China and India are both getting excited about creating bad banks, but neither has an answer to the fundamental question that bad banks create. The key question is always, “who is going to take the loss”? The concept of a bad bank is easy to understand; you remove the bad loans from a bank thus allowing it to concentrate on new lending. The hard part of getting a recovery from the bad loans is hived off to someone else.
The arguments usually begin when the price for the asset transfer has to be determined. The “good bank” wants the highest price possible so it doesn’t need to raise additional capital. The “bad bank” wants the lowest price possible so it has the best chance of making a decent return on the bad loans it has bought.
In well developed economies the market determines the price. The good bank offers the loan for sale and takes the price from the highest bidder. However, when there is a substantial downturn, or if the market for bad loans isn’t well developed then government intervention often occurs. In Ireland, Italy and Spain, the government has intervened and bought bad loans at a price well above what the market would pay. Taxpayers ultimately get stuck with the bill for the poor decisions of banks, regulators and politicians.
In China, there’s a group of asset management companies that exist to buy bad loans from banks. Whilst there is always an overlay of government intervention in China, the asset management companies mostly act as profit seeking entities paying a fair price for bad loans. This means that banks must be ready to sell the loans at a substantial discount (say 20-40% of the face value) which reduces the balance sheet value of their assets and equity. China’s banks aren’t ready for this and are looking for ways to avoid or defer taking this hit.
This year the value of debt for equity swaps has soared. Of the $150 billion completed so far, 55% has been from coal and steel companies. In theory, this process should force the banks to write down the value of the bad loans to their fair value as part of a swap, but there are a number of ways to game this. The regulator only requires banks to hold capital against the newly created equity at around one-third the level that would normally be required for the first two years. The naïve way of looking at this is that it allows banks additional time to raise capital to offset the losses. The more experienced hands call it kicking the can down the road.
Another plan the Chinese government is exploring is allowing banks to establish their own asset management companies. These would buy the bad loans at an inflated price, with external investors “partnering” with the banks to fund the purchase. This plan assumes that banks will find muppets to “co-invest” with them. Recent history in China shows that just about anything can be sold if there is a promise of a good yield.
It is believed that wealth management products are already being used for this purpose, with the banks packaging up bad loans and selling them at face value to retail investors. From a bank’s perspective, this is a fantastic outcome as the loan has moved off balance sheet at no loss. The downside is it becomes a powder keg for social unrest, when the investors realise they’ve been duped. Some investors are applying leverage to wealth management products to further juice returns, pulling banks back into the bad loans they think they have gotten rid of.
India wants to create more bad banks, but again no one has a plan to raise the capital required to cover the losses. Indian banks have around 10% of their total loans marked as non-performing. This might be the tip of the iceberg with India ratings seeing half of the country’s debt at risk of default. Charlene Chu estimated that one-third of all of China’s bank loans are at risk of default.
In the UK, subprime lender Provident Financial saw its stock fall 70% in a month after a flurry of negative announcements. It announced a substantial loss, halted its dividend, divulged that it was subject to a regulatory investigation and saw its CEO leave. The root cause of much of its problems was that it sought to cut costs by reducing the staff it employed in collections. As a result, its repayment rates dropped from 90% to 57%. It’s a reminder that credit is all about lending the money and getting it back.
Australia’s largest bank, the Commonwealth Bank (CBA) has been hit by yet another self-inflicted scandal. The allegations that it failed to report obvious money laundering and potential terrorism financing transactions is the worst offence in banking. In previous scandals in its financial planning and insurance businesses CBA was able to correct errors by paying compensation to victims. In money laundering, there’s no way to right the wrong. CBA has (allegedly) indirectly assisted drug dealers buy and sell drugs and helped terrorists buy weapons. It is not lost on financial regulators that drugs and terrorists kill people, with billions of dollars in fines issued in the last decade for this type of misconduct. The allegations in this case are similar to HSBC’s 2012 settlement that cost it US$1.92 billion.
Written by Jonathan Rochford for Narrow Road Capital on August 31, 2017. Comments and criticisms are welcomed and can be sent to email@example.com
Narrow Road Capital is a credit manager with a track record of higher returns and lowers fees on Australian credit investments. Clients include institutions, not for profits and family offices.