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SHANGHAI (Reuters) - As China's banks prepare for a rigorous quarterly inspection of their books by the central bank, the ructions in money markets and an explosion in inter-bank borrowing show how addicted they are to risky methods of funding and investments.
For the first time since it was launched last year, the Macro Prudential Assessment, or MPA, will include off-balance sheet wealth management products to give authorities a better sense of potential risks to the financial system.
Wealth management products (WMPs), often linked to shadow banking, have seen explosive growth in the last few years even as authorities try to contain risks from a rapid build-up in debt.
Banks which fail the assessment are believed to face stiff penalties, though the results are not publicly released. The People's Bank of China (PBOC) will conduct the MPA at the end of this month.
Ahead of the review, Chinese banks have rushed to make their books look healthier, hoarding cash and curbing lending.
That has tightened cash conditions more than usual heading into the end of the month and the quarter. Short-term rates CN7DRP=CFXS have trebled to as much as 9 percent in a few weeks, pushing up bond yields and rattling the stock market.
Some lenders have rushed to buy more liquid assets and sold-off riskier loans.
"Ensuring liquidity is the priority now ahead of the MPA,” said Qiu Gaoqing, an economist with Bank of Communications.
Qiu says the Chinese model wherein banks finance longer-term risky investments with short-term money is unsustainable, but the immediate priority for banks has been to stay liquid to ensure they receive a passing grade.
Analysts believe banks are assessed on seven parameters including asset quality, capital adequacy, their proportion of liquid assets and the stability of their funding.
China's banks extended a record 12.65 trillion yuan ($1.84 trillion) of loans in 2016, despite worries about dangers of the explosive jump in credit.
Banks' wealth management product portfolio was 26.28 trillion yuan ($4.04 trillion) at the end of June 2016. It had risen 42 percent in a year, and analysts estimate it rose a further 4 trillion yuan in the second half of 2016.
"We're still adopting a wait-and-see approach, because we don't really know exactly what the regulators want," said a person in the wealth management products department at one of China's five listed state-owned banks.
Hu Wenhao, an analyst at Northwest Securities, says banks need to shrink their wealth management business, pare bond exposure and reduce funding to non-bank financial institutions.
China CITIC Bank (601998.SS)vice-president and chief financial officer Fang Heying told Reuters at an earnings conference that the economy was just at the starting point for financial de-leveraging.
He said the bank needs to take a capital-light, asset-light and cost-light path, and the first steps would be to adjust the structure of its balance sheet.
- For graphic on 'China's wealth management products' click: tinyurl.com/krb9xok
Because they are unwilling to unwind their WMP portfolios in a hurry, banks have raced to borrow from each other over the past few months via negotiable certificates of deposit (NCDs). These aren't as yet included in the MPA estimates for interbank liabilities, on which there are limits.
Inter-bank CD issuance surged 140 percent last year to 13.3 trillion yuan.
One trillion yuan worth were issued in January and nearly twice that in February. As of mid-March, total outstanding NCDs stood at 3.84 trillion yuan, compared with just 1.4 trillion at the end of June 2015.
Some analysts believe the PBOC will include NCDs in future quarterly assessments.
"Banks and regulators have always been playing a game of cat and mouse," said Zheng Lianghai, analyst at Donghai Securities Co.
"No bank is willing to be the first to retreat voluntarily, even if that means suffering losses, as some banks have been borrowing money at all costs to sustain their liquidity".
The process has been slow, but there is anecdotal evidence that banks are pruning high-risk portfolios linked to shadow banking as regulators slowly clamp down on the sector.
"We’ve seen a 30 to 40 percent decrease in funds from banks since October last year,” said Du Yang, the managing director at Yaozhi Asset Management Co. LLP, a private fund that helps banks handle money they raise from wealth management products.
"For example, some banks which previously handed over 3 billion yuan, have now shrunk this amount to 1 billion,” said Du, adding that banks have also started taking such business in-house rather than using private funds.
Because most of the cash in wealth management products is channeled into bonds, analysts expect banks would gradually have to cut their exposure to bonds.
“The MPA would have a relatively big impact on the bond market," said Northwest's Hu.
So far though, the impact has been contained within money markets, mainly seen in a surge in demand and rates on overnight loans and NCDs.
"Leverage is like drugs. Once you’re addicted to it, it’s difficult to get rid of it,” Zheng said.
($1 = 6.8926 Chinese yuan renminbi)
Additional reporting by Shu Zhang in BEIJING; Writing by Vidya Ranganathan; Editing by Kim Coghill