China faces decade-long clean-up of embattled rural banks

Expect more mergers and consolidations, and even some closures, S&P says.

It could take up to a decade to reform China’s rural financial sector– an endeavor that will involve not just reforming risk culture but also consolidations.

China has launched reforms for its 3,800 rural financial institutions (FIs), including a number of consolidations. Most notably, Liaoning Rural Commercial Bank will absorb 36 rural banks in the Liaoning province, as stated in a plan approved by authorities in 20 June. Overall, rural FIs make up 14% of the total assets in China’s banking system.

Strengthening rural institutions would improve overall confidence in China's banking system, S&P Global Ratings credit analyst Ryan Tsang said in a report. 

Tsang estimates that reforming the rural financial sector could take up to a decade.

“We reckon that it would take four to five years to substantially clean up the high-risk rural financial institutions,” Tsang said.

“it would take another few years to reorganize these lenders and institutionalize changes in corporate governance, management structure and risk culture,” he added.

Individually, most of the rural FIs are insignificant and unlikely to pose a systemic risk to the Chinese banking sector.

But frequent occurrences of stress cases– which are more common in rural FIs– could weaken the public's confidence in the Chinese financial system and may cause regional stress from time to time, Tsang warned.

“In our view, authorities will prioritize riskier institutions for capital injections and balance sheet cleanup,” he noted.

For the rest, authorities may opt to form new institutions to take over weak lenders or encourage the stronger ones to absorb weaker players.

Authorities could also choose to close select FIs, as in two bankruptcy cases in Liaoning province: that of Liaoyang Rural Commercial Bank, and Liaoning Taizihe Village and Township Bank.

“The cleanup process will likely involve write-offs and/or disposal of nonperforming assets on the bank balance sheets and capital injections from local governments, local state-owned enterprises, or other strategic investors. Holders of capital instruments of a failed bank are likely to bear losses, and institutional creditors could also see some haircuts,” Tsang said.