Banking is a fantastic business to be in. You take in money at a certain interest rate, lend it at a higher rate and pocket the difference. As long as you do not do anything silly, you are assured a steady sum year after year. But there is a flip side to it as well. Banks have perhaps the highest debt to equity ratios of all the industries. Infact, a debt to equity ratio in the region of 10:1 is considered pretty normal here.
Quite understandably then, the headroom for error is very little. Even if 2% of your total loans outstanding go bad, it can wipe away nearly 20% of your equity. Little wonder, investors in banking companies start sulking once they see NPAs climbing more than 1%-2%.
However, banks in a particular nation are run slightly differently. Not an eyebrow is raised even if as much as 20% of loans to a particular sector go bad. Infact, people rejoice that the default rate is 20% whereas it could easily have been higher by a factor of 2. Has this gotten you interested in knowing which nation is this? Well, it is the banking system of the world's fastest growing economy, China.
As per FT, Chinese banks have indeed come a long way since the days of full ownership and perpetual near-insolvency. But unfortunately, they have not come far enough. China's banks have revealed that they face default to the tune of 1.6 trillion Yuan worth of loans made indirectly to local governments. This figure forms a whopping 20% of the total money lent to them.
The seeds of this problem were sown a couple of years back in 2008. And it had to do with the Government's enormous stimulus policies unleashed in the wake of the financial crisis. In other countries, Government undertook stimulus measures through their own balance sheets. But not China. The dragon nation chose to do so using the country's banking system. It is believed that the Government just does not have the means to run such a big stimulus program through the central budget.
Most of the stimulus was injected through the country's domestic banks. In other words, the shareholders of these banks bore the brunt of the stimulus measures. Since there were no strict lending practices in place, quite a few of these loans have now turned bad.
Of course, the Chinese Government will not allow the banking system to collapse. It will stand behind all the loans gone bad. But the question that begs itself is how long will this continue? The economy is certainly going great guns currently and hence, can withstand shocks such as these. But if growth slows down, things can really spiral out of control.
Furthermore, as it seeks to attract private capital, it will have to show the world that it does after all care for the interest of the shareholders. It is high time it starts looking at default rates of 20% rather more seriously.