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DBS Group Research • June 2019DBS Asian Insights76n

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SECTOR BRIEFING

China Banking Sector Who needs capital?

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DBS Asian Insights SECTOR BRIEFING 7602

China Banking Sector Who needs capital?

Produced by:Asian Insights Office • DBS Group Research

go.dbs.com/research @dbsinsights [email protected]

Wen Nan Tan EditorMartin Tacchi Art Director

Ken SHIH Research [email protected]

Cindy WANG Associate Research [email protected]

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Executive Summary

Who needs capital?

What if the economy suffers a hiccup ahead…

What if the residential credit bubble bursts?

What if POEs continue to suffer?

Expect Rmb2tr capital needed to be raised for the industry

What would happen if China factors in countercyclical capital buffer?

How far away from meeting TLAC regulation?

Expanding capital-replenishing tools to fill the gap

Stimulating growth in China’s ABS market

Speeding up capital raising


Given the challenging macro economy ahead, we ran stress test on 19 China banks based on FY20F estimates to gauge their capital sufficiency.

These 19 banks are Agricultural Bank of China (ABC), Bank of China (BOC), Bank of Communications (BOCOM), China Construction Bank (CCB), China Everbright Bank (CEB), China CITIC Bank (CITIC), China Merchants Bank (CMB), China Minsheng Bank (CMSB), Chongqing Rural Commercial Bank (CQRCB), Bank of Ningbo (BON), Bank of Shanghai (BSH), Bank of Zhengzhou (BZZ), China Development Bank (CDB), China Zheshang Bank (CZB), GuangFa Bank (GFB), Ping An Bank (PAB), Postal Savings Bank of China (PSBC) and Shanghai Pudong Development Bank (SPDB).

Under scenario 1: Macro and economic risks We assume China GDP slowdown to result in lower loan demand, benchmark rate cut to ease corporates’ financing burden, and trade disputes to adversely affect vulnerable export-related sectors.

The result shows that CZB, CDB, SPDB and BOC’s CET1 capital will be hit by 106-122bps under the bear case when loan growth slows down by 2% from FY19 assumption, loan/deposit benchmark rate cut by 150bps/75bps, NPL ratio for manufacturing and wholesale and retail up 5% from FY19, and 10% of special-mention loans migrating to NPLs.

Under scenario 2: Rising residential leveragingChina’s household debt in GDP surged to 51.5% in 3Q18, up from 18% in 2008, or ~triple during the past ten years. The fast growth in residential leveraging has triggered market concerns as China has never experienced a credit downcycle in retail loans.

1. Mortgage risks, we assume that China’s housing prices would fall 31% in FY20F under the bear case which we based on the US housing bubble where residential housing prices were down 34% from the peak during 2007-2012, and we also assume foreclosure discounts of 30%. ABC, CCB, PSBC and CDB‘s CET1 capital will be more vulnerable and be hit by 98-113bps given high mortgage loan exposure at 29-36%, vs peers’ 19%

2. Credit card loan risks, we assume FY20F credit card NPL ratio to be +5ppts above FY19F level, which will hit ~7% NPL ratio in the bear case, in line with US/TW/S. Korea’s credit card bubble burst with its NPL ratio at 6-8%, and we also assume credit card loan growth slowdown to 10%. GFB, CEB, CMB and PAB’s CET1 ratio would be hit by 70-133bps due to their credit card loan exposure of 18-36%, vs peers’ 9%

Executive Summary

What if residential credit bubble bursts?




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Under scenario 3: POEs risks Privately owned enterprises (POEs) have been experiencing financing difficulties and liquidity crunch since 2017 when China started to combat shadow banking which used to be the main financing channel for POEs. To support SMEs and “Sannong” economy to recover, China regulators have released a series of policies in FY19 to alleviate companies’ tax and interest burden, and increase funding support from banks.

1. Non-standard asset (NSA) risks, we assume NSA growth to decline by 10% per annum in FY19/20F given ongoing WMP restructuring, and 10% of NSAs deteriorating to NPLs in FY20F under bear-case scenario. BZZ, CZB, CEB and BON’s CET1 capital will be hit by 84-170bps given their exposure to NSAs at 16-33%, vs peers’ 9%

2. SME loan risks, we assume SME loan to grow by 15% in FY19F but come down to 10% in FY20F when asset quality starts to deteriorate, and assume FY20F SME NPL ratio to rise 4.5% on top of FY19F basis. PSBC, SPDB and CDB’s CET1 capital will be hit by 180-221bps given their higher SME loan exposure of 39-54% vs peers’ 27%

When an economic downturn occurs, the above scenarios will happen sequentially, like a domino effect. Under the all-in situation, we estimate ~Rmb1.5tr capital needs to be raised for 19 banks under the bear-case scenario, implying an aggregate of Rmb2tr capital need to be raised for the industry as the 19 banks represent ~76% of total assets.

CCB, CMB, CQRCB and BSH passed the stress test under the bear case, helped by lower exposure to risky segments and sufficient capital level to cover credit risks. BOCOM will have 1% equity dilution, BOC and ABC have 10% equity dilution, whereas other mid-to-small banks have 14-35% dilution based on BASEL III requirement.

Based on BIS, the CCyB is 0-2.5% determined by the gap between non-financial credit to GDP ratio and its long-term trend.

Given China regulators’ shift from deleveraging to stable liquidity in FY19, banks are encouraged to distribute more loans to support the private sector’s credit, and the recovering bond and equity financing, driving credit to GDP gap upwards. We estimate that banks need to raise CET1 capital by up to Rmb3.9tr if factoring in CCyB by 2.5% based on FY2020 RWAs assumed growth of 8% per annum. An additional of Rmb780bn of CET1 capital will need to be raised per 0.5% CCyB.

Based on TLAC, BASEL conservative buffer and GSIB additional capital buffers, the minimum capital requirement ratio for the Big Four banks would be 19.5-20% in January 2025, and 21.5-22% in January 2028, or three years’ ahead of schedule, assuming CCyB to be 0%.

Expect to raise Rmb2tr capital under bear-case

scenario

Up to Rmb3.9tr to be raised if factoring in

CCyB

Expect to raise Rmb4.1-4.5tr for Big Four

banks to meet TLAC requirement

Capital needs to raise would be Rmb4.1tr-4.5tr. BOC needs to raise Rmb1.2-1.4tr capital and/or LTD given they are required GSIBs buffer at 1.5%, vs 1% for CCB and ABC. Meanwhile, ABC needs to raise Rmb1.1-1.2tr, while CCB only requires Rmb550m.

Since 2019, China banks have completed or announced the issuance of more than Rmb1tr of capital replenishing as they are facing high pressure on:

1. Loans shifting back to on-balance sheet

2. Building up WM subsidiary

3. Increasing loan distribution on POEs



With the challenging macro economy ahead, deleveraging campaign on shadow banking, and uncertainty between US-China trade, China’s economy has been facing downward pressure on corporates’ lack of willingness to invest and expand capacity, increasing unemployment rate, as well as faltering domestic demand.

PMI for mid- and small-sized firms has been trending below 50 since 3Q18 and their deterioration accelerated in 4Q18, likely due to a lagged effect towards the liquidity crunch in 1H18 when many SMEs faced financing and refinancing difficulties. On the other side, the CIER index, which is published by China Institute for Employment Research to reflect the overall trend of China’s job market, showed that demand for recruitment cooled down in 2018, which would inevitably impact consumer spending thereafter.

To stimulate the economy, China’s government has implemented a series of monetary and fiscal policies, such as cutting RRR to empower banks with more loan capacity and lower funding costs, and reducing tax rates to improve corporates’ profit margin.

But what if China’s GDP growth slows further, PBOC cuts interest rates to ease corporates’ interest burden, and asset quality deteriorates amid corporates’ solvency issues, especially in export-related industries? How would that impact China banks’ loan growth, NIM, NPL ratio, as well as capital level?

We conducted stress test on 19 banks under three scenarios to gauge their capital sufficiency under base, worse and bear cases based on FY20F estimates. The three scenarios are:

1. Macro and economic risks

2. Rising residential leveraging

3. POEs risks

These 19 banks are Agricultural Bank of China (ABC), Bank of China (BOC), Bank of Communications (BOCOM), China Construction Bank (CCB), China Everbright Bank (CEB), China CITIC Bank (CITIC), China Merchants Bank (CMB), China Minsheng Bank (CMSB), Chongqing Rural Commercial Bank (CQRCB), Bank of Ningbo (BON), Bank of Shanghai

Who needs capital?

A stressed economic scenario


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(BSH), Bank of Zhengzhou (BZZ), China Development Bank (CDB), China Zheshang Bank (CZB), GuangFa Bank (GFB), Ping An Bank (PAB), Postal Savings Bank of China (PSBC) and Shanghai Pudong Development Bank (SPDB).

Scenario 1: Macro and economic risks In our first scenario, we stress tested China banks’ FY2020 NPL and capital level based on base, worse and bear cases assuming that China’s GDP growth slows down to 6%/5%/4%, benchmark rate is cut by 50bps/100bps/150bps, NPL ratio for manufacturing and wholesale and retail sector rises 100bps/300bps/500bps, and special-mention loan migration to NPL of 1%/5%/10% in 2020.

#1 Assuming the slowdown in GDP directly impacts loan demand

China banks’ loan growth is highly correlated with GDP growth at 0.92 (between 2010-2018). Although China’s GDP growth is gradually slowing down, loan growth remains strong at above 13% y-o-y (+13.7% in 1Q19) helped by PBOC’s RRR cuts which stand at 13.5%/11.5% for large banks/small banks respectively, as each 1-ppt cut could provide liquidity of Rmb1.2-1.5tr to banks. Based on DBS’s economists, China’s GDP is expected to grow at 6% y-o-y in 2020 and we use this number as our base case to model each bank’s loan growth to be flattish/-1%/-2% on top of the 2019 base.

China banks’ loan growth is highly correlated with GDP

Source: PBOC, WIND, DBS HK

Unchanged benchmark rate

due to interest rate liberalization


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In terms of benchmark rate, it has been unchanged with lending/deposit benchmark rate at 4.35%/1.5% respectively since October 2015 after interest rates were liberalised. Although interest rates are currently determined by the market, it is “window guided” by regulators to set the rate above or below the benchmark rate. As long as the benchmark rate is fixed, the interest spread between loans and deposits would stay at 2.85%. The spread could be diverse depending on the capability of securing deposits and loan mix strategy.

PMI for mid and small corporates dropped

The cooling employment market in China

Source: WIND, DBS HK

Source: CIER, DBS HK; CIER Index= number of recruitment demands/ number of market applicants

supply side reform

Among our coverage banks, the correlation between lending benchmark and loan yield with a one-year lag is 0.84-1 during 2007-2018 which proves that banks take about 6-9 months to reprice loans, while deposit benchmark rate and deposit cost with a one-year lag is 0.32 to 0.9. Big Four banks have deposit costs that are highly correlated with deposit benchmark rates due to their strong capability of securing deposits, whereas joint-stock banks need to use premium deposit costs to attract depositors, thus correlation is low at 0.3-0.5.

#2 Assuming lending/deposit interest rate cut at end-2019 to impact banks’ NIM in 2020

In our base/worse/bear-case scenarios, we assume lending rate to be lowered by 50bps/100bps/150bps and deposit benchmark rate to be trimmed by 25bps/50bps/75bps respectively at end-2019, which would be reflected in banks’ NIM in 2020. We assume deposit rate cut to be milder than lending rate 1) as the deposit benchmark rate is already low at 1.5%, with not much room for further cuts, 2) to ease corporates’ interest burden, the cut in lending rate would need to be larger than that for deposit rate. The same situation was seen during 2012-2015.

Benchmark rate vs Shibor 3M

A lagging effect after benchmark rate revised Source: PBOC, Bloomberg Finance L.P., DBS HK

Source: PBOC, Company, DBS HK; data from 2007-2018

High correlation for banks’ loan pricing and

benchmark rate


Correlation ABC BOC BOCOM CCB ICBCLending benchmark rate vs loan yield (one-year lag)

0.99 0.98 0.97 1.00 1.00

Deposit benchmark rate vs deposit cost (one-year lag)

0.87 0.78 0.32 0.90 0.90

Correlation CEB CITIC CMB CMSB CQRCLending benchmark rate vs loan yield (one-year lag)

0.87 0.93 0.84 0.96 0.92


0.58 0.70 0.83 0.52 0.82


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Correlation ABC BOC BOCOM CCB ICBCLending benchmark rate vs loan yield (one-year lag)

0.99 0.98 0.97 1.00 1.00


0.87 0.78 0.32 0.90 0.90

Correlation CEB CITIC CMB CMSB CQRCLending benchmark rate vs loan yield (one-year lag)

0.87 0.93 0.84 0.96 0.92


0.58 0.70 0.83 0.52 0.82

Historical benchmark lending and deposit rate change schedule

2008 - 1-year benchmark loan and deposit rate lowered by 1.89%Oct. 2008 benchmark lending & deposit

rate decreaseOne-year benchmark deposit and loan interest rate were both lowered by 0.27% , to 3.87% and 6.93% respectively.

Oct. 2008 benchmark lending & deposit rate decrease

One-year benchmark deposit and loan interest rate were both lowered by 0.27% , to 3.6% and 6.66% respectively.

Nov. 2008 benchmark lending & deposit rate decrease


Dec. 2008 benchmark lending & deposit rate decrease


2010-2011- 1-year benchmark loan and deposit rate increased by 1.25%Oct. 2010 benchmark lending & deposit

rate increaseOne-year benchmark deposit and loan interest rate were both increased by 0.25% , to 2.5% and 5.56% respectively.

Dec. 2010 benchmark lending & deposit rate increase

One-year benchmark deposit and loan interest rate were both increased by 0.25% , to 2.75% and 5.81% respectively.

Feb. 2011 benchmark lending & deposit rate increase

One-year benchmark deposit and loan interest rate were both increased by 0.25% , to 3% and 6.06% respectively.

Apr. 2011 benchmark lending & deposit rate increase


Jul. 2011 benchmark lending & deposit rate increase


2012-2015- 1-year benchmark loan and deposit rate decreased by 2.21% and 2% respectivelyJun. 2012 benchmark lending & deposit

rate cutOne-year benchmark deposit and loan interest rate were both lowered by 0.25% , to 3.25% and 6.31% respectively.

Jul. 2012 benchmark lending & deposit rate cut

One-year benchmark deposit rate was lowered by 0.25% to 3% and one-year benchmark lending rate was lowered by 0.31% to 6%.

Nov. 2014 benchmark lending & deposit rate cut

One-year benchmark deposit was lowered by 0.25% to 2.75% and one-year loan interest rate was lowered by 0.4% to 5.6% respectively.

Feb. 2015 benchmark lending & deposit rate cut


May. 2015 benchmark lending & deposit rate cut


Jun. 2015 benchmark lending & deposit rate cut

PBOC lowered the one-year benchmark bank lending rate by 25bps to 4.85% and the one-year benchmark deposit rate was lowered by 25bps to 2%.

Aug. 2015 benchmark lending & deposit rate cut

PBOC lowered the one-year benchmark bank lending rate by 25bps to 4.6% and the one-year benchmark deposit rate was lowered by 25bps to 1.75%.

Oct. 2015 benchmark lending & deposit rate cut

PBOC lowered the one-year benchmark bank lending rate by 25bps to 4.35% and the one-year benchmark deposit rate was lowered by 25bps to 1.50%.

Source: PBOC, DBS HK

Since the US proposed a list of US$200bn worth of Chinese goods on which to impose an additional tariff of 10% in July 2018, China’s new export orders PMI index dropped sharply, falling to 45.2 in February 2019 from 49.8 in July 2018, the lowest point since the global financial crisis (GFC). The reduced business investment, delays in purchases and worsening economic conditions in key export markets all resulted from the latest downturn. Although the US and China agree to a temporary truce to alleviate trade tensions in December 2018, the uncertainty remains an overhang and export demand continued to deteriorate in line with the global trade slowdown.

In China, manufacturing and wholesale and retail industries contribute 29%/8% of total GDP, and 50%/30% of final goods and services are export-oriented. That said, every 1% decline in manufacturing/wholesale & retail impacted by the trade dispute would cause GDP growth to slow by 0.15%/0.02%. Thus, China’s economic growth could be weighted down even as trade negotiations are pending.

Breaking down China banks’ asset quality, 32%/28% of non-performing loans came from the manufacturing/ wholesale & retail sectors respectively in 2017, while most banks’ asset quality in relation to manufacturing and wholesale and retail further worsened in 1H18. This was mainly due to 1) the channeling of funding away from “old economy” sectors and matured industries struggling with overcapacity, where banks cut down on their loan quotas which led to liquidity issues, and 2) industry’s structural changes, including manufacturing upgrades and the booming of e-commerce, which caused legacy corporates’ solvency issues.

A special-mention loan, by definition, is recognised when the borrower 1) is negatively impacted by external or internal factors which would adversely affect the borrower’s ability to make loan payments, or 2) has potential liquidity issues due to an increase in contingent debt, or 3) is unable to make loan payments using normal operating income, yet the bank is able to collect principal and interest due to ample collaterals. China banks’ special-mention loan ratio improved from 4.1% in 4Q16 to 3.1% in 4Q18, yet loan loss reserve ratio was only 3.4% which was insufficient to cover broad-based NPL ratio at 4.96% (1.83% NPL ratio plus 3.1% special-mention loan ratio) if all special-mention loans deteriorated and turned into non-performing loans in the credit downcycle.

#3 Assuming asset quality further deteriorated in export-related industries, as well as special-mention loans

In our base/worse/bear-case scenarios, we assume NPL ratios for manufacturing and wholesale & retail sectors weakened by 100bps/300bps/500bps, and 1%/5%/10% of special-mention loans turned into NPLs respectively, to reflect trade disputes’ adverse effect on the industries’ solvency. Historically, manufacturing and wholesale & retail’s NPL ratios once hit 11.9%/20.5% in 2005 (vs 4.2%/4.7% in 2017). Thus, we think the 500-bp increase on top of FY19F’s NPL ratio to model the two sectors’ NPL ratios on the bear case appears reasonable.

A leading indicator for NPL

Trade dispute to cause shrinkage in export

demand


PMI new export orders have been trending down since trade dispute between China/US began

Manufacturing and wholesale & retail NPL represent 60% of total NPL in China


Source: WIND, DBS HK; data in 2017


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Manufacturing and wholesale & retail NPL ratios were at 4-5% range

China banks’ loan loss reserve ratio is still insufficient to cover broad-based NPL ratio

Historical trend for manufacturing and wholesale & retail sectors

Source: Company, DBS HK

Source: CBRC, DBS HK

Source: CBRC, DBS HK



CZB, CDB, SPDB and BOC’s capital levels

appear more vulnerable on Scenario 1 stress test


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Scenario 1: Macro and economic risksWe assume China’s economic slowdown, benchmark rate cut (or market rate trending downwards), and trade dispute to weaken export demand, leading to deterioration in asset quality in manufacturing and wholesale & retail deteriorating, as well as migration of special-mention loans to NPLs.

Base-case assumption: 6% GDP growth, loan growth as the same as FY19F, loan/deposit benchmark rates cut by 50bps/25bps, NPL ratio for manufacturing and wholesale & retail up by 1%, and 1% of special-mention loans migrating to NPLs.

Worse-case assumption: 5% GDP growth, loan growth slowing down by 1%, loan/deposit benchmark rates cut 100bps/50bps, NPL ratio for manufacturing and wholesale & retail up by 3%, and 5% of special-mention loans migrating to NPLs.

Bear-case assumption: 4% GDP growth, loan growth slowing down by 2%, loan/deposit benchmark rates cut 150bps/75bps, NPL ratio for manufacturing and wholesale & retail up 5%, and 10% of special-mention loans migrating to NPLs.

Among the 19 banks, BZZ, CZB and BOC’s FY20F NPL ratio will increase by 144bps/125bps/114bps respectively under the bear case as they have higher loan exposure in export-related industries and special-mention loans at 28%/25%/22% respectively.

In terms of FY20F core-equity one ratio (CET1) of CZB, CDB, SPDB and BOC will be hit by 122bps, 111bps, 110bps, 106bps respectively. BZZ’s loans in total assets is only 35%, vs peers’ 54%, and thus its interest income is less sensitive to NIM pressure although it has a higher loan exposure to risky industries. Under our assumption, CZB, CDB, SPDB and BOC’s capital levels are more vulnerable when China and the macro economy experience a downturn.

Loan exposure comparison in manufacturing and retail & wholesale, and special mention loan


BZZ, CZB, and BOC have the major impacts on NPL ratio under Scenario 1 under macro risks

CZB, CDB, SPDB and BOC have the highest impacts on CET1 ratio under macro risks




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Stress test on macro and economic risks

Bank ABC BOC BOCOM CCB CEB CITIC CMB CMSB CQRCB

Ticker 1288 HK 3988 HK 3328 HK 939 HK 6818 HK 998 HK 3968 HK 1988 HK 3618 HK

Scenario 1- China economic slowdown/benchmark rate cut/trade dispute

Manufacturing loan (Rmb m) 1,317,529 1,455,177 603,462 1,250,499 255,884 343,862 313,459 355,723 68,831

Wholesale and retail loan (Rmb m)

356,353 1,140,012 316,832 436,275 109,268 193,818 172,087 229,264 21,351

Special mention loan (Rmb m) 445,475 400,297 147,612 460,635 67,081 105,485 68,548 142,095 11,408

Manufacturing loan as % of total loan

9.2% 10.6% 10.6% 7.6% 8.8% 8.1% 6.6% 9.3% 15.0%

Wholesale and retail loan as % of total loan

2.5% 8.3% 5.6% 2.7% 3.8% 4.6% 3.6% 6.0% 4.6%

Special mention loan ratio 3.1% 2.9% 2.6% 2.8% 2.3% 2.5% 1.5% 3.7% 2.5%

Base case: GDP 6% (loan growth unchanged), benchmark rate cut 50bps, NPL ratio for manufacturing and retail & wholesale up 1%, 1% of special mention loan migrate to NPL

NPL ratio impact (bps) 14.76 21.77 18.81 13.07 14.93 15.24 11.72 18.93 22.07

CET 1 ratio impact (bps) (17.82) (23.63) (21.39) (21.69) (19.98) (20.39) (19.89) (20.11) (10.54)

CAR impact (bps) (17.36) (22.82) (20.85) (21.28) (19.55) (19.90) (19.52) (19.78) (10.24)

Worse case: GDP 5% (loan growth slowdown by 1%), benchmark rate cut 100bps, NPL ratio for manufacturing and retail & wholesale up 3%, 5% of special mention loan migrate to NPL



CAR impact (bps) (47.85) (61.89) (55.76) (55.75) (49.61) (51.10) (48.41) (53.15) (30.16)

Bear case: GDP 4% (loan growth slowdown by 2%), benchmark rate cut 150bps, NPL ratio for manufacturing and retail & wholesale up 5%, 10% of special mention loan migrate to NPL



CAR impact (bps) (79.91) (101.75) (91.41) (91.72) (80.30) (83.05) (77.46) (87.85) (50.29)


Stress test on macro and economic risks cont.

BON BSH BZZ CDB CZB GFB PAB PSBC SPDB CQRCB

002142 SS 601229 SS

6196 HK non-listed

2016 HK non-listed

000001 SS

1658 HK 600000 SS

600000 SS

Scenario 1- China economic slowdown/benchmark rate cut/trade dispute

Manufacturing loan (Rmb m) 56,928 61,947 14,516 585,623 136,277 117,559 150,666 300,297 321,803

Wholesale and retail loan (Rmb m)

32,601 59,541 32,436 0 113,448 74,796 116,394 106,985 210,055

Special mention loan (Rmb m) 2,572 17,228 5,003 845,816 16,617 56,151 83,181 39,548 135,630

Manufacturing loan as % of total loan

11.1% 6.5% 7.8% 4.2% 13.0% 7.7% 6.2% 4.9% 7.6%

Wholesale and retail loan as % of total loan

6.3% 6.2% 17.5% 0.0% 10.8% 4.9% 4.8% 1.7% 5.0%

Special mention loan ratio 0.5% 1.8% 2.7% 6.0% 1.6% 3.7% 3.4% 0.6% 3.2%

Base case: GDP 6% (loan growth unchanged), benchmark rate cut 50bps, NPL ratio for manufacturing and retail & wholesale up 1%, 1% of special mention loan migrate to NPL



CAR impact (bps) (9.05) (14.23) (11.25) (22.20) (27.66) (16.96) (17.98) (6.11) (26.13)

Worse case: GDP 5% (loan growth slowdown by 1%), benchmark rate cut 100bps, NPL ratio for manufacturing and retail & wholesale up 3%, 5% of special mention loan migrate to NPL



CAR impact (bps) (27.38) (36.95) (33.25) (63.64) (72.34) (50.03) (48.61) (19.29) (66.54)

Bear case: GDP 4% (loan growth slowdown by 2%), benchmark rate cut 150bps, NPL ratio for manufacturing and retail & wholesale up 5%, 10% of special mention loan migrate to NPL



CAR impact (bps) (44.59) (59.68) (54.94) (109.59) (116.15) (84.68) (80.71) (32.24) (108.39)


Residential property prices are regulated


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What if the residential credit bubble bursts?

Scenario 2: Residential leveraging risks

Concerns on rising household debt

China’s household debt as a percentage of GDP surged to 51.5% in 3Q18, up from 18% in 2008, almost tripling within the past ten years, based on BIS. Although it remains below the global average of 59%, the fast pace of growth in residential loans has triggered market concerns, especially when China has never experienced a credit downcycle in retail loans.

In 2008, China banks only distributed 8% of loans to residents (excluding mortgage loans), compared to 80%/12% for corporate loans/mortgages, whereas the ratio now stands at 16%/64%/20% for consumer /corporate/mortgage loans respectively. China banks are more willing to offer loans to retail borrowers for the purchase of houses which have a collateral feature and lower likelihood of default, as compared to unsecured credit loans such as credit card and consumption loans.

Historically, China’s property prices have been relatively firm and ASP per square metre only dropped once, by 2% y-o-y in 2008 during the GFC, supported by the government’s relaxation of policy restrictions on mortgage loans for second home purchases and tax reduction for sale of homes more than two years from the purchase date, etc. Conversely, when the property prices rise too rapidly, regulators would adjust their measures to cool down the market, such as increasing down payment ratio and controlling residential land supply, etc.

In 2015, the relaxation policy was resumed as NPC and CPPCC stressed on the need to stabilise residential property consumption and stimulate housing demand, to promote shanty town transformation in lower-tier cities, and to clear existing inventory in the property market. This boosted demand and resulted in mortgage loans increasing 21%/35% y-o-y in 2015/2016. The residents’ net savings balance (residential savings minus residential loans) was at about the same time trending down as part of their wealth was tied down in property. Mortgage loans reached Rmb25.8tr in 2018 from Rmb3tr in 2008, enjoying a 24% CAGR in the past ten years.

China’s mortgage non-performing loan (NPL) ratio is quite stable at 0.3%, which is somehow implicitly protected by the policy that first-home/second-home buyers are required to pay at least 30%/40-60% down payment. On the other hand, as housing prices are on an upward trend, borrowers tend to sell their properties to repay loans rather than defaulting, which might result in profits. Thus, mortgage is the last loan that residents will default on, given the mortgage rate of c. 5% is lower than the interest rate of unsecured credit loans (such as credit card at 12-15%). Banks’ loan-to-value ratio (LVR) was low at 40-50% in 2018, which was helped by a high percentage of down payments and rising house prices.

Low defaults in mortgage


China’s household debt reached 52% of GDP in 3Q18

China residential ASP has been defensive

Source: Bank of International Settlement (BIS), DBS

Source: CEIC, DBS HK


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China residents’ net savings balance has been declining since 2016 as the wealth locked in mortgage

NPL ratio for mortgage was much lower than that for other consumer loans




Scenario 2(1): Stress test on mortgage

As the China government promotes the healthy development of the real estate market, we expect property prices to be up 2% y-o-y in 2019, and we assume FY20 China housing price to be flattish y-o-y, down 15%, and down 31% under base-, worse- and bear-case scenarios respectively, in our mortgage stress test. We assume that housing prices would drop by 31% based on the US housing bubble in 2007-2012 when residential property prices fell 34% from the peak. We also assume foreclosure discounts of 30% if banks need to clear out foreclosed homes, although the current foreclosure discounts in Shanghai are only 10% on average.

China residential prices are well regulated

Source: CEIC, DBS HK

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ASP growth: Residential YoY, %

(%) Rebased Jan - 07Announced the Suggestion on resolving difficulties of urban low-income families in Housing

State Council demanded that T2/3 cities with strong price growth should be put in place with strictive purchase policies

NPC &CPPCC reiterated the policy focus to digest existing inventory through selective policy measures according to cities

NPC &CPPCC stated that residential units are for living rather than invest-ment or speculation.

NPC &CPPCC indicated to enhance policy control according to cities, acceler-ate digestion of existing inventory and ensure the living charateristic in residential units

Digesting inventory in the property market has been set as a priority under the Central Economic Working Conference

National MOHURD indicate that each city may adjust housing policies according. Areas with large inventories should impose policies to acclerate inventory digestion

NPC & CPPCC meeting suggested to stabilise residential property consumption and stimulate actual living and upgrading demand

MOHURD and China Development Bank jointly issued "Notice on further promoting of shanty town through monetisation method" to promote the use of monetary method for settlement to affected residents

The implementation of "國三條"

Premier Li unveiled the concept of "New-Type urbanisation" and aim to move 100m rural residents to urban areas by 2020

Shanghai started to reduce downpayment ratio, followed by Shenzhen and other cities

The implementation of "國四條"

The implementation of "國五條"

(CH Prop) The implementation of "新國四條"

ABC, CCB, PSBC and CDB’s capital levels more vulnerable to

mortgage risks


23

There would basically be no impact on banks’ asset quality if housing prices are flattish and drop 15% y-o-y under the base and worse cases. This is because borrowers would only be likely to start defaulting on their loans if housing prices fall by more than 30% which more than the value of their down payments.

Under the bear case, ABC, CCB, PSBC and CDB’s FY20F NPL ratio will increase by 128bps/110bps/109bps/106bps respectively, due to higher loan exposure to mortgage at 34%/36%/29%/29%, vs peers’ 19%. We use urban renewal loans (which China Development Bank [CDB] provides to local governments for “shanty town redevelopment”) as a proxy for mortgage loans.

In terms of FY20F core-equity one ratio (CET1), ABC, CCB, PSBC and CDB will be hit by 113bps, 107bps, 112bps, 98bps respectively, when housing prices drop by 31% with foreclosure discount at 30%.

US housing prices dropped 34% during GFC

Source: US Census Bureau, DBS HK


ABC, CCB, PSBC, and CDB have the major impacts on NPL ratio under mortgage risks

Mortgage loan exposure comparison

ABC, CCB, PSBC, and CDB have the highest impacts on CET1 ratio under mortgage risks




Credit cards - Honey or poison?


25

The credit card business has become the key growth driver for banks’ retail banking segment, following the restructuring of wealth management products since 2017. With the increasing demand for instalment services through online shopping and large-ticket sized purchasing, as well as growing outbound travel, the demand for credit cards is increasing.

Thus, credit card issuance has been growing rapidly, revolving and outstanding credit card loans have enjoyed outstanding growth, and contributions from both interest income and fee income have been increasing.

The number of total active credit cards in China reached 686m in 2018, up 17% y-o-y, while credit card per capita was still low at 0.49, compared to bank cards at 5.46. The outstanding amount of credit card revolving loans and year-end loan balance reached Rmb15.4tr and Rmb6.9tr, up 23.4% and 23.2% y-o-y respectively, showing continued strong growth momentum.

While credit card loan book is growing rapidly, asset quality has started to become a concern due to increasing multiple lending risks as more small- and mid-sized banks jump into the market.

In China, credit card asset quality is somehow protected by the government as only people with a credit record in CCRC could be served by banks, and currently only 500m people have a credit record which somewhat lowers the default risks. As more-than-six-month overdue loans accounted for 1.15% of year-end loan balance in 2018, slightly down from 1.19% a year ago, we think the credit card risks are still manageable.

As banks used to be only serving the top echelons, China has never experienced any consumer credit crisis. China’s credit card non-performing loan ratio has been quite stable at the 2% level and the 6-month overdue loan ratio has been at 1.1-1.5%. Besides that, China banks’ competition in retail banking is not as intense as seen in other countries that had experienced a personal credit bubble, such as South Korea in 2002-2003, Taiwan in 2003-2005, and the US in 2008-2009.

Take South Korea for an example, during 1999-2002, its credit card market grew rapidly and the number of credit cards tripled while the volume of total credit card transactions expanded more than six fold. Credit card balance as a percentage of household loans/disposable income reached 45%/26% in 2002, resulting in the credit card crisis in 2002-2003. Then, the NPL ratio was at 8.3-8.6%.

Although it would be hard to predict the critical NPL level in China that would result in a consumer credit bubble, we think South Korea, Taiwan and the US could serve as useful benchmarks as their credit card NPL ratio had once hit a peak at 8.6%/7.5%/6.3% during their credit downcycle.

Credit card risks are under control

No consumer credit downcycle has ever

taken place


Credit cards have become the main fee income contributor

China credit card loan balance growing rapidly

China’s rising number of active credit cards





27

China credit card NPL

Credit card bubble in US/Taiwan/S. Korea Source: PBOC, DBS HK

Source: ECOS, CBC, Federal Reserve, DBS HK


China credit card market scale by cards issued, loan balance, and asset quality

Year 2012 2013 2014 2015 2016 2017 2018Credit cards and Quasi credit cards issued and in use (m)

331 391 455 432 465 588 686

YoY (%) 16.1% 18.1% 16.4% -5.1% 7.6% 26.5% 16.7%Credit card per capita 0.25 0.29 0.34 0.29 0.31 0.39 0.49

Outstanding revolving loan during the year (Rmb bn)

3,490 4,570 5,600 7,080 9,140 12,480 15,400

YoY (%) 30.9% 22.5% 26.4% 29.1% 36.5% 23.4%

Credit card year end loan balance (Rmb bn) 1,140 1,840 2,340 3,090 4,060 5,560 6,850

YoY (%) 61.4% 27.2% 32.1% 31.4% 36.9% 23.2%

> 6 months overdue loan (Rmb bn) 15 25 36 38 53 66 79

% of year end loan balance 1.29% 1.37% 1.53% 1.23% 1.31% 1.19% 1.15%

% of year end loan balance n.a. 1.3% 1.4% 1.5% 1.2% 0.9%

Scenario 2(2): Stress test on credit card

In our base/worse/bear-case scenarios, we assume FY20F credit card non-performing loan ratio to be 1ppt/3ppts/5ppts on top of FY19F NPL ratio if a credit card crisis happens.

Currently, China’s credit card NPL ratio is at the 2% level, and we use 5ppts on top of c. 2% to derive a 7% NPL ratio in the bear-case scenario. We think the assumption should be reasonable based on the experience of regional players which saw a credit card bubble when their credit card NPL shot up to 6-8%. We also forecast credit card loans to grow mildly at 10% y-o-y in FY20, down from c. 20-25% y-o-y, as banks would slow down credit card issuance and lower the loan quota if the above situation happens.

Among 19 banks, GFB, CEB, CMB and PAB’s FY20F NPL ratio will increase by 167bps/99bps/87bps/ 91bps respectively under the bear-case scenario, as they have higher exposure to credit card loans at 36%/21%/18%/20% respectively, vs peers of 9%.

In terms of FY20F core-equity one (CET1) ratio, GFB, CEB, CMB and PAB will be hit by 133bps/71bps/79bps/70bps respectively, if credit card NPL ratio rises by 5%.

GFB, CEB, CMB and PAB’s capital levels are

more vulnerable to credit card risks




GFB, CEB, CMB and PAB face the biggest impact on NPL ratio from credit card risks

Credit card loan exposure comparison


29



GFB, CEB, CMB and PAB face the biggest impact on CET1 ratio from credit card risks

Stress test on residential risks – Mortgage and credit card loans



Scenario 2- China residential leveraging risks

Mortgage 4,889,573 3,968,088 1,260,189 5,969,073 489,362 722,308 1,144,793 498,730 76,274

Mortgage/total loan 34.1% 28.8% 22.2% 36.3% 16.9% 17.1% 24.2% 13.0% 16.6%

Credit card loan 456,474 645,662 715,813 972,232 610,739 507,545 847,386 390,531 4,528

Credit card/total loan 3.2% 4.7% 12.6% 5.9% 21.1% 12.0% 17.9% 10.2% 1.0%

Mortgage sensitivity test - assume foreclosure discount by 30%

Base case: property price flat

NPL ratio impact (bps) - - - - - - - - -

CET 1 ratio impact (bps) - - - - - - - - -

CAR impact (bps) - - - - - - - - -

Worse case: property price drop 15%



CAR impact (bps) - - - - - - - - -

Bear case: property price drop 31%



CAR impact (bps) (111.05) (80.45) (51.48) (105.40) (31.80) (41.66) (64.39) (35.67) (32.99)

Credit card sensitivity test - assume credit card loan grow 10% y-o-y in FY20

Base case: credit card NPL ratio increase 1%



CAR impact (bps) (1.97) (4.35) (9.94) (5.30) (14.53) (8.97) (16.34) (7.23) (0.63)

Worse case: credit card NPL ratio increase 3%



CAR impact (bps) (6.80) (11.47) (27.03) (15.13) (41.09) (25.13) (46.19) (19.42) (1.63)

Bear case: credit card NPL ratio increase 5%



CAR impact (bps) (11.64) (18.61) (44.19) (24.98) (67.81) (41.34) (76.25) (31.65) (2.64)



Scenario 3: POE risks

Private companies, also known as POEs, have been experiencing financing difficulties since 2017 when the China government started to clamp down on shadow banking which used to be the main financing channel for POEs. In China, banks’ loan mix is roughly 70/30 for corporate/retail banking, and out of that, 70-80% of corporate loans are distributed to SOEs, implying only 15-20% of total loans are allocated to POEs.

However, by breaking down China’s GDP, over 60% is contributed by POEs. Hence, there is a mismatch between funding support and profit contribution.


Stress test on residential risks – Mortgage and credit card loans cont.

Bank BON BSH BZZ CDB CZB GFB PAB PSBC SPDB

Ticker 002142 SS 601229 SS 6196 HK non-listed 2016 HK non-listed 000001 SS 1658 HK 600000 SS

Scenario 2- China residential leveraging risks

Mortgage 1,757 93,085 18,372 4,147,415 73,332 189,626 238,535 1,802,574 788,229

Mortgage/total loan 0.3% 9.7% 9.9% 29.4% 7.0% 12.4% 9.8% 29.2% 18.6%

Credit card loan 47,093 35,712 1,620 0 16,634 544,525 488,841 111,687 505,154

Credit card/total loan 9.2% 3.7% 0.9% 0.0% 1.6% 35.6% 20.0% 1.8% 11.9%

Mortgage sensitivity test - assume foreclosure discount by 30%

Base case: property price flat



CAR impact (bps) - - - - - - - - -

Worse case: property price drop 15%



CAR impact (bps) - - - - - - - - -

Bear case: property price drop 31%

NPL ratio impact (bps) 1.28 44.55 106.22 37.66 46.49 36.57 109.41 69.75


CAR impact (bps) (0.67) (16.84) (20.12) (90.57) (31.49) (37.87) (28.87) (109.31) (56.76)

Credit card sensitivity test - assume credit card loan grow 10% y-o-y in FY20

Base case: credit card NPL ratio increase 1%

NPL ratio impact (bps) 8.33 3.06 0.80 - 1.22 30.73 15.01 1.46 11.40

CET 1 ratio impact (bps) (4.23) (1.59) (0.36) - (1.01) (24.26) (11.41) (1.41) (8.79)

CAR impact (bps) (4.14) (1.52) (0.33) - (0.95) (23.58) (11.12) (1.35) (8.60)

Worse case: credit card NPL ratio increase 3%



CAR impact (bps) (12.87) (5.05) (1.03) - (3.29) (76.26) (39.55) (4.54) (25.86)

Bear case: credit card NPL ratio increase 5%



CAR impact (bps) (21.61) (8.59) (1.73) - (5.64) (129.56) (68.16) (7.73) (43.18)

Deleveraging has caused POE’s liquidity

crunch


31

In 2018, according to the National Bureau of Statistics (NBS), POEs with revenue size above Rmb20m faced net profit margin deterioration of 34bps to 5.59%, vs SOE’s increase of 35bps to 6.79%, impacted by

1. Supply-side reforms driving up commodity prices which were negative to downstream manufacturers (mainly POEs), but positive to upstream suppliers (mainly SOEs)

2. Tight liquidity leading to higher interest burden.

Although there is no official data for small-scale POEs, which by definition are small and micro enterprises (SMEs) with revenue lower than Rmb20m, the profit squeeze was likely more severe in 2018.

To support SMEs and help the “Sannong” economy to recover, the government has released a series of policies in 2019, including fiscal tools to reduce tax burden, and monetary tools to relax interest burden and increase funding support from banks.

The State Council has announced further tax cut measures to include SMEs and broadened the definition of SMEs to allow more enterprises to benefit from the tax benefit which is estimated to reach Rmb200bn. On the other hand, the PBOC has relaxed its targeted RRR cuts to incentivise banks to provide financing to SMEs, as well as to provide cheaper funding to reduce SMEs’ interest burden.

We believe the China government’s intention of supporting the private sector, especially small and micro enterprises, is clear. Although the market was previously concerned about these private enterprises’ default risk, with the continued introduction of several supporting measures, these concerns may be overdone. The slowdown in China’s GDP growth may moderately impact China banks’ asset quality, but we expect the risk to be manageable.


POEs’ net profit margin was under pressure in 2018...

POEs’ margin pressure is also a concern

A series of policies to solve SMEs’ liquidity and solvency issues


Yet, margin pressure should ease amid normalising of PPI of raw materials


Source: PBOC, CBRC, State Council, MoF, Ministry of Agriculture and Rural Affairs, DBS HK

A series of favourable policies to support SMEs and “Sannong” economy

Date Regulator Subject Main content

Jan. 2018 PBOC Targeted RRR cut Cut banks' RRR by 0.5ppt/1.5ppts when their Inclusive Finance reach 1.5%/10% of total loans. This inject ~RMB800bn of liquidity in the market

Sep. 2018 MoF Exemption of Value-added tax on the interest income from SME Loan

1. The interest income received from loan to SME at the <150% of the PBOC interest rate benchmark will be exempted from value-added tax / Only the portion above the benchmark will be charged the tax at current level.

2. Applicable to financial institution with SME loan (<RMB10m) growth rate is not lower than other loans’ and the number of small and micro enterprises not lower than the same period of last year,

3. All interest income derived from the credit line of SME loan of <RMB 1m will be exempted from Value-added tax

Dec. 2018 PBOC Announced a new monetary tool to support SMEs

• PBOC announced to provide Targeted Medium-term Lending Facility (TMLF) which aims to release long-term liquidity to support private and small companies.

• Compared with the current Medium-term Lending Facility (MLF), the one-year interest rate on the TMLF will be 3.15%, 15bps lower than the MLF rate.

• Funds of TMLF can be used for three years (one year duration but can extend for another two years), compared to MLF funds which mature in a year.

• Large commercial banks, joint-stock commercial banks and major city commercial banks showing great support to the real economy and meet macro prudent requirement can apply for the TMLF.

• PBOC also announced an increase of relending and rediscount quotas by another RMB100bn, citing effectiveness of previous expansions in improving financing to SMEs as well as private companies. It has boosted the quotas by a total of RMB300bn with two hikes in June and Oct 2018.

• PBOC continues to maintain neutral monetary policy and ensure sufficient liquidity in the banking system.

Jan. 2019 PBOC Relax the criteria for Inclusive Finance Target RRR cut

• PBOC announced to relax the recognition criteria for Inclusive Finance Target RRR cut, from previous “ single credit facility less than Rmb 5m” to “ single credit facility less than Rmb 10m”.

• Based on existing policy for Target RRR cut on Inclusive Finance, banks with Inclusive Finance lending reaching 1.5% of total new outstanding loan in previous year will be granted a 0.5ppt RRR cut, and Inclusive Finance lending reaching 10% of total new outstanding loan in previous year will be granted a 1.5ppt RRR cut.

Jan. 2019 CBRC Requirements on rural commercial banks’ performance

1. outstanding loans must be at least 50% of total assets, 2. new loans to local economy must be at least 70% of loans to be advanced,3. loans related to agri-related and small and micro enterprises (SMEs) need to gradually increase per

annum till reach 80% of total loan, 4. loan size more than 2.5% of tier 1 capital or Rmb50m should gradually come down per annum till lower

than 30% of total loan, 5. loans related to agri-related and SMEs need to grow higher than other loans, 6. NPL ratio for agri-related and SME loans has up to 3ppt tolerance compared to other loans, and 7. rural banks were asked to limit the operations within the district.


33

Scenario 3(1): Stress test on non-standard assets (NSAs)

NSAs refer to proxy-loans and advances to customers through entrusted trusts, wealth management products, and bills, etc.

They may vary depending on each bank’s definition, but largely fall under the same concept. Banks had previously supported POEs through off-balance sheet financing as

Source: PBOC, CBRC, State Council, MoF, Ministry of Agriculture and Rural Affairs, DBS HK

A series of favourable policies to support SMEs and “Sannong” economy cont.

Date Regulator Subject Main content

Jan. 2019 MoF General tax cut on SME

1. Exempt Value-Added tax of SME whose monthly revenue is lower than 100k RMB2. For SMEs which have total taxable income < RMB 1m will be cut to 25% of the original amount and

taxed at the rate of 20%. For SMEs which has total taxable income between RMB 1m and RMB 3m , total taxable will be half-counted and taxed at 20%. * SMEs: Taxable Income should be lower than RMB3m with less than 300 employees and RMB50m total asset in average

3. Municipal / Province government can cut the tax rate of eight taxes* to the maximum of 50%. 4. SME who enjoyed the tax cut policy of the above 8 taxes can also be beneficial from THIRD Policy.5. Regarding the Angel Investment / Start up firms, the definition of Start-UP Firms adjusted from <200

Employees to <300 Employees and Asset , Annual Revenu < RMB 30m to <RMB 50mFeb. 2019 State

CouncilGuidance on government funding / financing for SMEs and Sannong

6. Government / State-Backed Fund should emphasise on the business with the SME /Sannong to offer adequate funding support , esp the new industry. The lending institutions and government should not put profit on the priority list but to maintain a lower financing fee for SME and Sannong on the basis of sustaining operation.

7. Maintaining >80% business with SME/Sannongs.8. Any Stated-backed fund / guarantee business has to keep the guaranteed loan of SMEs to at least 80%

of their guaranteed loan portfolio whilst >50% of the gurantee loan should be the loan >RMB 5m per firm.

9. Lower the average fee rate to below 1% on SMEs/Sannong. Charging no more than 1% for the guarantee amount of <RMB 5m and no more than 1.5% for the amount of >RMB 5m

10. State-backed funds and Banking Institutions have to bear the risk liability of >20% while the risk liability province level / Reguranteed Institution are required to be higher.

11. The municipal / Province government can subsidize any guarantee business with <RMB 5m and 1% Guarantee fee.

12. Encouraging each province to nurtue a leading institution in Guarantee Loan Business and reach the whole municipal funding coverage in 3 years.

13. Simplying the loan approval process and improve the risk management process.14. Optimizing the regulation / examination mechanism to lower the NPL level.

Feb. 2019 PBOC, CBIRC, MoF and the Ministry of Agriculture and Rural Affairs

Guidance on Rural Service Revitalization of Financial Services

1. Agri-banks should give priority to support poverty stricken areas and the growth rate of loans in deep poverty areas is higher than the average growth rate of loans in the provinces,

2. the balance of agri-related loans should be higher than the previous year, and the loans of farmers and new agri-business maintain a relatively fast growth rate,

3. relaxing the issuance requirements of special financial bonds for “Sannong”, and 4. NPL for agr-related loan could be higher than the annual target of NPL ratio by 2%. Other than that,

the guidance also directs capital market to support “Sannong” economy, such as bonds and equity, and increase agri-insurance coverage.

Mar. 2019 CBRC Guidance for banks to distribute loans to SMEs

1. SME loan growth rate is not lower than other loans’ and the number of small and micro enterprises not lower than the same period of last year,

2. the non-performing ratio of inclusive loans to SMEs will be allowed to reach a level no more than 3% above the other loans,

3. Big Five banks’ outstanding loans to small firms should rise by more than 30% y-o-y, and 4. offering the lending rates to SMEs on a reasonable level.


1. Most loan quota are allocated to SOEs, whose risks tend to be lower than POEs as they are government-backed

2. Off-balance sheet financing requires less capital and bears lower risks, as well as contribute fee income to banks

Regulators had discouraged NSAs mainly by clamping down on WMPs which were the main channel for banks to attract retail customers’/corporates’ idle funds and direct the funds to corporates which require financing but are not supported by banks.

After CBIRC issued new WMP rules that no principal guarantee for investors investing WMPs, no multi-layer investments to improve investment transparency, and non-standard assets cannot exceed 35% of WMP’s net capital, the outstanding NSA amount was cut down by ~10-20% y-o-y in 2018. Therefore, as most of NSAs can be recognised as a proxy loan to private companies, we run stress test on NSAs for 19 banks to assess POEs’ risks.

We assume NSA growth to decline by 10% per annum in FY19/20F and 2%/5%/10% of NSAs deteriorating to NPL in FY20F under base/worse/bear-case scenarios respectively. Although it might not be necessary for factor in asset quality deterioration, we think our assumption is reasonable if the economy is under downward pressure, as NSA assets might go bust given POEs’ risks are relatively higher.

Among 19 banks, BZZ, CZB, CEB and BON’s FY20F NPL ratio will increase by 318bps, 182bps, 156bps, 152bps, respectively, under the bear-case scenario, as they have higher exposure to NSAs (our calculation is NSA amount divided by the sum of loan and NSAs) at 33%/19%/16%/16% respectively, vs peers of 9%.

In terms of FY20F core-equity one (CET1) ratio, BZZ, CZB, CEB and BON will be hit by 170bps, 150bps, 109bps, 84bps, respectively, if 10% of NSAs deteriorate to NPLs.

BZZ, CZB, BON and CEB face the biggest impact on NPL ratio from NSA risks

BZZ, CZB, CEB and BON’s capital levels are

more vulnerable on NSA risks



35

Scenario 3(2): Stress test on small- and micro-enterprise (SME) loan risks

On average, SME non-performing loan ratio is likely to be 2-3ppts higher than other loans, at around the 4-5% range. However, it would depend on the individual bank’s risk-management capabilities, where rural banks tend to have weaker risk management and lower bargaining power to select quality borrowers as compared to big banks.

We assume SME loan to grow by 15% y-o-y in FY19F, higher than industry loan growth, but this is likely to fall to 10% y-o-y growth in FY20F if SME loans start to show signs of asset quality deterioration. Under our base/worse/bear-case scenarios, we assume SME NPL ratio to go up by 1.5%/3%/4.5% on top of FY19F figures. Our assumption is justified as SME NPL ratio would likely reach 6-8% under bear-case scenario which is fairly in line

NSA exposure under broad-based loan definition

BZZ, CZB, CEB and BON face the biggest impact on CET1 ratio from NSA risks

Source: Company, DBS HK; calculation is based on “NSA/(NSA+loan)”



with manufacturing and wholesale & retail’s NPL level (many POEs are in these sectors) under an asset quality downcycle.

Among 19 banks, BZZ, SPDB and PSBC, CDB’s FY20F NPL ratio will increase by 258bps, 233bps, 223bps, 180bps, respectively, under the bear-case scenario, as they have higher exposure to SME loans at 54%, 49%, 51%, 39%, respectively, vs peers of 27%.

In terms of FY20F core-equity one (CET1) ratio, PSBC, SPDB, and CDB will be hit by 221bps/183bps/180bps respectively, if SME non-performing loan ratio increases by 4.5% compared to 2019 level. BZZ’s CET 1 ratio is less impacted, only by 116bps, likely because its loan exposure is only 35% of total assets vs peers’ 54%.

BZZ, SPDB and PSBC face the biggest impact on NPL ratio from SME loan risks

SME loans exposure comparison


Source: Company, DBS HK; calculation is based on “NSA/(NSA+loan)”

PSBC, SPDB and CDB’s capital levels are more

vulnerable to SME loan risks


37

PSBC, SPDB and CDB face the biggest impact on CET1 ratio from SME loan risks



Fig 47: Stress test on POE risks – SME loan and non-standard assets



Scenario 3- SME loan and non-standard assets (NSA) risks

NSA 564,008 353,706 217,194 343,300 564,008 365,945 307,178 580,566 36,166

NSA/(total loan+NSA) 3.78% 2.51% 3.68% 2.05% 16.30% 7.98% 6.10% 13.13% 7.29%

SME loan 4,965,377 2,028,529 1,072,455 2,241,125 582,304 731,180 651,143 499,753 153,540

SME loan/total loan 34.6% 14.7% 18.9% 13.6% 20.1% 17.3% 13.8% 13.0% 33.4%

NSA risks sensitivity test - assume NSA growth decline 10% y-o-y in FY20

Base case: 2% of NSA deteriorating to NPL



CAR impact (bps) (4.55) (2.91) (4.31) (2.64) (20.43) (9.20) (7.57) (14.33) (5.39)

Worse case: 5% of NSA deteriorating to NPL



CAR impact (bps) (11.39) (7.28) (10.79) (6.60) (51.29) (23.05) (18.96) (35.93) (13.49)

Bear case: 10% of NSA deteriorating to NPL



CAR impact (bps) (22.83) (14.57) (21.61) (13.21) (103.33) (46.24) (38.04) (72.22) (27.04)

SME loan sensitivity test - assume SME loan growth +10% y-o-y in FY20

Base case: SME NPL ratio increase 1.5%



CAR impact (bps) (46.40) (19.69) (22.28) (20.40) (23.15) (21.19) (19.52) (13.77) (31.09)

Worse case: SME NPL ratio increase 3%



CAR impact (bps) (88.19) (37.33) (42.42) (38.24) (43.89) (39.50) (37.49) (26.03) (56.91)

Bear case: SME NPL ratio increase 4.5%



CAR impact (bps) (130.39) (55.04) (62.65) (56.16) (64.74) (57.88) (55.54) (38.31) (82.88)


Expect Rmb2tr capital needed to be raised for the industryThe 19 banks that we covered in this report represent close to 76% of total assets among China banks, which we think would be a good proxy for the industry. When an economic downturn occurs, GDP growth slows down, corporates’ financing demand declines due to the step-back in capacity and fixed asset investment, and their profitability may decline to cause solvency issues, leading to banks’ asset quality deterioration. The situation would spill over to the residential segment as unemployment rate may rise causing the income level of retail borrowers to decline, resulting in difficulties of repayment. Thus, when recession hits, there would be a domino effect for both corporate and retail borrowers, who will face difficulties to repay, rather than a single event.


Fig 47: Stress test on POE risks – SME loan and non-standard assets cont.



Scenario 3- SME loan and non-standard assets (NSA) risks

NSA 97,610 105,192 91,372 822,041 246,941 89,145 211,580 197,848 551,914

NSA/(total loan+NSA) 15.95% 9.90% 33.03% 5.51% 19.04% 5.51% 7.96% 3.10% 11.52%

SME loan 216,948 162,540 99,693 5,425,417 298,233 327,054 208,214 3,169,354 2,095,725

SME loan/total loan 42.2% 17.0% 53.8% 38.5% 28.4% 21.4% 8.5% 51.3% 49.4%

NSA risks sensitivity test - assume NSA growth decline 10% y-o-y in FY20

Base case: 2% of NSA deteriorating to NPL



CAR impact (bps) (16.25) (9.66) (30.64) (6.72) (27.31) (6.78) (8.94) (5.17) (15.62)

Worse case: 5% of NSA deteriorating to NPL



CAR impact (bps) (40.74) (24.18) (77.12) (16.82) (68.68) (16.97) (22.39) (12.93) (39.17)

Bear case: 10% of NSA deteriorating to NPL



CAR impact (bps) (81.89) (48.51) (156.03) (33.73) (138.75) (34.01) (44.94) (25.89) (78.77)

SME loan sensitivity test - assume SME loan growth +10% y-o-y in FY20

Base case: SME NPL ratio increase 1.5%



CAR impact (bps) (33.83) (12.49) (40.37) (51.09) (35.14) (27.61) (11.85) (76.68) (63.96)

Worse case: SME NPL ratio increase 3%



CAR impact (bps) (65.63) (24.09) (74.47) (97.15) (68.48) (52.36) (21.32) (143.38) (121.07)

Bear case: SME NPL ratio increase 4.5%



CAR impact (bps) (97.67) (35.73) (108.84) (143.69) (102.08) (77.25) (30.82) (211.11) (178.92)

A domino effect when the bear market comes


39

How much capital needs to be raised?

~Rmb1.5tr capital raising for 19 banks

we cover in the report, implying Rmb2tr for

the industry

We calculate the all-in situation for the three scenarios above, including macro risks, residential leveraging risks, and POE risks, to gauge whether banks’ asset quality and capital level could pass our stress test under the bear-case situation.

As CBRC requires banks to adhere to BASEL III requirements by the end of 2018, CET1/CAR should reach 7.5%/10.5% for non-SIBs, and 8.5%/11.5% for SIBs. SIBs in China include the Big Four banks, BOCOM and CMB. Besides that, we add additional capital buffer for G-SIBs that BOC needs to add 1.5% capital buffer and CCB and ABC add 1% capital buffer based on Financial Stability Board (FSB) Nov 2018 revised version.

Only CCB, CMB, CQRCB and BSH passed the stress test under the bear case, helped by lower exposure in risky segments and sufficient capital level to cover credit risks. BOCOM will face 1% equity dilution while BOC and ABC will have 10% equity dilution, whereas other mid-to-small banks will see 14-35% equity dilution.

In aggregate, the 19 banks would need to raise at least Rmb1.5tr capital if FY20 economic downturn happens - Rmb1.2tr in core-tier one, and Rmb300m in tier-one or tier-two. This also implies that the industry might need to raise ~Rmb2tr capital to cover a likely surge in bad loans, causing about 9% dilution based on total system’s equity, in our view.

If all scenarios happen, BZZ, SPDB, CZB, BON and CEB’s NPL ratio would shoot up by 4.7ppts -7.7ppts…

…while SPDB, CZB, PSBC, and CDB’s CET1 ratio would drop significantly by 390bps-480bps…




Regulatory requirement under Basel III

Capital needs to be raised under bear case

Equity dilution once capital replenishment is done under bear case





41


Under all scenarios, who would need to raise capital?



If all situations happen concurrently…

Base case:



CAR impact (bps) (70.29) (49.77) (57.38) (49.62) (77.65) (59.26) (62.94) (55.11) (47.35)

Worse case:


CET 1 ratio impact (bps)

(159.93) (123.14) (140.97) (119.19) (193.45) (144.49) (156.19) (137.98) (105.19)

CAR impact (bps) (154.23) (117.97) (136.00) (115.72) (185.88) (138.77) (151.04) (134.53) (102.19)

Bear case:



(366.95) (280.59) (280.42) (298.85) (361.79) (280.69) (321.39) (272.23) (201.09)

CAR impact (bps) (355.82) (270.42) (271.35) (291.45) (347.98) (270.17) (311.67) (265.70) (195.83)

After the shock…

Base case:

FY20F NPL ratio after stress test

1.66% 2.00% 2.20% 1.89% 2.65% 2.46% 2.04% 2.64% 2.45%

FY20F CET1 ratio after stress test

11.19% 10.96% 10.59% 13.65% 8.41% 7.81% 12.68% 8.82% 10.61%

FY20F CAR after stress test

14.53% 14.93% 14.08% 16.63% 12.13% 11.83% 15.78% 11.23% 12.96%

Worse case:


2.68% 2.83% 3.22% 2.56% 4.12% 3.50% 3.00% 3.83% 3.63%


10.32% 10.24% 9.77% 12.97% 7.29% 6.98% 11.77% 8.01% 10.04%


13.69% 14.25% 13.29% 15.97% 11.05% 11.03% 14.90% 10.44% 12.41%

Bear case:


5.07% 4.66% 4.99% 4.38% 6.34% 5.27% 4.76% 5.83% 5.56%


8.25% 8.67% 8.38% 11.17% 5.60% 5.62% 10.11% 6.67% 9.08%


11.67% 12.72% 11.94% 14.21% 9.43% 9.72% 13.29% 9.13% 11.47%



Under all scenarios, who would need to raise capital? cont.



Regulatory requirement on capital level

CET 1 ratio 9.5% 10.0% 8.5% 9.5% 7.5% 7.5% 8.5% 7.5% 7.5%

CAR 12.5% 13.0% 11.5% 12.5% 10.5% 10.5% 11.5% 10.5% 10.5%

Base case- Need capital replenish?

CET 1 ratio 1.69% 0.96% 2.09% 4.15% 0.91% 0.31% 4.18% 1.32% 3.11%

CAR 2.03% 1.93% 2.58% 4.13% 1.63% 1.33% 4.28% 0.73% 2.46%

Min capital raising (Rmb m)

CET 1 - - - - - - - - -

CAR - - - - - - - - -

Total capital raising - - - - - - - - -

Worse case- Need capital replenish?

CET 1 ratio 0.82% 0.24% 1.27% 3.47% -0.21% -0.52% 3.27% 0.51% 2.54%

CAR 1.19% 1.25% 1.79% 3.47% 0.55% 0.53% 3.40% -0.06% 1.91%


CET 1 - - - - 7,918.7 27,418.1 - - -

CAR - - - - - - - 3,270.3 -

Total capital raising - - - - 7,918.7 27,418.1 - 3,270.3 -

Bear case- Need capital replenish?

CET 1 ratio -1.25% -1.33% -0.12% 1.67% -1.90% -1.88% 1.61% -0.83% 1.58%

CAR -0.83% -0.28% 0.44% 1.71% -1.07% -0.78% 1.79% -1.37% 0.97%


CET 1 191,318.7 195,325.4 8,508.0 - 70,117.1 99,389.0 - 45,204.8 -

CAR - - 29,177.9 -

Total capital raising 191,318.7 195,325.4 8,508.0 - 70,117.1 99,389.0 - 74,382.7 -

Equity 1,903,055 1,998,305 836,560 2,292,505 371,996 491,260 667,295 524,315 88,252

Equity dilution 10.1% 9.8% 1.0% 0.0% 18.8% 20.2% 0.0% 14.2% 0.0%


43


Under all scenarios, who would need to raise capital?



If all situations happen concurrently…

Base case:



CAR impact (bps) (63.27) (37.89) (82.59) (80.00) (91.06) (74.92) (49.88) (89.30) (114.32)

Worse case:



(149.96) (94.25) (200.39) (180.71) (226.37) (201.08) (135.44) (188.95) (258.12)

CAR impact (bps) (146.62) (90.28) (185.87) (177.61) (212.79) (195.62) (131.87) (180.13) (252.64)

Bear case:



(252.06) (176.63) (367.83) (389.88) (418.75) (373.08) (260.12) (402.32) (475.60)

CAR impact (bps) (246.43) (169.36) (341.66) (377.57) (394.11) (363.38) (253.50) (386.29) (466.01)

After the shock…

Base case:


2.01% 1.83% 4.77% 1.71% 2.59% 2.43% 2.39% 1.91% 3.21%


7.97% 10.10% 7.34% 8.70% 7.37% 7.76% 8.76% 8.18% 10.14%


9.95% 14.58% 13.25% 10.53% 12.83% 10.37% 11.14% 12.44% 12.09%

Worse case:


3.64% 2.71% 7.14% 2.76% 4.09% 3.97% 3.45% 2.89% 4.85%


7.12% 9.56% 6.23% 7.71% 6.07% 6.52% 7.92% 7.23% 8.73%


9.12% 14.05% 12.22% 9.55% 11.62% 9.16% 10.32% 11.53% 10.71%

Bear case:


5.57% 3.79% 10.58% 5.05% 6.33% 6.11% 5.06% 5.02% 7.43%


6.09% 8.73% 4.55% 5.62% 4.15% 4.80% 6.67% 5.10% 6.56%


8.12% 13.26% 10.66% 7.55% 9.80% 7.49% 9.11% 9.47% 8.57%



Under all scenarios, who would need to raise capital? cont.



Regulatory requirement on capital level

CET 1 ratio 7.5% 7.5% 7.5% 7.5% 7.5% 7.5% 7.5% 7.5% 7.5%

CAR 10.5% 10.5% 10.5% 10.5% 10.5% 10.5% 10.5% 10.5% 10.5%

Base case- Need capital replenish?

CET 1 ratio 0.47% 2.60% -0.16% 1.20% -0.13% 0.26% 1.26% 0.68% 2.64%

CAR -0.55% 4.08% 2.75% 0.03% 2.33% -0.13% 0.64% 1.94% 1.59%


CET 1 - - 600.22 - 1,526.61 - - - -

CAR 5,070.62 - - - - 2,289.19 - - -

Total capital raising 5,070.62 - 600.22 - 1,526.61 2,289.19 - - -

Worse case- Need capital replenish?

CET 1 ratio -0.38% 2.06% -1.27% 0.21% -1.43% -0.98% 0.42% -0.27% 1.23%

CAR -1.38% 3.55% 1.72% -0.95% 1.12% -1.34% -0.18% 1.03% 0.21%


CET 1 3,558.2 - 4,854.7 - 16,711.3 17,395.6 - 15,675.3 -

CAR 9,222.9 - - 150,890.9 - 6,344.4 5,213.0 - -

Total capital raising 12,781.1 - 4,854.7 150,890.9 16,711.3 23,740.0 5,213.0 15,675.3 -

Bear case- Need capital replenish?

CET 1 ratio -1.41% 1.23% -2.95% -1.88% -3.35% -2.70% -0.83% -2.40% -0.94%

CAR -2.38% 2.76% 0.16% -2.95% -0.70% -3.01% -1.39% -1.03% -1.93%


CET 1 13,004.1 - 11,248.4 300,135.3 39,244.7 47,963.9 24,259.6 139,565.8 46,044.7

CAR 9,010.5 - - 169,271.2 5,592.1 16,508.3 47,991.7

Total capital raising 22,014.6 - 11,248.4 469,406.5 39,244.7 53,556.1 40,767.9 139,565.8 94,036.3

Equity 84,817 193,564 39,999 1,533,866 115,422 153,687 291,489 584,168 590,536

Equity dilution 26.0% 0.0% 28.1% 30.6% 34.0% 34.8% 14.0% 23.9% 15.9%


45

What would happen if China factors in countercyclical capital buffer? The concept was first proposed by the Basel Committee on Banking Supervision (BCBS) via its publication “Basel III: a global regulatory framework for more resilient banks and banking systems” in December 2010.

The countercyclical capital buffer (CCyB) aims to ensure that the banking sector’s capital requirements would take account of the macro-financial environment in which banks operate. Its primary objective is to use a buffer of capital to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth that have been associated with the system-wide risk. In economic downturns, the regime should help to reduce the risk that the supply of credit will be constrained by regulatory capital requirements that could undermine the performance of the real economy and result in additional credit losses in the banking system.

CCyB is implemented as an extension of the capital conservation buffer and consists entirely of CET1 capital. If the minimum buffer requirements are breached, capital distribution constraints will be imposed on the banks. This capital can then be “released” when the credit cycle turns to absorb losses and enables the banking system to continue lending in the subsequent downturn.

Based on BIS, the countercyclical buffer is 0-2.5% as determined by the gap between non-financial credit to GDP ratio and its long-term trend. The “trend” can be seen as a sustainable average of ratio of credit to GDP based on the historical experience of the given economy. The lower and upper thresholds of 2% and 10% of credit-to-GDP gap, which provides a reasonable specification based on historical banking crises, determine the timing and the speed of the adjustment on countercyclical capital buffer.

• When credit-to-GDP gap is 2% or less above its long-term trend, the countercyclical capital buffer would be 0%.

• When credit-to-GDP gap is 10% or more than its long-term trend, the countercyclical capital buffer would be 2.5%.

• When credit-to-GDP gap is 2-10%, the countercyclical capital buffer will vary at 0-2.5%.

Authorities in each jurisdiction can propose any other variables that are applicable to the country for purposes of assessing the sustainability of credit growth and the level of system-wide risk, as well as in making buffer decisions.

Buffer depends on credit-to-GDP gap

What is countercyclical capital buffer?


The US’s credit-to-GDP ratio has been below its trend since 2010 when BIS initially proposed the buffer capital concept to protect banks from experiencing excess credit growth associated with system-wide risks. US private and non-financial credit has been stabilised at 148-150% of GDP which indicates that the pace of credit growth is aligned with GPD growth and there is hence lower risk of seeing excess credit growth. During the recent Federal Reserve Board vote in March 2019, it reaffirmed that the countercyclical capital buffer remains at 0%.

US countercyclical buffer is at 0%

US credit-to-GDP ratio is now lower than its historical trend

US credit-to-GDP gap has been lower than 0% since 2010, thus no requirement on countercyclical buffer

Source: BIS calculation, DBS HK; Trend is based on a one-sided HP filter using a smoothing parameter (lambda) equal to 400,000

Source: BIS, DBS HK


47

The Hong Kong Monetary Authority (HKMA) announced in January 2018 that it would be increasing the countercyclical capital buffer (CCyB) to 2.5% in 2019, from 1.875% in 2018 as the key indicators, such as the credit-to-GDP gap and the property price/rent gap, remained at elevated levels. HK’s credit growth has been highly correlated with its property market. HK property prices almost doubled in the past ten years, and property-related loans accounted for 69% of total domestic loans. Thus, a weak sentiment in property market and price pullback would put pressure on banks.

Based on HKMA calculations, the credit-to-GDP gap exceeded 19% in 2017 (vs BIS estimates of 30.5%), suggesting that system-wide risks have not subsided. Thus, HKMA has increased CCyB from 0.625% in 2016 to 2.5% in 2019 to provide an additional measure of resilience for the banking system.

HK reached 2.5% of CCyB in 2019

HK credit-to-GDP ratio is above its trend

HKMA continued to raise countercyclical buffer, reaching 2.5% in Jan 2019


Source: BIS, HKMA, DBS HK


In June 2012, CBRC released the rules on capital management which included counter-cyclical reserve of 0-2.5% for banks. However, it has yet to be implemented to date. Supposedly, China should execute a 2.5% countercyclical buffer as its credit-to-GDP gap was above 10% from 2012-2017, after which it gradually came down to 2% after deleveraging campaign.

As China lowered its benchmark rate and cut required reserve ratio (RRR) during 2012-2015 to stimulate its economy. Coupled with ample liquidity in the market, China banks’ loan growth was strong at 14-15% per annum, and simultaneously, shadow banking grew strongly through WMPs which enjoyed a three-year CAGR of 42% and reached Rmb29tr, equalling 27% of bank loans, in 2016. Thus, China’s private non-financial credit-to-GDP ratio expanded from 149% in 2011 to 204% in 2016, far higher than its credit-to-GDP trend. However, CBRC did not implement CCyB likely due to the low capital level among China banks when they experienced the credit downcycle in 2014-2016.

In 2017, China’s government started deleveraging campaigns to lower the risks from shadow banking which was the key financing channel for the private sector. Consequently, the credit-to-GDP gap was reduced to nearly 2% by the end of 2018, implying the absence of pressure to execute CCyB in the short term.

Given China regulators’ shift in focus from deleveraging to stable liquidity in FY19, banks are encouraged to distribute more loans to support the private sector’s credit demand, and the recovering bond and equity markets help corporates to have more funding sources, which would likely drive China’s non-financial credit-to-GDP gap to reverse and head upwards. In that case, China regulators might need to consider factoring in CCyB to stem excessive aggregate credit growth if GDP growth does not catch up.

We estimate that China banks need to raise CET1 capital by up to Rmb3.9tr if the regulator requests to factor in countercyclical buffer to 2.5% based on FY20 RWAs (assuming RWA increases by 8% per annum in FY19/20F). Per 0.5% CCyB increase, CET1 capital would need to be increased by Rmb780bn. China banks can increase CET1 capital through internal means, e.g. increasing retained earnings, cutting cash dividends, or distributing stock dividends; or externally, e.g from issuing new shares, rights issue or convertible bonds to meet the requirement.

China has not factored in CCyB

Up to Rmb3.9tr to raise for CET1 capital if China factors in 2.5%

of CCyB


49

China credit-to-GDP gap shrinks after the deleveraging campaign

China credit-to-GDP gap is close to 2%, implying no pressure on CCyB in the short term


Source: BIS, DBS HK


Current countercyclical capital buffer (CCyB) by countries

Source: BIS, DBS HK

Country Current CCyB Effective date Future CCyB Expected effective date

Argentina 0 01-Apr-16 n.a. n.a.

Australia 0 01-Jan-16 n.a. n.a.

Belgium 0 01-Jan-16 n.a. n.a.

Brazil 0 09-Mar-17 n.a. n.a.

Canada n.a. n.a. n.a. n.a.

China n.a. n.a. n.a. n.a.

France 0 30-Dec-15 0.0025 01-Jul-19

Germany 0 01-Jan-16 n.a. n.a.

Hong Kong 1.875% 01-Jan-18 0.025 01-Jan-19

India 0 05-Feb-15 n.a. n.a.

Indonesia 0 01-Jan-16 n.a. n.a.

Italy 0 01-Jan-16 n.a. n.a.

Japan 0 31-Mar-16 n.a. n.a.

Korea 0 31-Mar-16 n.a. n.a.

Luxembourg 0 01-Jan-16 n.a. n.a.

Mexico 0 07-Apr-16 n.a. n.a.

Netherlands 0 01-Jan-16 n.a. n.a.

Russia 0 01-Jan-16 n.a. n.a.

Saudi Arabia 0 01-Jan-16 n.a. n.a.

Singapore 0 01-Jan-17 n.a. n.a.

South Korea 0 30-Nov-17 n.a. n.a.

Spain 0 01-Jan-16 n.a. n.a.

Sweden 2% 19-Mar-17 0.025 19-Sep-19

Switzerland 0 16-Feb-16 n.a. n.a.

Turkey 0 01-Jan-16 n.a. n.a.

UK 1% 28-Nov-18 n.a. n.a.

US 0 01-Jan-16 n.a. n.a.


51

How far away from meeting TLAC regulation?

Total loss-absorbing capacity (TLAC) is an international standard, which was finalised by the Financial Stability Board (FSB) in November 2015, and intended to ensure that global systemically important banks (G-SIBs) have enough equity and bail-in debt to pass losses to investors and minimise the risk of a government bailout.

There are two phases for G-SIBs to adopt TLAC requirement. From January 2019, the minimum TLAC requirement for G-SIBs will be at least 16% of risk-weighted assets (RWAs) and 6% of leverage ratio, increasing to at least 18% of RWA and 6.75% of leverage ratio in January 2022. Emerging market G-SIBs, such as China, must meet 16% of RWA no later than January 2025 and 18% before January 2028.

The minimum TLAC requirement does not include any applicable regulatory capital buffers (under BASEL III), which must be met in addition to the TLAC RWA minimum. Thus, G-SIBs must meet the TLAC requirement plus capital conservation buffer, a countercyclical capital buffer and additional capital buffer for GSIBs based on different buckets.

Take JPMorgan (JPM US) and Goldman (GS US) as an example, both banks did the necessary to meet the TLAC requirement in January 2019. Given US countercyclical buffer is 0%, the TLAC plus BASEL III regime lead to JPMorgan’s minimum capital requirement is 23% of RWA (18% TLAC+2.5% conservation buffer+2.5% additional buffer) while Goldman’s minimum capital requirement is 22% of RWA (18% TLAC+2.5% conservation buffer+1.5% additional buffer), which raised the capital requirement higher.

The eligible external long-term debt (LTD), such as subordinated and senior debt, can be calculated as external TLAC by up to 2.5%/3.5% of RWA in 2025/2028. Certain eligible criteria include debt must be unsecured, have a minimum residual maturity of more than one-year, arise through a contract, and be subordinated to liabilities. Eligible debt with remaining maturities of 1-2 years still qualify, but at a 50% haircut.

Failure to maintain TLAC at the regulatory minimum plus applicable buffers may result in limitations to the amount of capital that banks can distribute, such as dividends.

China to adopt TLAC by 2025, but likely to be three years’ ahead of schedule, if its outstanding non-financial corporate and financial bonds (excluding policy bank) exceed 55% of GDP before 2020. The ratio was 41% in China as at end-2018, based on our calculation. However, if corporate and financial bonds outstanding amount grow by 30% y-o-y in 2019/20, and nominal GDP grows by 10% per annum, the ratio would exceed 55% in FY20F.

As refinancing pressure for corporate bonds has gone up rapidly in 2019-2021 and banks have increased capital raising through tier-two capital bonds and convertible bonds etc., we think China would most likely adhere to TLAC requirement by 2022.

Country Current CCyB Effective date Future CCyB Expected effective date

Argentina 0 01-Apr-16 n.a. n.a.

Australia 0 01-Jan-16 n.a. n.a.

Belgium 0 01-Jan-16 n.a. n.a.

Brazil 0 09-Mar-17 n.a. n.a.

Canada n.a. n.a. n.a. n.a.

China n.a. n.a. n.a. n.a.

France 0 30-Dec-15 0.0025 01-Jul-19

Germany 0 01-Jan-16 n.a. n.a.

Hong Kong 1.875% 01-Jan-18 0.025 01-Jan-19

India 0 05-Feb-15 n.a. n.a.

Indonesia 0 01-Jan-16 n.a. n.a.

Italy 0 01-Jan-16 n.a. n.a.

Japan 0 31-Mar-16 n.a. n.a.

Korea 0 31-Mar-16 n.a. n.a.

Luxembourg 0 01-Jan-16 n.a. n.a.

Mexico 0 07-Apr-16 n.a. n.a.

Netherlands 0 01-Jan-16 n.a. n.a.

Russia 0 01-Jan-16 n.a. n.a.

Saudi Arabia 0 01-Jan-16 n.a. n.a.

Singapore 0 01-Jan-17 n.a. n.a.

South Korea 0 30-Nov-17 n.a. n.a.

Spain 0 01-Jan-16 n.a. n.a.

Sweden 2% 19-Mar-17 0.025 19-Sep-19

Switzerland 0 16-Feb-16 n.a. n.a.

Turkey 0 01-Jan-16 n.a. n.a.

UK 1% 28-Nov-18 n.a. n.a.

US 0 01-Jan-16 n.a. n.a.

TLAC to prevent “too big to fail” risk

High capital requirement under

TLAC


China will execute TLAC by 2025, or likely three years ahead of the schedule

TLAC and capital buffer requirements for China Big Four banks

Source: Bloomberg Finance L.P., DBS HK

Source: FSB, DBS HK


53

GSIBs in China include Big Four banks that CCB’s CAR was at 17.2% in FY18, while other three banks were at 15-15.4%. Based on TLAC, BASEL conservative buffer and GSIB additional capital buffers, the minimum capital requirement ratio for Big Four banks would be 19.5-20% in January 2025, and 21.5-22% in January 2028, or three years ahead of schedule, assuming countercyclical buffer would be 0%. We use FY18 CAR as a base, and assume earnings growth of 5%, dividend pay out of 30%, and RWA growth of 6%, to estimate the amount of capital shortfall to meet the minimum capital requirement.

Under scenario one, if China needs to match 19.5-20%/21.5-22% by January 2022/2025, we estimate Big Four banks to raise Rmb2.4tr by the end of 2021, and another Rmb1.7tr during 2022-2024 to meet the requirement.

Under scenario two, if executed three years later by January 2025/2028, Big Four banks would need to raise Rmb2.4tr by the end of 2024 and another Rmb2.1tr during 2025-2027.

The total capital needed to be replenished would be around Rmb4.1-4.5tr. The estimates are subject to annual growth rates in net income and RWA and we also take LTD into consideration, which can be recognised as external TLAC and can take up 2.5-3.5% of RWA, or Rmb2.9-3.4tr.

BOC needs to raise Rmb1.2-1.4tr capital and LTD as it requires another 0.5ppt of additional buffer under GSIBs buffer at 1.5%, vs 1% for CCB and ABC. ABC needs to raise Rmb1.1-1.2tr, while CCB only needs to raise Rmb550m as it has the highest capital level among China banks.

Big Four banks need to raise Rmb4.1tr capital and LTD to meet TLAC if schedule is ahead three years

Source: Company, DBS HK estimates

Raising Rmb4.1-4.5tr capital and LTD for Big

Four banks to meet TLAC requirement

Capital raising from most to least:

BOC>ABC>CCB


Big Four banks need to raise Rmb2.4/Rmb2.1tr capital and LTD to meet TLAC before 2025/2028

China GSIBs’ vs peers’ capital levels


Source: Bloomberg Finance L.P., DBS HK; data based in 2018


55

Source: DBS HK

Big Four banks’ capital raising estimates under TLAC requirement

CCB ABC BOCa) FY18 net profit (Rmb m) 254,655 202,783 180,086 b) FY18 Capital (Rmb m) 2,348,646 2,073,343 1,922,350 c) FY18 RWA (Rmb m) 13,659,497 13,712,894 12,841,526 =b/c) FY18 CAR 17.2% 15.1% 15.0%d) TLAC by 2022/2025 16.0% 16.0% 16.0%e) TLAC by 2025/2028 18.0% 18.0% 18.0%f) Additional capital buffers 1.0% 1.0% 1.5%g) BASEL conservative buffer 2.5% 2.5% 2.5%h=d+f+g) Total minimum capital requirement in Jan 2025 19.5% 19.5% 20.0%i=e+f+g) Total minimum capital requirement in Jan 2028 21.5% 21.5% 22.0%

Earnings growth assumption 5%RWA growth assumption 6%

Net profit (Rmb m)2019 267,388 212,922 189,090 2020 280,757 223,568 198,545 2021 294,795 234,747 208,472 2022 309,535 246,484 218,896 2023 325,011 258,808 229,840 2024 341,262 271,749 241,332 2025 358,325 285,336 253,399 2026 376,241 299,603 266,069 2027 395,053 314,583 279,372 j) Retained earnings till 2021 (ex dividend) 590,058 469,866 417,275 k) Retained earnings till 2024 (ex dividend) 1,273,124 1,013,795 900,323 l) Retained earnings till 2027 (ex dividend) 2,063,858 1,643,460 1,459,511 m=b+j) Capital base in 2021 2,938,704 2,543,209 2,339,625 n=b+k) Capital base in 2024 3,621,770 3,087,138 2,822,673 o=b+l) Capital base in 2027 4,412,504 3,716,803 3,381,861 p) RWA in 2021 16,268,679 16,332,276 15,294,463 q) RWA in 2024 19,376,258 19,452,002 18,215,950 r) RWA in 2027 23,077,433 23,167,646 21,695,488 s=m/p) CAR in 2021 18.1% 15.6% 15.3%t=n/q) CAR in 2024 18.7% 15.9% 15.5%u=o/r) CAR in 2027 19.1% 16.0% 15.6%Scenario 1- reach TLAC 16% in Jan 2022/18% in Jan 2025h) Total minimum capital requirement in Jan 2022 19.5% 19.5% 20.0%i) Total minimum capital requirement in Jan 2025 21.5% 21.5% 22.0%v=(h-s)*p)Capital replenishment before 2022 (Rmb bn) 234 642 719w=(i-t)*q-v) Capital replenishment before 2025 (Rmb bn) 310 453 466

Scenario 2- reach TLAC 16% in Jan 2025/18% in Jan 2028h) Total minimum capital requirement in Jan 2025 19.5% 19.5% 20.0%i) Total minimum capital requirement in Jan 2028 21.5% 21.5% 22.0%x=(h-t)*q) Capital replenishment before 2025 (Rmb bn) 157 706 821y=(i-u)*r) Capital replenishment before 2028 (Rmb bn) 393 558 571

Source: Company, DBS HK estimates


Total loss-absorbing capacity term sheet

Objective The objective of TLAC is to ensure that G-SIBs have the loss abosorbing and recapitalisation capacity without taxpayers' funds or financial stability being put at a risk

Minimum requirement

Minimum TLAC must be at least 16% of RWAs as from Jan 1, 2019 and at least 18% from Jan 1, 2022. This requirement does not include any applicable regulatory capital buffers (Basel III), which must be met in addition to the TLAC RWA minimum. Minimum TLAC must be at least 6% of the Basel III leverage ratio denominator as from Jan 1, 2019, and at least 6.75% in Jan 1, 2022.

Instruments eligible for external TLAC

There is no requirement that senior creditors are exposed to loss when such a contribution is made, and there is no particular limit specified in law in respect of the amount which may be contributed. Credible ex-ante commitments to recapitalise a G-SIB must be pre-funded by industry contributions and may account for an amount equivalent to 2.5% RWA toward the resolution entity's minimum TLAC when the TLAC RWA minimum is 16% and for an amount equivalent to 3.5% RWA when the RWA minimum is 18%. "

Eligibility criteria

TLAC-eligible instruments must: 1. be paid in 2. be unsecured 3. not be subject to set off or netting rights that would undermine the loss absorbing capacity in resolution 4. have a minimum remaining contractual maturity of at least one year or be pepetual 5. not be redeemable by the holder 6. not be funded directly or indirectly by the resolution entity or a related party of the resolution entity, except approved by the authorities

Liabilities excluded from TLAC

TLAC-eligible instuments must not include: 1. insured deposits 2. sight deposits and short-term deposits (maturity less than a year) 3. liabilities arising from derivatives 4. debt instruments with derivative-linked features, such as structured deposits 5. liabilities arising other than through a contract, such as tax liabilities 6. liabilities which are preferred to senior unsecured creditors under the relevant insolvency law 7. any liabilities are excluded from bail-in, or cannot written down, or converted to equity

Conformance period

Firms that are currently headquartered in an EME and designated by the FSB as G-SIBs by the end of 2015 and continue to be designated thereafter will comply with the minimum TLAC requirement 1) by Jan 1, 2025 for the 16% RWA/6% of the Basel III leverage ratio, and 2) by Jan 1, 2028 for the 18% RWA/6.75% of the Basel III leverage ratio. The conformance date would have three-year ahead the schedule if, before 2020, the aggregate amount of the financial and non-financial corporate debt securities or bonds outstanding exceeds 55% of the country's GDP (as measured using BIS statistics, excluding issuance by policy bank). Any G-SIBs that fails and enters resolution, it allows 24 months to comply with the TLAC standard.

Source: FSB, DBS HK estimates


57

Expanding capital-replenishing tools to fill the gapBased on our estimation, China banks would need to raise at least Rmb2tr if credit downcycle happens in FY20. An additional Rmb3.9tr of core tier 1 capital would need to be raised if China executes countercyclical buffer by 2.5% which has not been factored in based on BCBS proposal of 0-2.5% CCyB to stem the excess aggregate credit growth that have been associated with the system-wide risk.

In terms of TLAC, Big Four banks are expected to raise Rmb4.1-4.5tr capital and/or long-term debt to meet the minimum capital requirement of 19.5-20% in January 2025, and 21.5-22% in January 2028, or three years ahead of schedule. To face such high capital-raising pressure, what capital replenishment tools can China banks use?

In China, the tools for capital raising are quite obsolete as IPO and rights issue (mostly private placements) are for core-tier 1 capital, preference shares are for tier 1 capital, and tier 2 capital bonds are for tier 2 capital. Convertible bonds that are convertible into equity could replenish CET1. Looking back at the historical fund raising, post 2014, most capital replenishment has been from tier 2 capital bonds, likely due to the long IPO waiting list and lengthy approval processes for preference shares and convertible bonds.

In 1Q19, tier 2 capital bonds’ outstanding amount had reached Rmb1.8tr, jumping from Rmb2bn in 2013, or around 56% of total capital raising (except preference shares) since 2013. Tier 2 capital bonds have a write-down clause in that the issuer does not need the bondholders’ consent to fully reduce the bond principle, thereby providing a cushion for banks when they face a crisis.

Tier 2 capital bonds issued have reached Rmb1.86tr


A big chunk of capital demand

Tier 2 capital bonds have become the main

replenishing tool


In January 2019, CBIRC approved the first perpetual bond whereby BOC issued Rmb40bn of perpetual bonds with 4.5% interest rate to become an additional tool to replenish tier 1 capital. Following BOC’s successful issuance of the bonds, another nine listed banks also announced a total of Rmb470bn perpetual bond proposals, including ABC (Rmb120bn), CMSB, CITIC, CEB, BOC, BOCOM and Huaxia Bank (Rmb40bn each), as well as SPDB (Rmb30bn).

We expect more banks to announce plans for issuing perpetual bonds given the government’s support that allows bondholders to swap perpetual bonds with central bank bills to increase liquidity. This would increase the incentive to subscribe and enjoy high-yield dividends and low-cost funding.

China banks started issuing preference shares in 2014 which peaked in 2015 when they faced a credit downcycle. Preference shares have a clause that allows them to be converted into core equity when the bank’s CET 1 ratio drops below 5.125%, or any tier 2 capital instrument trigger event happens, to provide additional CET1 buffer. The peak of preference shares issuance was in 2014-15 and banks have the right to redeem all or part of the shares after five years from the date of issuance.

As current interest rates are lower now than five years ago, we expect banks such as BOC (Rmb32bn with 6% coupon), to redeem or reissue the shares to save on dividend payments if it does not contain the clause that requires coupon rates to be reset after five years of issuance.

Tier 2 capital bonds were the main capital replenishing tool


Perpetual bonds, a new tool to replenish tier 1

capital

Expect another round of preference share

issuance in FY19


59

The peak of preference share issuance was in 2014-2015

Source: Company, DBS HK; 19 banks covering in the report


China banks have issued preference shares mostly with resetting coupon rate clause

Date Banks Stock Code

Capital riased Coupon rate

Reset coupon

Sep-14 ABC 1288 HK RMB 40bn 6% Yes, reset every five years

Oct-14 BOC 3988 HK RMB 40bn 6.75% Yes, reset based on five-year US treasury rate plus fixed spread every five years

Nov-14 BOC 3989 HK RMB 32bn 6% No

Nov-14 SPDB 600000 SS RMB 1.5bn 6% Yes, reset based on China government bond plus fixed rate every five years

Mar-15 ABC 1288 HK RMB 40bn 5.50% Yes, adjusted every five years

Mar-15 BOC 3989 HK RMB 28bn 5.50% No

Mar-15 SPDB 600000 SS RMB 1.5bn 5.50% Yes, reset based on China government bond plus fixed rate every five years

Jun-15 CCB 939 HK RMB 60bn 4.75% Yes, reset based on China government bond plus 0.89% fixed rate every five years

Jun-15 CEB 6818 HK RMB 20bn 5.30% Yes, reset based on China government bond plus fixed rate every five years

Jul-15 BOCOM 3328 HK RMB15bn 5% Yes, reset based on five-year US treasury rate plus 3.344% fixed spread every five years

Dec-15 BON 002142 SS RMB 4.85bn 4.60% No

Mar-16 PAB 000001 SS RMB 20bn 4.37% No

Aug-16 CEB 6818 HK RMB 10bn 3.90% Yes, reset based on China government bond plus fixed rate every five years

Sep-16 BOCOM 3328 HK Rmb45bn 3.90% Yes, reset based on China government bond plus 1.37% rate every five years

Nov-16 CITIC 998 HK RMB 35bn 3.80% No

Mar-17 CZB 2016 HK RMB 14.989bn 5.45% Yes, adjusted every five years

Sep-17 PSBC 1658 HK RMB 47.846bn 4.50% Yes, adjusted based on US treasury rate plus 2.634% spread every five years

Oct-17 CMB 3968 HK USD 1bn 4.40% Yes, adjusted every five years

Oct-17 BZZ 6196 HK RMB 7.86bn 5.50% Yes, adjusted every five years

Dec-17 BSH 601229 SS RMB 20bn 5.20% Yes, adjusted every five years

Dec-17 CMB 3968 HK Rmb 27.5bn 4.81% Yes, adjusted every five years

Nov-18 BON 002142 SS RMB 10bn 5.30% No


The replenishment of core tier 1 capital is mainly derived from common stocks and the equity premium generated when ordinary shares are issued. Due to the initial state-owned structure, the China government set up Central Huijin in 2003 to inject capital into big banks and reform share structure, and open up banks to work with strategic partners, as well as to list in A-share and/or H-share capital markets to increase core tier 1 capital. After listing, banks can also use rights issue or stock dividend (less prevalent among China banks) to improve CET1 capital.

For unlisted city commercial banks and rural commercial banks, they mainly rely on the introduction of strategic investors, capital increase from existing shareholders through private placement and retained earnings. With “strong supervision” to control risks, trustworthy NPL recognition, and loan shifting from off-balance sheet to on-balance sheet, bank’s capital consumption would accelerate and demand for core tier 1 capital replenishment would increase.

As of April 2019, 13 banks, mainly city and rural commercial banks, have announced A-share listing plans and aim to issue new shares with 12-40% dilution. However, it usually takes a while, at least one year, to go through the IPO process in China due to the long waiting list. Apart from IPOs, banks can seek funding through private placements, stock dividends, or cutting cash dividends to increase retained earnings.

Eager to replenish core tier 1 capital

A-share IPO waiting list for China banks SHEXIPO waiting list

Bank Type HQ location

H share listed

IPO plan IPO funding Capital

10 Bank of Ruifeng

Rural commercial bank

Zhejiang No issue A shares no less than 151m and no more than 453m; total shares no more than 1.811 after IPO

replenish core tier 1 capital

2017 CET1 ratio 11.44%, T1 ratio 11.45%, CAR 15.35%

31 Zheshang Bank (CZB)

Joint-stock commercial bank

Zhejiang 2016 HK issue A shares no more than 4.49bn shares, or 20% of total shares



32 Xiamen Bank

City commercial bank

Xiamen No issue A shares no more than 25% of total shares, and total shares no more than 3.167bn


1H18 CET 1 ratio 10.59%, T1 ratio 10.6%, CAR 14.74%

42 CQRC Rural commercial bank

Chongqing 3618 HK issue no more than 1.375bn A shares, or 11.95% share dilution.



43 Yaodu Bank Rural commercial bank

Bozhou, Anhui

No issue A shares no more than 25% of total shares after IPO


9M18 CET1 ratio 11.06%, T1 ratio 11.06%, CAR 14.06%

50 Halan Bank Rural commercial bank

Jiangsu No issue no more than 328m A shares, 32.8% share dilution


2018 CET 1 ratio 12.97%, T1 ratio 12.97%, CAR 14.13%

71 Bank of Chongqing


Chongqing 1963 HK issue no more than 781m A shares, 19.98% of total shares after IPO


2018 CET 1 ratio 8.47%, T1 ratio 9.94%, CAR 13.21%


61

The advantage of issuing convertible bonds (CB) is the potential to convert them into equity and replenish core tier 1 capital with a low coupon rate of less than 1%. However, as convertible bonds do not have a write-down clause as tier 2 capital bonds, they cannot be recognised as tier 2 capital bonds. Before CBs are converted, they are classified as debt.

In China, convertible bonds are not popular due to the following reasons:

1. Uncertainty in the timing of conversion into equity as the rights belong to the CB holders

2. They cannot be converted into equity if the stock trades below the conversion price

3. It takes time to obtain regulators’ approval and capital cannot be replenished immediately

Thus, China banks are normally reluctant to issue convertible bonds.

Take Bank of China as an example. It issued Rmb40bn convertible bonds in 2010, but the conversion price was set at too high a level that the stock was trading lower than the conversion price. This resulted in the bonds having almost 0% conversion rate during 2010-2012. In 2013, BOC proposed a downward adjustment to the conversion price and subsequently managed to convert nearly all of the CB into equity during 2014-2015 when the A-shares enjoyed a rally.

Convertible bonds = wild card


SZEX

IPO waiting list

Bank Type HQ location H share listed

IPO plan IPO funding Capital

6 Bank of Lanzhou


Gansu No issue no more than 1.29bn A shares



8 Bank of Suzhou


Suzhou No issue no more than 1bn A shares



13 Dafeng Rural Commercial Bank


Jiangsu No issue no more than 25% or no less than 10% of total shares after IPO



26 Ma'anshan Rural Commercial Bank


Anhui No issue no more than 500m shares, or 40% of total shares after IPO



46 Bank of Dongguan


Dongguan No issue no more than 726m A shares



50 Guangzhou Rural Commercial Bank


Guangzhou 1551 HK issue no more than 1.597bn shares




Recently, as their A-shares rebounded from the bottom, PingAn Bank, Bank of Jiangsu and CITIC all issued convertible bonds worth Rmb26bn/Rmb20bn/Rmb40bn respectively, and are expected to replenish 90/150/70bps in CET1 once converted into equity. Thus, convertible bonds can serve as a wild card for China banks to replenish their core tier 1 capital, bypassing IPOs, rights issues or private placements.

China banks’ increasing CB issuance since 2017



Historical convertible bonds issued by China banks

Issuance Date

Bank Issuance amount (Rmb bn)

Coupon rate (%)

Maturity Date

3/4/2019 China CITIC Bank 40.0 0.3 3/4/2025

3/14/2019 Bank of Jiangsu 20.0 0.2 3/14/2025

1/21/2019 Ping An Bank 26.0 0.2 1/21/2025

11/12/2018 Jiangsu Zhangjiagang Rural Commercial Bank 2.5 0.4 11/12/2024

8/2/2018 Jiangsu Suzhou Rural Commercial Bank 2.5 0.5 8/2/2024

1/30/2018 Wuxi Rural Commercial Bank 3.0 0.5 1/30/2024

1/26/2018 Jiangsu Jiangyin Rural Commercial Bank 2.0 0.5 1/26/2024

1/19/2018 Jiangsu Changshu Rural Commercial Bank 3.0 0.5 1/19/2024

12/5/2017 Bank of Ningbo 0.4 12/5/2023

3/17/2017 China Everbright Bank 30.0 1.0 3/17/2023

3/15/2013 China Minsheng Banking 20.0 0.6 3/15/2019

8/31/2010 Industrial & Commercial Bank of China 25.0 1.4 8/31/2016

6/2/2010 Bank of China 40.0 1.7 3/15/2015

11/10/2004 China Merchants Bank 6.5 2.5 11/10/2009



63

After CBRC issued “Measurement for foreign institutional investors to invest Chinese financial institutions” to lift foreign FIs’ investment ratio from up to 15% to 20% share for individual banks, and from up to 20% to 25% share for total banks in December 2003, international banks sequentially announced their strategic plans to acquire China banks’ shares during 2003-2006 which was around the same period when China banks were under pressure to replenishing capital due to the write-off of legacy NPLs.

Based on the regulation, China banks’ shares need to be held for at least a 3-year investment period. Given the restrictions on shareholdings, foreign investors invested around 5-20% of China banks’ shares. For strategic purposes, foreign investors would invest up to 20% of shares to secure board seats and look for new initiatives, such as credit cards, asset management, investment banking, etc. with China banks to expand their financial services. An example would be HSBC and BOCOM partnering on the credit card business.

Besides that, most foreign banks prefer to invest in city commercial banks where they can easily become the second largest shareholder after local governments and could be more engaged in the operations, i.e. Bank of Nova Scotia/Bank of Xi’An, ING/Bank of Beijing, BNP/Bank of Nanjing, etc.

In terms of only investing 5-10% of shares, it would be more of an investment purpose as foreign investors are not involved in China banks’ business decisions. Thus, after the three-year holding period, most of them would choose to exit gradually, e.g. BOA sold CCB shares, UBS/Royal Bank of Scotland sold BOC.


Historical convertible bonds issued by China banks

BOC’s convertible bonds were successfully converted within five years

Issuance Date

Bank Issuance amount (Rmb bn)

Coupon rate (%)

Maturity Date

3/4/2019 China CITIC Bank 40.0 0.3 3/4/2025

3/14/2019 Bank of Jiangsu 20.0 0.2 3/14/2025

1/21/2019 Ping An Bank 26.0 0.2 1/21/2025

11/12/2018 Jiangsu Zhangjiagang Rural Commercial Bank 2.5 0.4 11/12/2024

8/2/2018 Jiangsu Suzhou Rural Commercial Bank 2.5 0.5 8/2/2024

1/30/2018 Wuxi Rural Commercial Bank 3.0 0.5 1/30/2024

1/26/2018 Jiangsu Jiangyin Rural Commercial Bank 2.0 0.5 1/26/2024

1/19/2018 Jiangsu Changshu Rural Commercial Bank 3.0 0.5 1/19/2024

12/5/2017 Bank of Ningbo 0.4 12/5/2023

3/17/2017 China Everbright Bank 30.0 1.0 3/17/2023


8/31/2010 Industrial & Commercial Bank of China 25.0 1.4 8/31/2016

6/2/2010 Bank of China 40.0 1.7 3/15/2015

11/10/2004 China Merchants Bank 6.5 2.5 11/10/2009


BOC- CB (2010-2015)

Convertible bonds Rmb40bn

Conversion price Rmb4.02/share, adjusted based on cash dividends and specified increase in share capital

Fixed interest rate 0.5% for the first year and annual increase of 0.3% through the remaining term

Term CB holders can convert to A-share beginning from six months after the date of issuance

2010 2011 2012 2013 2014 2015

Converted shares (m) 0.06 0.11 0.01 217.2 9,366.6 5,656.6

Amount of conversion (Rmb m)

0.23 0.41 0.03 612.6 24,540.5 14,820.4

Remaining uncoverted CB 99.9994% 99.9984% 99.9983% 98.4669% 37.12% 5.61%

Converted price 3.75 3.72 3.51 2.82 2.62 2.62

Adjusted conversion price 3.74 3.59 3.44 2.82 2.62 2.62

Strategic partnerships with foreign investors

could be another funding source


In April and August 2018, PBOC and CBIRC relaxed the investment regulations for foreign banks that

1. Loosened investment restriction from only 20%/25% of shares on individual/total China banks to non-restriction

2. Simplified administrative steps to set up RMB, derivative, agency and underwriting businesses

3. Loosened working capital rules for branch set-up

The move is to speed up the entry of foreign banks into the China market by either M&A or their own expansion. As the investment cap of 20% shares has been removed, foreign banks can consider acquiring more shares to secure more controlling rights. This would make it easier for foreign banks to expand their businesses in China through M&A rather than to expand on their own as each branch would need the approval of local regulators. Thus, even though foreign banks had entered China since 1980, their market share is tiny at 1.6% of total asset size.

As most rural and city commercial banks are facing capital pressure, we think foreign banks could look for good quality banks that are temporarily facing capital pressure due to heavy capital consumption to support strong credit demand. In return, China banks can replenish capital by selling a portion of their shares to foreigner investors which could bring retail banking and technology expertise, to the mutual benefit of both parties.

Loosening restrictions on foreign ownership

likely to increase foreign banks’ interests to invest which would

help China banks replenish capital

Previous round of foreign banks’ investment in China banks

Investment schedule

Foreign bank Investee bank Acquire shareholding

Exit schedule

Mar-04 Hang Seng Bank Industrial Bank 15.98% Feb/May 2015 sold 5%/4.99% shares, and only hold 0.55% shares currently

Aug-04 HSBC BOCOM 19.90% n.a.

Nov-04 Bank of Nova Scotia Bank of Xi'An 19.99% n.a.

Dec-04 Standard Chartered Bank China Bohai Bank 19.99% n.a.

Mar-05 ING Bank of Beijing 19.90% c. 13% share

Apr-05 Commonwealth Bank of Australia Bank of Hangzhou 19.90% c. 18% share

Aug-05 BOA CCB 9.00% Gradually sold all shares in 2008-2013

Oct-05 BNP Paribas Bank of Nanjing 19.00% c. 18.19% share

Oct-05 Deutche Bank Huaxia Bank 13.98% Sold all shares in 2016

Nov-05 UBS, Royal Bank of Scotland BOC 1.33%/8.25% Sold all shares in 2009

Dec-05 ANZ Bank of Tianjin 19.90% c. 11.95% share

Nov-06 Citi Bank Guanfa Bank 20.00% Feb 2016 sold all shares to China Life

Source: Bloomberg Source: Company, DBS HK L.P., DBS HK


65

Stimulating growth in China’s ABS market

Asset-backed securitisation (ABS) is a structured product that takes an illiquid asset or pool of assets and transforms them into tradable securities. This product has reached the maturity stage in the US/EU, but was introduced in China only in 2005 and is relatively new and still evolving. After the temporary suspension in 2009-2011 due to the GFC, ABS re-emerged in China after the PBOC, CBRC and MOF jointly issued a notice to expand credit asset securitisation (CAS) in 2012 which could be viewed as an alternative funding channel to help curb shadow banking.

China’s ABS market, which has been growing strongly to reach Rmb3tr, or 47% y-o-y in 2018, can be segregated into three segments, CAS, companies’ ABS, and asset-backed notes (ABN), representing 49%, 45% and 6% respectively of FY18 ABS outstanding amount. Under CAS scheme, which is specifically for FIs, residential mortgage-backed securities

An early stage of ABS market

Source: PBOC, CBIRC, DBS HK

Further relaxation of regulations of foreign banks

Subject Before April/Aug 2018 After April/Aug 2018

Foreign-funded shareholding restrictions

Can invest domestic banks only up to 20% of total shares for one bank, and 25% for total

No restrictions on shareholding. Encourage trusts, financial leasing, auto finance, currency brokerage, and consumer finance etc to introduce overseas investors

Branch/subsidiary limitation

Branch and subsidiary cannot co-exist No limitation to set up branch and subsidiary

RMB and derivative businesses

Each branch need to get approval on RMB and derivative business

Can directly assess their branches to operate RMB, derivative businesses as long as headquarter gets the approval to operate those businesses, and report to the local banking agency of the State Council and provide the related materials before branch runs the business.

Agency distribution, agency redemption or underwriting government bond

Obtain the approval from the State Council Foreign banks' branch, wholly owned or joint venture may conduct agency distribution, agency redemption or underwriting government bond in accordance with the law. It shall report to the regulatory within 5 working days after the business is carried out without obtaining the approval from the State Council.

Working capital Working capital requirement calculated by each branch

The working capital allocated by a foreign bank to branches in China can be calculated in consolidated. If the combined working capital meets the minimum requirement, the foreign bank may authorize the branch to allocate working capital to the new added branch.


account for 63%, followed by auto loans, collateralised loan obligations (CLO), credit card loans, consumption loans, and NPL ABS of 13%, 11%, 8%, 3% and 2% respectively.

RMBS grew sharply at a 204% CAGR in 2014-18 and surpassed CLO to become the largest portion of CAS mainly as 1) demands for mortgage continued to be strong, together with the limited loan quota for banks and high capital pressure, banks were more than willing to issue RMBS, and 2) the default rate for RMBS’s underlying assets (less than 1%) is lower than that of other ABS, resulting in strong investor demand.

On the other side, CLO’s underlying asset is a pool of corporate loans which recently included small- and micro-enterprise loans, whose risks are relatively higher. Thus, the size of CLO shrunk from Rmb314bn in 2015 to Rmb98bn in 2018 likely impacted by the corporate loan’s credit downcycle which happened in 2015 and that lowered investors’ confidence to invest in the product.

Nonetheless, the ABS penetration rate is still low in China as RMBS only represented 2.3% of mortgage loans, vs 36.7% in the US, and credit card ABS accounted for only 1.2% of credit card loans, vs the US’s 15.4%, suggesting that China’s ABS market has the potential to grow to at least 10-15x the current size once the market matures with comprehensive regulations and transparent data, added secondary market, and diversified risks through product design to increase investors’ interests.

We expect ABS to gradually become an important tool for banks to not only transfer some of liquidity risks to investors but also free up loan quota to support credit demand, thereby easing the pressure from loan shifting back from off-balance sheet and capital consumption.

Strong supply-demand in RMBS compared to

CLO

A 10-15x ABS market potential in China

Credit assets securitisation breakdown in 2018



67

Credit assets securitisation breakdown in 2018

Credit card/mortgage ABS grew strongly in 2016-2018

ABS low penetration rate in China


Source: WIND, DBS HK; data calculated based on ABS/loan


Speeding up capital raising

Since 2019, China banks have completed or announced plans to replenish capital by more than Rmb1tr, including Rmb306.5bn tier 2 capital bonds from CCB, ABC, CMSB, BOCOM, and Bank of Guiyang; Rmb235bn of preference shares from CITIC, CEB, BOC, CMSB and Bank of Beijing; and Rmb470bn of perpetual bonds from BOC, ABC, BOCOM, CEB, CMSB CITIC, SPDB and Huaxia Bank.

US credit card/mortgage ABS ratio much higher than China’s

Big banks are main issuers in ABS market

Source: Federal Reserve, Sifma, DBS HK; data calculated based on ABS/loan and based in 2018


Coming capital shortage


69

With an IPO schedule that includes 13 banks in the A-share waiting list, the banks’ capital raising plans are stepping up as they are facing high pressure on:

1. Loans shifting back from off-balance sheet to on-balance sheet

2. Building up wealth management subsidiary

3. Expanding loan distribution on POEs whose risks are higher to stimulate economy

According to Bloomberg, in 1Q19, China banks raised a total of Rmb326bn in capital, 90%/10% from bond/equity issuance, where bond issuance hit a historical record high. With ongoing capital shortage, we expect more capital-raising plans to be announced in FY19-20.

Overall, the tools for China banks to raise capital are mainly through IPOs, rights issues, private placements, preference shares, perpetual bonds (newly added), and tier 2 capital bonds. Optional tools include convertible bonds (which might take 3-5 years to be fully converted into equity based on share performance), ABS to spare loan capacity, and selling shares to strategic foreign investors.

Besides that, given TLAC requirement is approaching in either 2022 or 2025, the regulator is likely to provide a new capital-raising tool called TLAC capital bonds, to help Big Four banks meet the requirement.

When an economic downturn occurs, China’s GDP growth would slow down, and corporates’ profitability would decline while residential income level would drop to cause solvency issues. In addition, banks’ asset quality would also inevitably deteriorate and each bank would be exposed to different risks based on its loan mix and borrowers’ profiles.

US credit card/mortgage ABS ratio much higher than China’s

China banks speed up on capital raising

Big banks are main issuers in ABS market

Source: Bloomberg Finance L.P, DBS HK

Bond raising to hit historical high in 1Q19


China banks’ capital-raising proposal and completed YTD

Date Status Banks Stock Code

Instruments Capital riased Remark

2019 Proposal BOC 3988 HK Convertible bonds RMB100bn

Mar-19 Completed CITIC 998 HK Convertible bonds RMB40bn Nominal rate of convertible bonds issued this time: first year 0.30%; second year 0.80%; third year 1.50%; fourth year 2.30%; fifth year 3.20%; sixth year 4.00%. , 6-year bond

2019 Proposal CMSB 1988 HK Convertible bonds RMB50bn

2019 Proposal SPDB 600000 SS Convertible bonds RMB50bn

Feb-19 Completed PAB 000001 SS Convertible bonds RMB26bn Nominal rate of convertible bonds issued this time: first year 0.20%; second year 0.80%; third year 1.50%; fourth year 2.30%; fifth year 3.20%; sixth year 4.00%, 6-year bond

2019 Proposal CQRCB 3618 HK Equity maximum of 20% of each of the issued Domestic Shares or H Shares of the Bank

2019 Proposal CZB 2016 HK Equity Issuance of A Share and H share)

2019 Proposal ABC 1288 HK Perpetual bonds RMB120bn

Jan-19 Completed BOC 3988 HK Perpetual bonds RMB40bn Coupon rate 4.5%(Adjustable each 5 years). Investors have right to redeem in each dsitribution payment date from the fifth years

2019 Proposal BOCOM 3328 HK Perpetual bonds RMB40bn

2019 Proposal CEB 6818 HK Perpetual bonds RMB40bn

2019 Proposal CITIC 998 HK Perpetual bonds RMB40bn

2019 Proposal CMSB 1988 HK Perpetual bonds RMB40bn

2019 Proposal Huaxia Bank 600015 SH Perpetual bonds RMB40bn

2019 Proposal SPDB 600000 SH Perpetual bonds RMB30bn

2019 Proposal Beijing Bank 601169 SH Preference shares RMB40bn

2019 Proposal BOC 3988 HK Preference shares RMB100bn

2019 Proposal CEB 6818 HK Preference shares RMB35bn

2019 Proposal CITIC 998 HK Preference shares RMB40bn

2019 Proposal CMSB 1988 HK Preference shares RMB20bn

Mar-19 Completed ABC 1288 HK Tier-2 capital bonds RMB10bn Coupon rate 4.53%, 15-year bond, after 10-year can have redeem right

Mar-19 Completed ABC 1288 HK Tier-2 capital bonds RMB50bn Coupon rate 4.28%, 10-year bond , after 5-year can have redeem right

2019 Proposal BOCOM 3328 HK Tier-2 capital bonds RMB80bn

Feb-19 Completed CCB 939 HK Tier-2 capital bonds USD1.85bn Coupon rate 4.25%(Adjustable each 5 years) , 10-year bond. Investors have right to redeem starting from the fifth years

Mar-19 Completed CMSB 1988 HK Tier-2 capital bonds RMB40bn Coupon rate 4.48% , 10-year bond. Investors have right to redeem starting from the fifth years

2019 Proposal Bank of Guiyang

Tier-2 capital bonds Rmb4.5bn 10-year bond



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Disclaimers and Important Notices

The information herein is published by DBS Bank Ltd (the “Company”). It is based on information obtained from sources believed to be reliable, but the Company does not make any representation or warranty, express or implied, as to its accuracy, completeness, timeliness or correctness for any particular purpose. Opinions expressed are subject to change without notice. Any recommendation contained herein does not have regard to the specific investment objectives, financial situation and the particular needs of any specific addressee.

The information herein is published for the information of addressees only and is not to be taken in substitution for the exercise of judgement by addressees, who should obtain separate legal or financial advice. The Company, or any of its related companies or any individuals connected with the group accepts no liability for any direct, special, indirect, consequential, incidental damages or any other loss or damages of any kind arising from any use of the information herein (including any error, omission or misstatement herein, negligent or otherwise) or further communication thereof, even if the Company or any other person has been advised of the possibility thereof.

The information herein is not to be construed as an offer or a solicitation of an offer to buy or sell any securities, futures, options or other financial instruments or to provide any investment advice or services. The Company and its associates, their directors, officers and/or employees may have positions or other interests in, and may effect transactions in securities mentioned herein and may also perform or seek to perform broking, investment banking and other banking or financial services for these companies.

The information herein is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation.


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