What Do Increasing Loan Impairment Losses Mean for Chinese Banks?

December 5, 2011 2:15 PM

Chinese banks are setting aside more money for loan impairment losses, in effect reducing current profits by accounting for expected losses. An increase in expected losses seems puzzling at first given that banks’ loan portfolios have been improving over the past several years as shown by a steadily declining non-performing loan (NPL) rate, as reported by the China Banking Regulatory Commission (CBRC).

One possible explanation for why NPL have not increased in tandem with loss provisions would be an increase in write-offs. NPL rates can be kept low by aggressively writing off bad loans, effectively reducing the numerator in the NPL ratio (NPLs/Total Loans). However, an examination of the financial reports of several banks shows that those setting aside more provisions are not dramatically increasing their write offs.

Another possible answer has to do with China’s loan classification system. In 1998, the Peoples’ Bank of China (PBoC) set forth new standards for evaluating loan health as part of a general effort to improve the banking system. The table below is a simplified representation of the current system:

Loan type Classification Criteria Impairment Loss
Pass No overdue payments, no expectation of future trouble None
Special Mention Payments are less than 90 days overdue, expectation of a less than 5 percent loss 2% provisioning required
Sub-Standard Payments are more than 90 days but less than 180 days overdue, expectation of a 30 to 50 percent loss 25% provisioning required
Doubtful Payments are more than 180 days overdue, expectation of a 50 to 75 percent loss 50% provisioning required
Loss Borrower cannot repay the loan, expectation of a 75 to 100 percent loss 100% provisioning required

The bottom three categories, sub-standard, doubtful, and loss loans, are all considered NPLs. For these types of loans banks are required to take increasing loan impairment losses as a loan deteriorates in quality. The current increase in loan impairment losses, however, is not explained by a worsening composition of NPLs. The chart below shows that the composition of NPLs has stayed roughly the same over the past year.

Increased loan loss provisioning is not due to a growing number or a change in the composition of NPLs.

What is most likely occurring is that banks are increasing impairment losses in anticipation of future NPLs. As mentioned above banks are required to take a 2% impairment loss on loans in the special mention category, loans for which there are a reasonable suspicion of default. Additionally, in accordance with new accounting standards (Chinese language) for listed banks adopted in 2006, banks must take greater impairment losses on sectors that are deemed to be riskier, such as loans to property developers and local government investment platforms. A growing number of risky loans has led banks to take increasing loan loss provisions despite a declining number of NPLs.

The chart below shows that not only are loan loss provisions growing in absolute terms, but also that the provision coverage ratio (provisions/ NPLs) has more than doubled in the past three years, increasing from 133 percent to 270 percent. This is far in excess of the required level of 150 percent banks must adhere to starting next year (Chinese language).

So what can we take away from all this? According to the loan classification standards, even if a borrower is not yet in default, Chinese banks must take loan impairment losses if there are concerns about repayment or the loans are to a risky industry.

An increase in the provision coverage ratio (provisions/NPLs) can therefore be a leading indicator of a potentially deteriorating loan portfolio. The current increase in the provision coverage ratio is consistent with expectations that there will be an uptick in the number of NPLs next year.

It’s possible that many of the current loan impairment losses may be reversed as the financial situation of the borrowers improves. However, if the slowdown in the Chinese economy continues many of these loans might further deteriorate, forcing additional loan impairment losses and hurting bank profitability. It’s safe to say that in the environment of credit tightening and slowing economic growth this possibility weighs heavily on the minds of Chinese bank managers.

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