Special audit reveals big problems in China’s small rural banks

China’s National Audit Office late last week submitted a special audit report on rural banks in Henan province. Of 42 banks inspected, a dozen were found to hold non-performing loans (NPLs) in excess of 20 % of their loan stocks. Several had NPL ratios above 40 %.

At the end of 2018, Henan banks reported NPL ratios of around 2.5 % on average, which was still above the nationally reported average of 1.9 %. However, Chinese banks are famously reluctant to report or write down bad loans, so it is evident that similar problems of mischaracterisation of loan status found in Henan are fairly widespread. Banks allow non-performing receivables to accumulate after funding unprofitable projects under political pressure. Chinese banking rules require banks to hold reserves to cover such bad loans, but if NPLs were reported honestly, their reserve buffers would have to be increased dramatically to meet official requirements.

The situation for China’s banking sector overall was relatively stable last year. Lending grew steadily and banks managed to slightly widen the interest rate spread between loans and deposits from which banks derive most of their earnings. Banks also managed to boost solvency ratios. Profitability measures (ROE, ROA) remain quite low, though. Overall, the situation within the banking sector remains one in which large banks perform much better than small banks by just about any performance measure.

Most banks consider the current operating environment challenging. In addition to external uncertainties, growth of China’s domestic economy is slowing, thereby increasing problems with loan repayments and competitive pressures from the large financial technology (FinTech) firms.