China debt swap could leave banks in capital hole

China’s mooted debt-for-equity swap could leave the country’s banks in a capital hole. New rules are being proposed that would allow lenders to exchange bad loans for shares. That could ease pressure on ailing companies. But it would also put pressure on bank capital ratios.

In developed economies, it’s not unusual for creditors of troubled companies to accept shares in exchange for loans. In China, however, banks are restricted from investing in non-financial companies, limiting their scope for restructuring ailing borrowers.

The regulations being prepared would remove that constraint, Reuters reported on March 10, potentially clearing the way for a wave of debt conversions. Some exchanges are already happening: Huarong Energy, a troubled shipbuilder, announced on March 8 it would give creditors a 60 percent stake in the company in return for forgiving debt worth $2.2 billion.

Yet while such swaps help overindebted Chinese companies, they are less positive for banks. True, the industry’s reported ratio of non-performing loans – which rose to 1.7 percent of total lending at the end of 2015 – will fall. But capital requirements will also rise as banks recognize more losses.

Under China’s interpretation of international Basel rules, corporate loans typically attract a risk weighting of 100 percent for capital purposes. But the risk weighting for equity investments is at least 400 percent, and can be as high as 1250 percent, according to a 2013 assessment of Chinese regulations by the Bank for International Settlements. In other words, any bank that swaps a corporate loan for equity of the equivalent value will need at least four times as much capital for that exposure.

This calculation also assumes that banks have already written down troubled loans to their correct value. In reality, that’s unlikely to be the case. So-called “special mention” loans, which are wobbly but not yet officially classed as bad, accounted for a further 3.8 percent of overall lending at the end of last year. The true level of non-performing debt is probably much higher.

The result is that any large-scale swap of debt-for-equity in the country will leave lenders short of capital. As the largest shareholder of Chinese banks, the government would have to step in. Though that might be one way to start solving China’s debt problem, other investors in the banks would feel the pain.