The capital base of China 's banks is less solid than it looks. That doesn't mean the financial system is about to collapse, but it should give investors pause for thought.
Bad debts from two years of reckless lending are starting to come home to roost. Recent reports from Liaoning —a province in northeastern China —revealed that 85% of local government-backed borrowers missed debt-service payments in 2010.
The easy answer to those concerns is that China 's banks are strongly capitalized. Tier 1 capital ratios–a measure that compares risk-weighted assets to banks' own capital to assess their resilience to losses—are above 9% for all of the big four banks. That suggests they are well placed to weather the storm. But capital is a regulatory construct and different measurements produce different results.
In particular, capital ratios for China 's banks are flattered by large volumes of loans to big state-backed enterprises, which carry a low risk weighting. A different measure of capital adequacy, comparing total equity with total assets, suggests China 's banks are rather less secure.
Take Industrial and Commercial Bank of China , the largest bank in the China . Its Tier 1 capital ratio at the end of the first half was 9.82%, but the ratio of total equity to total assets was a less impressive 5.77%. That compares with a ratio of 9.8% at Bank of America. For China 's banking sector as a whole, Fitch says, the equity-to-asset ratio is the lowest in the emerging-market class.
The lesson of the U.S. financial crisis is that in a pinch, it is the ratio of equity to assets, not the capital-adequacy ratio, that is the focus of attention. In China , banks' already low equity-to-asset ratios are set to come under assault from two fronts. Banks are expanding the asset side of their balance sheets as they add loans, and the cost of covering defaults on local government debt will eat into their equity bases.
Banks have options to solve the problem, but none are particularly appealing. Raising equity would be challenging given volatile markets, and force owners in the government to cough up more cash to avoid seeing their stakes diluted. A more likely alternative is the use of profits to boost capital. The downside is that takes time and means less is available to pay as dividends to shareholders.
Of course, China 's government has deep pockets and will stand behind the big banks if any problems arise. But the threat of rising bad loans and the prospect of lower dividends should keep bank investors cautious, even if the stocks look cheap.