some months led to deposits exiting the formal banking system on net. Since 2004, deposits have grown by 14 percent on a year-over-year (YoY) basis during periods of negative real interest rates, compared to 20 percent growth for periods when the real interest rate was positive. Because China’s capital account is mostly closed, these deposits are forced to stay within the country and chase higher yields offered in real estate or financial products offered by non-bank financial intermediaries.
The graph below shows the relationship between savings deposits and the real interest rate on deposits.
The flight of deposits from banks reduces the amount of credit they can extend to businesses and individuals. Banks are required by the China Banking Regulatory Commission (CBRC) to maintain a loan-to-deposit ratio of less than 75 percent. When deposits leave the banks the loan-to-deposit ratio of banks is automatically forced up, reducing the amount of credit available.
The CBRC has been vigilant in enforcing the loan-to-deposit ratio limit. The requirement was strengthened this year when the CBRC began assessing banks’ ratios on a monthly rather than quarterly basis. The regulator even monitored banks’ ratios on a daily basis this past June.
The third quarter numbers from the CBRC show that the commercial banks on average had a loan-to-deposit ratio of 65.3 percent, comfortably below the limit. However, there are several reasons why this number might not accurately reflect the pressure facing banks.
First, banks have structured wealth management products to boost the appearance of deposits. In order to hold on to fleeing depositors seeking positive real interest rates, banks offer high-yield financial products are that are short in duration. These wealth management products are often timed to mature and convert into deposits the day before a bank must report its loan-to-deposit ratio. Soon after, these deposits are rolled over into new wealth management products. Thus deposits are temporarily boosted and the loan-to-deposit ratio appears lower. Banks’ ability to retain these deposits over the long run is tenuous in an environment of negative real deposit rates set by the central bank and therefore they may be in greater danger of exceeding the loan-to-deposit ratio than appearances would suggest. The CBRC has caught on to this practice and it may no longer be an option.
Second, banks still need to grapple with the issue of loans sold to trust companies. Previously, banks would frequently take loans off their books by packaging them together and selling them to trust companies. However, the CBRC told banks at the beginning of this year that they would have to end this practice and bring those loans back on to their books. The extent to which banks have complied with this mandate is unknown and therefore many banks may be facing a sharp increase in their loan-to-deposit ratios.
Third, there is a significant disparity between large banks and small banks. Large banks with extensive branch networks are able to suck in deposits at much greater rates. Consequently they usually have lower loan-to-deposit ratios than smaller banks. This past month several medium-sized banks, including CITIC Bank, Minsheng, and Merchants Bank, approached or exceeded the 75 percent loan-to-deposit ratio. Only one of the four large commercial banks, Bank of China, exceeded the limit. The fact that the loan-to-deposit ratio disproportionately affects smaller banks worsens the funding crunch for small and medium enterprises because these banks are their most likely source of credit.
The longer real interest rate on deposits remain negative, the more money will be pushed outside of bank deposits, negatively affecting both banks and borrowers.