Analysis: CCP drives wave of small bank mergers, exacerbating future risks.

Last year, the Chinese Communist Party initiated an unprecedented wave of large-scale rural bank mergers in an attempt to mitigate the risks within the small banking sector. However, analysts have warned that this initiative could backfire and potentially lead to even more serious issues.

According to Reuters, many of China’s approximately 4,000 small banks rely heavily on support from debt-ridden local governments and primarily obtain funding through short-term money markets and interbank borrowing. The collapse of a few of these banks could jeopardize overall financial stability.

This consolidation comes at a time when many small banks are experiencing slowing loan growth and a surge in bad debts, issues closely tied to the Chinese real estate crisis and ongoing economic downturn.

Based on Reuters’ analysis of regulatory and company documents over the past 12 months, in 2024, at least 290 rural banks and cooperative societies in China were merged into larger regional banks.

This largely unreported scale of mergers highlights deep-seated problems in critical areas of China’s financial system. It represents the most extensive consolidation effort since the Chinese Communist Party transitioned rural commercial banks from socialist-style cooperative societies in the early 2000s.

As of the end of June 2023, China’s small banking sector boasted around 3,700 institutions with total assets of approximately 57 trillion yuan (around $7.8 trillion USD), equivalent to double the size of Australia’s banking sector and one-third of the U.S. banking sector.

However, analysts such as Jason Bedford, renowned for his in-depth research on the Chinese banking sector at Bridgewater and UBS Asia, have pointed out that many of these mergers simply consolidate bankrupt institutions into “larger troubled banks,” failing to address financial risks effectively.

Requests for comments to the Chinese banking regulatory authority, the China Banking and Insurance Regulatory Commission, by Reuters have gone unanswered.

Over the past decade, many small banks amassed loans to real estate developers and local government financing platforms, aiming to expand their businesses and boost profits. However, this high-risk model has left these banks vulnerable, especially amidst the economic downturn post-pandemic, real estate market turbulence, and deterioration of local government finances.

Official data shows that in the third quarter of 2023, rural commercial banks had a non-performing loan (NPL) ratio of 3.04%, nearly twice the industry average of 1.56%. Analysts believe the financial conditions of many small banks are worse than officially reported.

One of the largest merger cases in 2023 involved Liaoning Province establishing Liaoning Rural Commercial Bank with registered capital of 20.8 billion yuan in September, absorbing 36 local small rural banks by June 2024. Several of these institutions had soaring bad debt ratios, putting their financial health at risk.

Documents reviewed by Reuters revealed that the merged Liaoning Lighthouse Rural Commercial Bank had an NPL ratio as high as 21.54% by the end of 2021, significantly above the industry average of 1.73% at the time.

Liaoning Rural Commercial Bank has not publicly disclosed its balance sheet, and the bank did not respond to requests for comments.

In another recent merger, Lanzhou Bank in Gansu Province received regulatory approval in December 2023 to acquire two rural banks. While specific financial details of this acquisition were not disclosed by regulators, Lanzhou Bank’s annual report showed assets totaling 453 billion yuan by the end of 2023, with an NPL ratio of 1.73%.

Since 2022, the Chinese authorities have been pushing for reforms in the rural banking sector, aiming to restructure struggling institutions through mergers of small banks and quelling a series of financial scandals. However, these scandals have not only caused deposit losses for some customers but have also sparked rare public protests, severely shaking trust in the financial system.

Official disclosure documents accessed by Reuters revealed that an additional 10 small banks in Liaoning Province were set to merge into Liaoshen Bank. Established in June 2021, the bank originally absorbed 12 smaller regional banks.

Nevertheless, these mergers have not truly addressed the problems but have instead introduced new risks. For instance, Liaoshen Bank acquired a large amount of non-performing assets from the two smaller banks, resulting in NPL ratios of 4.67% in 2022 and 4.53% in 2023, far exceeding the 1.75% average level of urban commercial banks.

“These two original banks had inadequate quality of assets, high cost of liabilities, unbalanced business structures, and weak operational management,” Liaoshen Bank stated in its 2022 annual report, acknowledging that the bank “has not yet reached the standard of a normal bank.”

Liaoshen Bank did not respond to Reuters’ requests for comments.

Additionally, a report released by the People’s Bank of China in December…