Banks 

www.fitchratings.com  17 December 2009 

China Special Report 

Chinese Banks – Annual Review and Outlook Summary As Western banks continue to wrestle with the events of the past year, Chinese banks have emerged from the global crisis relatively unscathed, and now stand among the largest financial institutions in the world. The resilience of Chinese banks has attracted a growing amount of attention and inquiry from market participants. Could banks in China be stronger than they are being given credit for?

With lending expected to rise by close to 30% of GDP by year‐end (2008: 16.7%) and loan spreads down 160bp from mid‐2008, many analysts have been worried about a deterioration in Chinese banks’ performance. However, earnings and asset quality have generally surprised on the upside in 2009. Consequently, most measures of capitalization, although clearly weaker than at end‐2008, have demonstrated less erosion than expected given the magnitude of growth.

While recent performance has been better than anticipated, Fitch Ratings continues to believe that a high degree of caution is still warranted due to major ongoing weaknesses in loan classification and disclosure of off‐balance‐sheet exposures, Chinese banks’ lack of experience operating through a full economic cycle, and the lengthy process of instilling a new credit culture. Meanwhile, although this year’s fiscal and monetary stimulus appear to be succeeding in reviving the economy, the aggressive growth of credit in H109 has raised the spectre of a medium‐term bad loan crisis, although this by no means is a foregone conclusion.

Other recent developments provide additional cause for concern; chief among these is the growing amount of unreported loan transactions, which are increasingly distorting credit growth figures at an institutional and systemic level and represent a growing pool of hidden credit risk.

Reflecting Fitch’s long‐standing caution in China, many of these concerns are already built into the Individual Ratings of Chinese banks, which continue to hover at the lower end of the scale from ‘A’ (high) to ‘F’ (low, see Table 1). However,

Table 1: Fitch’s Ratings of Chinese Banks (at End‐November 2009) Bank LT IDR Individual Support China Merchants Bank (Merchants) C/D 2 China CITIC Bank (CITIC) C/D 2 Bank of Beijing (BoB) D 3 Bank of China (BOC) A D 1 Bank of Communications (BCOM) A‐ D 1 Bank of Shanghai (BoSH) BB‐ D 3 China Construction Bank (CCB) A D 1 China Minsheng Banking Corporation (Minsheng) D 3 Industrial & Commercial Bank of China (ICBC) A D 1 Industrial Bank Co.Ltd. (IND) D 3 Shanghai Pudong Development Bank (SPDB) D 3 China Everbright Bank (CEB) D/E 2 Guangdong Development Bank (GDB) D/E 3 Hua Xia Bank (HXB) D/E 3 Shenzhen Development Bank (SZDB) D/E 3 Agricultural Bank of China (ABC) E 1 Agricultural Development Bank of China a (ADBC) A+ n.a. 1 China Development Bank a (CDB) A+ n.a. 1 Export‐Import Bank of China a (ExIm) A+ n.a. 1 a Fitch does not assign Individual Ratings to policy banks, as they do not operate on a fully standalone basis Source: Fitch 

Analysts Charlene Chu +8610 8567 9898 x 112 charlene.chu@fitchratings.com

Chunling Wen +8610 8567 9898 x 105 chunling.wen@fitchratings.com 

Related Research • Bank Systemic Risk Report (November 2009) • Chinese Banks: Soaring Credit Amid Weak

Corporate Climate a Concern (May 2009) • Asset Quality Under Pressure As Credit

Cycle Turns (January 2009) • Chinese Banks: Signs of Strain Emerging,

Despite Strong H108 (September 2008)

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Chinese Banks – Annual Review and Outlook December 2009  2 

downward revisions are possible for some institutions in 2010‐2011 if the growing divergence between credit risk and capitalization materially worsens. In contrast, the Outlooks for the Long‐Term IDRs of China’s major banks are Stable, as the ratings are underpinned by strong expectations of state support in the event of stress. This report discusses recent trends in China’s banking system and highlights the key challenges heading into 2010, including managing brisk loan growth amid increasingly thin capitalization, rising hidden credit exposure, and the growing amount of credit and liquidity risk in interbank and investment securities portfolios. 

Credit Growth Without question, the dominant theme in 2009 has been the unprecedented level of credit growth, which has surpassed all forecasts published at the start of the year. Fitch expects total combined CNY and foreign currency loan growth of 32%, or USD1.5trn, for 2009, with the total loans/GDP ratio rising to 127% from 106% at end‐2008 (see Chart 1). This is a tremendous amount of money to enter an emerging‐market economy in the span of one year, particularly given that over three‐quarters of it was concentrated in just the first six months. Credit growth of this magnitude inevitably places a strain on banks’ internal risk management, and raises concerns about a future deterioration in loan quality.

In other countries, past episodes of banking system distress have often been preceded by periods of very rapid credit growth in excess of nominal GDP growth. In its semi‐annual “Bank Systemic Risk Report” (see Related Research on front page), Fitch’s sovereign team evaluates trends in credit growth, asset prices, and real effective exchange rates for 86 countries under coverage, and assigns a Macro‐ Prudential Indicator (MPI) score ranging from ‘1’ (low risk) to ‘3’ (high risk). China’s MPI has been ‘1’ since the launch of the report in July 2005, but this could be revised upward in 2010 given this year’s acceleration in lending.

Looking into next year, loan growth will be less brisk than in 2009 as the pressure for economic stimulus eases and balance sheet constraints from weakened capital and loan/deposit ratios become more binding. Fitch’s baseline estimate is net new loans of CNY8trn or more, or 20%+ growth yoy. A key factor to monitor will be the trend in outright sales of loans and/or re‐packaging of loans into wealth management products, which are growing in popularity but are largely unreported. These transactions, which free up space to extend new loans and lessen the pressure on capital and liquidity, can lead to a noticeable reduction in a bank’s outstanding loans and result in understated credit growth figures at an institutional and systemic level. Fitch suspects this activity was one factor behind the marked slowdown in aggregate loan growth figures in H209, which may not have moderated as much as official figures suggest.

No comprehensive data is available on the nominal amount of this activity, but there is evidence that loan re‐packaging transactions picked up in H209 (see Chart 2; no concrete data is available on outright loan sales). Although Chinese

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Q107 Q207 Q307 Q407 Q108 Q208 Q308 Q408 Q109 Q209 Q309 Oct‐Nov 09

Loan‐only products Products with loans as a core component

Chart 2: No. of Loan‐Related Wealth Management Products Issued

Source: Wind, Fitch

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Chart 1: CNY Loan Growth

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Chinese Banks – Annual Review and Outlook December 2009  3 

banks argue that they face little to no exposure to losses on these transactions, Fitch believes that banks could still be reputationally liable for some portion of losses, placing a larger portion of capital at risk than would appear on the surface (see the section Key Themes in 2010 on page 11).

Who Lent the Most? State‐owned and joint‐stock banks (JSCBs) have accounted for the majority of new credit this year, extending 74% of all new loans from January to September 2009 (see Chart 3). This reflects these institutions’ closer relationships with state enterprises and the infrastructure‐heavy nature of a large portion of this year’s lending. State‐owned banks’ contribution is broadly consistent with their overall market share, while JSCBs’ 20% share of new loans is 6pp above their share of system assets. More aggressive growth at JSCBs in part reflects the intense level of competition and ceaseless drive to gain or maintain market share between these institutions, which often trumps considerations of safety and soundness.

A unique feature of the growth in H109 was the large share of short‐term loans, in particular discounted bills, which made up 23% of new lending in H109 (this share fell to 10% by Q309 owing to numerous maturities). Historically, the popularity of these instruments rises whenever competition between banks intensifies, as they are the only instruments Chinese banks can use to compete on price (for additional information, see “Chinese Banks: Soaring Credit Amid Weak Corporate Climate a Concern” under Related Research on front page).

Although bills have been contracting rapidly in H209, it is worth spending some time to discuss these exposures, as there seems to be some confusion as to who is carrying what type of credit risk from these instruments. A discounted bill in China is money advanced by a bank to a corporate borrower that submits a valid acceptance from another bank (or sometimes the same bank). When the bank extends the money to the borrower, it is actually taking on exposure to the bank that issued the acceptance, ie interbank exposure, while the final exposure to the corporate entity resides with the bank that issued the acceptance.

In this context, the most accurate measure of who took on the most non‐bank credit exposure in H109 is not gross loans, but gross loans less discounted bills plus acceptances. By this measure, China Minsheng Banking Corp. and China Merchants Bank posted the fastest growth in H109 of 48% and 42% un‐annualized (see Table 2).

Table 2: Breakdown of H109 Credit Exposure Gross loans Gross loans – discounted bills + acceptances

Loans – bills + acceptances/ tangible equity

Bank

H109 increase (CNYm)

Growth (%) a

Loans/ tangible equity (x)

H109 increase (CNYm)

Growth (%) a (x)

Change from 2008 (x)

BOC 1,017,328 30.9 8.8 977,255 29.2 8.8 +1.9 ICBC 864,475 18.9 9.5 852,343 19.1 9.2 +1.3 ABC 858,900 27.7 n.a n.a. n.a. n.a. n.a. CCB 731,414 19.3 9.3 834,209 21.7 9.6 +1.0 Merchants 277,805 31.8 16.0 413,740 42.4 19.3 +4.9 BCOM 400,628 30.2 10.9 364,139 25.1 11.4 +1.7 Minsheng 245,574 37.3 15.6 354,996 48.0 18.9 +5.3 CITIC 323,824 48.7 10.0 282,013 33.4 11.4 +2.5 SPDB 241,154 34.6 20.1 255,124 29.0 24.3 +3.1 CEB 148,664 32.0 n.a n.a. n.a. n.a. n.a. IND 141,647 28.4 12.2 206,674 36.5 14.6 +3.0 HXB 70,434 19.8 15.1 88,599 18.8 19.9 +2.8 SZDB 58,605 20.7 19.1 67,069 16.5 26.5 +1.5 BoB 56,750 29.4 7.1 53,216 27.1 7.1 +1.2 BoSH 59,560 34.4 12.0 40,113 22.0 11.5 +1.7 GDB n.a. n.a. n.a. n.a. n.a. n.a. n.a. a Un‐annualised Source: Bank financial statements, Fitch

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2007 2008 H109

HK India Korea

Taiwan China

Chart 4: Asian Leverage Gross loans/tangible equityª

(x)

ª Average of top 10 banks Source: Bank financial statements; Fitch

JSCBs 20%

Big 5 54%

Chart 3: New Loans Share End‐2008 to Q309

Source: PBOC

Policy banks, coops

16%

City commercial banks

8%

Rural banks 2%

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Chinese Banks – Annual Review and Outlook December 2009  4 

With growth of assets outstripping growth of equity almost across the board, every bank reporting H109 data showed a rise in leverage. By end‐June 2009, the most highly leveraged Chinese banks under Fitch’s coverage had levels of non‐bank credit exposure to equity of 20x or more, well above historical averages in China and other Asian countries (see Chart 4). Fortunately, four of the five most highly leveraged banks — Shenzhen Development Bank, Shanghai Pudong Development Bank, China Minsheng Banking Corp. and China Merchants Bank — have raised or are in the process of raising additional equity in H209. While this will lower these figures somewhat, leverage ratios are likely to remain high relative to the rest of the region, and will continue to be a key factor placing downward pressure on Chinese banks’ Individual Ratings.

Where Did the Money Go? One of the core factors underlying Fitch’s concerns about the medium‐term asset quality outlook for Chinese banks is their aggressive lending to what is a qualitatively weaker corporate sector (see Chart 5; note that all figures in this section apply to CNY loans only as no sectoral data is available on foreign‐currency loans). Just under 79% of the new loans extended by Chinese banks from end‐2008 to end‐Q309 went to corporate borrowers, while the remaining 21% were retail loans (of which close to one‐third were small business retail loans). In nominal terms, this amounts to CNY6.8trn (just under USD1trn) in net new corporate loans in January‐September 2009, which is greater than total net new corporate lending in 2007 and 2008 combined. Add to this another CNY870bn in net new corporate fixed‐income issuance during the period, and it is no wonder that the Chinese corporate sector has begun to revive.

The key question heading into next year is whether the February 2009 bottoming of corporate profitability reflects an improvement in core earnings power of Chinese enterprises, or is simply a product of cheap, loose credit. To the extent the latter is the case, enterprises could begin to face difficulties later next year as monetary policy begins to tighten. With close to a quarter of all outstanding discounted bills already having matured in Q309, some Chinese corporates are already starting to face an effective interest rate increase as these bills, which were extended at rates in the neighbourhood of 2% on average, are rolled over into regular loans at a minimum rate of 4.4% (six‐month loans priced at 0.9x the base rate).

Close to two‐thirds of the corporate loans extended from end‐2008 to Q309 were medium‐ to long‐term credits, the vast majority of which had been extended to infrastructure‐related projects or entities, followed by local government financing platforms (which fall under the category “leasing and commercial services”), property development, and manufacturing (see Chart 6). The borrowers involved in these activities tend to be among China’s larger enterprises and have closer ties to the central and/or local governments, both of which make them a safe haven for banks in this more difficult environment. 

Corporate short­term 16.9% 

Corporate discounted bills 10.1% 

Consumer 14.5% 

Small business retail 6.7% 

Other 2.5% 

Infrastructure 24.1% 

Leasing & commercial services 6.8% 

Property development 5.5% 

Manufacturing 5.0% 

Other 7.9% 

Other 49.3% 

Chart 6: Sectoral Breakdown of Net New Loans, End‐2008 to End‐Q309

Source: PBOC

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Chart 5: Corporate Loans Up, Profits Down

Source: Bloomberg

(% yoy)

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Chinese Banks – Annual Review and Outlook December 2009  5 

After a quiet start of the year, retail lending began to accelerate in March 2009 in tandem with the stronger residential property market and the government’s push to increase credit to consumers and small enterprises (in China, loans to very small businesses and farm households are recorded as retail loans). In Q309, net new retail loans exceeded net new corporate loans by a margin of 1.5:1. Problems with credit card lending have increasingly been in the headlines, but it is important to keep in mind that the scale of such loans remains extremely small, comprising less than 1% of total outstanding loans for the 16 Chinese commercial banks under Fitch’s coverage, although some institutions clearly have larger exposure than others, eg China Merchants Bank at 2.9% of total loans in H109. Chinese regulators also have been quite proactive on this issue, encouraging banks to monitor their credit card portfolios more closely and to reduce their reliance on third‐party marketers of cards. 

Performance Historically, the performance of Chinese banks has tended to be broadly comparable due to very similar balance sheet and earnings structures. However, in the wake of this year’s credit boom, Chinese banks have begun to demonstrate noticeable differences in a number of areas as institutions pursue different strategies to cope with the fall in net interest margin (NIM) and fund growth. Nevertheless, a few universal themes are worth highlighting:

• Although loan growth has been very brisk across the sector, growth of total assets has tended to be more muted as Chinese banks reduce their balances of safer, liquid assets and channel them into lending (see Chart 7). This has helped prop up key ratios such as RoAA and equity/assets, but also contributed to a very noticeable rise in some banks’ exposure to credit risk.

• Although data for the entire system shows deposit growth lagging loan growth since February 2009, in reality nine of China’s 12 listed banks posted increases in the nominal amount of customer deposits that exceeded the rise in gross loans through end‐Q309. China’s large state banks in particular have benefited from an influx of deposits associated with the ramp up of numerous central‐ and local‐government infrastructure projects. In aggregate, gross new loans at state banks amounted to 79% of their total deposit intake through Q309 (excludes Agricultural Bank of China).

• Although slower growth of assets has helped prop up equity/assets ratios, risk‐ adjusted capital ratios have fallen across the board for listed banks due to rising credit exposure and rapid growth of off‐balance‐sheet items. By Q309, the average Tier 1 and total capital adequacy ratios (CARs) for listed banks reporting data had fallen 73bp and 74bp, respectively, from end‐2008.

Earnings Despite a sizeable contraction in loan‐to‐deposit spreads, net income of most Chinese banks has held up extremely well in 2009. The average RoAA of China’s 12

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Chart 8: Listed Banks' Earnings Breakdown Percent of average assets

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Source: Bank financial statements, Fitch

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Chart 7: Loan vs. Asset Growth

Source: Bank financial statements; Fitch

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Chinese Banks – Annual Review and Outlook December 2009  6 

listed banks rose 2bp to 1.07% in H109, while net income as a share of total average business volume (the sum of on‐balance‐sheet assets plus total reported off‐ balance‐sheet items) remained unchanged at 0.99% (see Chart 8). How RoAA held steady amid a drop in NIM is partly explained by the slower growth of total assets compared with loans, noted above. In addition, net income for each bank was also boosted by varying combinations of reduced credit and operating costs, non‐ recurring items, and increased non‐interest income from acceptances, advisory and consulting services, and fair value/other gains on securities (see Table 3).

Notwithstanding the dramatically different credit environment in H209, Fitch expects year‐end net profitability will remain broadly in line with that reported at mid‐year. Although NIM began rebounding in Q309 as expiring discounted bills were shifted into regular, higher‐yielding loans, this rise in net interest revenue is being quickly offset by declining fee and commission income growth from slower expansion of off‐balance‐sheet items and, for some institutions, higher operating expenses and credit costs.

In an environment in which corporate profits continue to contract, one would expect credit impairment charges to be a major factor weighing on Chinese banks’ profitability. However, in some cases, the China Banking Regulatory Commission’s (CBRC) new 150% loan loss reserve coverage target appears to be having the unintended effect of lowering impairment charges for those institutions with coverage ratios already above the 150% level. (At end‐Q309, only one of China’s listed banks, Bank of Communications, had a reserve coverage ratio more than 10bp below the 150% target, while four institutions had ratios above 210%.) Table 3 shows that every listed bank posted a decline in impairment charges in H109, resulting in an average contribution to RoAA of +37bp. While improving asset quality contributed to this lowering of credit costs (see Asset Quality section below), the new 150% reserve coverage target has clearly provided some banks with significant leeway on this parameter, eg, Industrial Bank, whose loan loss provisioning declined from 16.7% of pre‐provision profit in 2008 to 1% in H109, while loan loss reserve coverage fell only 8pp to 219%.

Looking into 2010, NIM should benefit from tightened credit policy as loan growth slows to the low 20% range and the popularity of low‐yielding discounted bills fades. However, RoAA is likely to remain in the neighbourhood of 1%‐1.1% in 2010 as additional revenue is used to make up for lower operating costs and under‐ provisioning in 2009. Increases in administered interest rates are a possibility later in the year, which would be positive for banks’ NIM as interest rate changes typically have a faster impact on Chinese banks’ assets, while deposits take longer

Table 3: Changes to Components of RoAA (End‐2008 to End‐H109) No. of percentage points

Revenue Expenses a

Net interest revenue

Investment gains + losses

Net fees+ other income

Operating costs

Impairment charges Taxes

Non‐recurring items + other

Total change in RoAA

SZDB −0.54 0.06 ‐0.08 −0.10 −1.34 0.13 0 0.76 Minsheng −0.75 ‐0.02 ‐0.04 −0.27 −0.18 0.02 0.79 0.42 BOC −0.57 −0.02 ‐0.03 −0.30 −0.43 −0.02 ‐0.02 0.11 ICBC −0.68 0.06 0.04 −0.18 −0.41 −0.05 ‐0.02 0.04 CCB −0.73 0.10 ‐0.05 −0.27 −0.41 −0.02 0.01 0.02 HXB −1.02 0.37 0.02 −0.20 −0.33 −0.07 0 −0.03 IND −0.64 0.03 ‐0.08 −0.24 −0.36 0.01 0.02 −0.09 BoSH −0.89 −0.17 0.04 −0.41 −0.41 −0.09 0 −0.10 CITIC −0.92 −0.02 ‐0.03 −0.38 −0.39 −0.10 0 −0.11 BoB −0.65 −0.13 0.01 −0.27 −0.36 −0.03 ‐0.02 −0.13 BCOM −0.73 0.02 0 −0.37 −0.15 −0.06 0 −0.13 SPDB −0.87 0 ‐0.06 −0.60 −0.08 −0.01 0 −0.24 Merchants −1.19 0.15 ‐0.08 −0.25 −0.01 −0.26 0.06 −0.54 a Negative figures represent a decline in expenses, thereby providing a positive contribution to RoAA Source: Bank financial statements; Fitch

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Chinese Banks – Annual Review and Outlook December 2009  7 

to re‐price. However, it should be noted that Fitch’s sovereign team expects monetary tightening will first focus on draining liquidity through higher reserve requirements and/or central bank issuance, followed secondarily by interest rate increases to prevent attracting further capital inflows.

Of course, a key unknown that could significantly affect next year’s profitability is asset quality and associated loan loss impairment charges. As noted earlier, Chinese corporates could come under greater strain as monetary conditions tighten. Nevertheless, Fitch does not currently anticipate impairment charges will rise much beyond historical averages in 2010, though this could change in the event of more aggressive tightening and/or greater corporate distress.

Asset Quality For more than a year, Fitch has been voicing concern about the asset quality outlook for banks in China. But rather than worsening, the asset quality figures reported by most Chinese banks have actually been improving in 2009. In addition to declines in nonperforming loan (NPL) and special‐mention (SM) loan ratios from the denominator effect of fast credit growth, 11 of China’s 12 listed banks posted a drop in the nominal amount of SM loans, while half recorded a fall in the absolute amount of NPLs by end‐June 2009 (see Table 4). How does this add up at a time when the economy has faced its worst downturn in a decade and corporate profits have been under pressure?

Table 4: Trends in NPLs and SM Loans of China’s 12 Listed Banks 2006 2007 2008 H109

NPLs (CNYm) 417,514 369,351 351,976 331,603 NPLs/gross loans (%) 3.29 2.50 2.04 1.53 SM loans (CNYm) 942,881 744,504 767,458 688,064 SM loans/gross loans (%) 7.43 5.05 4.46 3.18 Gross charge‐offs (CNYm) 27,872 32,447 44,132 21,885

Source: Bank financial statements, Fitch

Fitch has emphasized all along that asset quality deterioration is a medium‐term issue for banks in China because of the extended time it can take for loans to be recognized as impaired due to widespread rolling‐over of delinquent credits and the bullet‐oriented structure of most corporate lending. This is not to be overlooked, as one could argue that many of the flaws in the global financial system might still be hidden today if banks in the US had been more lenient in classifying delinquent mortgages.

Another key reason for the improvement in the nominal amounts of SM loans and NPLs in 2009 is that some new loans were used to pay off old, delinquent credits. With Chinese corporates raising over CNY7.7trn from loans and fixed‐income issuance from January to September 2009, many companies that were strapped for cash in late 2008 may have been able to repay or become current on past‐due loans in 2009. The stock of NPLs and SM loans stood at CNY352bn and CNY767bn for China’s 12 listed banks at end‐2008. These amounts are quite small relative to the CNY7.7trn in new corporate financing, and one can see how channelling just a small fraction of new financing toward paying off old delinquent debts could have a noticeable impact on the balances of NPLs and SM loans.

Assessing the Newly Disclosed Migration Data One very interesting, but complex new piece of asset quality data that China’s listed banks began disclosing in 2009 is the downward rates of migration within the five‐tier loan classification, ie the rate of migration of normal loans to SM or NPL status, SM loans to NPL status, etc. (see Table 5). At first glance, some of the ratios appear surprisingly high given how little movement there is each period in the balances of NPLs, SM loans and charge‐offs. For example, in 2008, listed banks reported an average migration rate of normal loans to SM or NPL status of 3.7%.

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Chinese Banks – Annual Review and Outlook December 2009  8 

According to Fitch’s calculations, this implied somewhere in the neighbourhood of CNY500bn of combined new NPLs and SM loans in 2008; yet the combined reported amount of NPLs and SM loans adjusted for charge‐offs rose only CNY50bn for listed banks during this period. What happened to the other CNY450bn?

Reconciling Chinese banks’ elevated migration rates with relatively stable nominal amounts of NPLs and SM loans is extremely difficult in the absence of detailed data on loan portfolios and loan loss reserves. Nevertheless, after numerous conversations with Chinese banks on this issue, Fitch has come to two important conclusions:

• the migration ratios currently reported by many banks appear to be systematically overstated owing to deficiencies in the mathematical formulas underlying the ratios; and

• even taking into account this overstatement, it would appear that a substantially greater amount of loans are migrating to SM and NPL status each period than changes in the balances of NPLs or SM loans would indicate. This means that a large number of existing NPLs and SM loans must either be moving upward in the classification, or getting repaid or disposed of to offset this downward movement.

With regard to the first point, the formula that the CBRC has suggested banks use to calculate migration rates requires that all loans within the same class that were repaid, upgraded or downgraded during the period be subtracted from the denominator, resulting in systematic understatement of the denominator, and by extension overstated migration rates. 1 For instance, in the example above, Fitch’s estimate of CNY500bn of combined new NPLs and SM loans was derived by multiplying 3.7% by the total amount of listed banks’ normal loans at end‐2007, or CNY13,625bn. However, according to the CBRC’s suggested formula, any normal loans that were repaid or downgraded during the period should first be subtracted from this amount. If 50% of normal loans at end‐2007 were repaid or migrated during 2008 (this is not inconceivable, as 44% of all CNY loans outstanding at end‐ 2007 had maturities of one year or less), the implied combined amount of new NPLs

1 Migration formulas typically consist of the nominal amount of loans that migrated during the period in the numerator, divided by the beginning balance of loans in that category during the period in the denominator (or ending balance of loans in that category during the prior period). For example, a migration ratio for normal loans to SM or NPL status of 5% in H109 would typically mean that 5% of normal loans on 1 January 2009 (or 31 December 2008) migrated to SM or NPL status by 30 June 2009. However, in China the CBRC instructs banks to subtract from the denominator all loans within the same class that are repaid or migrate upwards or downwards during the period, which in turn results in understated denominators and inflated migration rates.

Table 5: Five‐Tier Migration Rates Reported by Listed Banks (%) Normal loans to SM or NPL status SM loans to NPL status

Bank 2007 2008 H109 a 2007 2008 H109 a

BCOM 1.72 2.32 1.48 13.67 21.72 13.26 CCB 2.96 3.60 1.41 9.43 8.40 3.89 ICBC 3.50 4.60 1.30 10.40 9.30 6.70 BOC 2.62 3.65 1.28 10.79 8.02 4.99 IND 5.53 1.90 1.13 26.29 13.04 10.64 Merchants 4.06 2.52 1.01 15.99 11.89 6.30 HXB 12.02 5.92 1.00 17.06 14.41 9.80 Minsheng 1.23 3.48 0.96 26.96 16.47 7.61 SZDB 1.46 2.78 0.61 62.22 1.90 28.10 SPDB 3.25 4.07 0.59 20.07 22.23 8.45 CITIC 1.20 1.42 0.44 6.12 6.94 4.67 BoB 1.15 7.71 0.16 2.84 0.39 0.19 Average 3.39 3.66 0.95 19.49 11.23 8.72 a Un‐annualised Source: Bank financial statements, Fitch

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Chinese Banks – Annual Review and Outlook December 2009  9 

and SM loans would be closer to CNY250bn. This is considerably lower than Fitch’s initial estimate, but remains above the CNY50bn in new NPLs and SM loans adjusted for charge‐offs.

This brings us to the second point: even though the migration rates are overstated, they continue to point to substantially greater movement of loans between categories than fluctuations in the balances of NPLs or SM loans reported each period would suggest. Precisely what accounts for this discrepancy is difficult to identify without more comprehensive data, but Fitch believes that a number of factors are likely at play, including repayments of past NPLs and SM loans, upgrades of NPLs and SM loans to normal status or the transfer or sale of NPLs and SM loans to other financial institutions. Lastly, it should be noted that although most banks use the CBRC’s formula, it is not mandatory, and some banks employ their own formulas. Consequently, migration rates at one bank may not always be comparable with those at other banks.

Because of these numerous issues with the data, the migration rates currently reported by Chinese banks cannot be relied upon to accurately gauge the flow of new problem loans, or to evaluate one bank’s migration rates against another’s. Until there is more consistency in the formulas, the data can only reliably be used to assess trends within a single bank’s own data set. Looking at the figures from this perspective shows that a number of listed banks registered a noticeable rise in the rate of migration of normal loans to SM or NPL status in 2008 — which is consistent with the rise in impairment charges (see Chart 8) — followed by an improvement in H109 due to the reasons cited earlier (note that the H109 migration figures are not annualised). The CBRC reportedly is re‐evaluating its suggested formula for calculating migration rates, and changes may be made in the future.

Capital Given the extent of on‐ and off‐balance‐sheet expansion in 2009, it is no surprise that the capital ratios of most Chinese banks have eroded noticeably this year (see Table 6). In response, a number of mid‐tier nationwide banks have raised or are in the process of raising additional equity, and even China’s large state banks, which are generally better capitalized than smaller entities, have stated that they are considering additional capital raising, although these efforts may be focused initially on Tier 2 instruments. While certainly positive, in many cases the amounts

Table 6: Changes in Key Capitalization Ratios

Total CAR Tier 1 CAR Tangible equity/ tangible assets

Bank Q309

(%) Change from

2007 (bp) Q309

(%) Change from

2007 (bp) Q309

(%) Change from

2007 (bp) BoB a 16.12 ‐399 13.48 ‐399 7.26 ‐26 ICBC 12.60 ‐49 9.86 ‐113 5.20 ‐79 CITIC 11.24 ‐403 9.84 ‐330 7.22 ‐107 CCB 12.11 ‐47 9.57 ‐80 5.54 ‐57 BOC 11.63 ‐171 9.37 ‐130 6.16 ‐125 BoSH a 10.09 ‐118 8.51 ‐79 4.65 ‐6 BCOM 12.52 ‐192 8.08 ‐219 4.85 ‐140 ABC b 9.41 n.a. 8.04 n.a. 3.77 n.a. IND 10.63 ‐110 7.50 ‐133 4.38 ‐14 HXB a 10.36 +209 6.84 +254 3.54 +129 SPDB 10.16 +101 6.76 +175 4.09 +102 GDB b 11.63 +449 6.67 ‐48 3.54 +3 Merchants 10.54 +14 6.61 ‐217 3.76 ‐138 CEB b 9.10 +191 5.98 ‐22 3.72 +59 Minsheng a 8.48 ‐225 5.90 ‐150 4.29 ‐115 SZDB 8.60 +283 5.20 ‐57 3.42 ‐25 a Total and Tier 1 CAR data is from H109 b Q309 data is unavailable and replaced with end‐2008 data Note: Underlined banks have raised or are in the process of raising equity in H209‐H110 Source: Bank financial statements, Fitch

Banks

Chinese Banks – Annual Review and Outlook December 2009  10 

being raised are just sufficient to bring banks back to their original starting points in 2007‐2008 before the lending boom, and Fitch does not expect much qualitative improvement in overall capitalization levels compared with the past. In other words, recent capital‐raising efforts are simply making up for lost ground in 2009.

Fitch has received numerous inquiries about how much capital Chinese banks need to raise, and, in that context, what benchmark levels Fitch requires for different rating categories. Of course, capitalization makes up only one component of the agency’s assessment of Chinese banks, and there are no specific targets for any given rating level. That said, given the rise in hidden credit exposure from the growing popularity of unreported loan sales, as well as ongoing weaknesses in loan classification, Fitch would prefer to see Chinese banks maintaining levels of capital at the upper end of regional peers, which currently is not the case (see Chart 4 on page 3).

Over the past year, the CBRC has tightened capital requirements by restricting subordinated debt to no more than 25% of core capital, imposing a minimum 10% total CAR for those banks wanting to open new branches or expand into new lines of business (eg, loans for mergers and acquisitions), requiring that banks deduct from their own supplementary capital any holdings of other banks’ subordinated debt purchased after 1 July 2009, and requiring that state‐owned and joint‐stock banks have a minimum 7% Tier 1 CAR in order to issue Tier 2 instruments (5% for smaller institutions). In practice, this means that banks need to have in the neighbourhood of a 7%‐8% Tier 1 CAR to reach the new effective minimum of a 10% total CAR. At end‐Q309, half of the 16 Chinese commercial banks under coverage had Tier 1 CARs below this 8% threshold. Of these entities, six have raised or are in the process of raising additional core capital, which should lift these banks’ Tier 1 CARs to 8%‐9%.

Given Fitch’s expectations for continued elevated credit growth, capital burn is likely to remain a central issue in 2010 and 2011. Over the longer term, greater equilibrium between the pace of growth and internal capital generation is needed, and can be achieved by a combination of more restrained balance sheet expansion, improved non‐interest sources of income and more sustainable dividend payout policies, particularly for state‐owned banks, which have been distributing on the order of 40%‐50% of net income in dividends each year.

Risk‐Adjusted Capital Ratios Alone Are Insufficient in Assessing Capitalization Over the past year, Fitch has become increasingly focused on measures of leverage when assessing Chinese banks’ capitalization, rather than on risk‐adjusted capital ratios, due to what the agency perceives to be growing distortions in Chinese banks’ calculations of risk‐weighted assets from rapid growth of acceptances, discounted bills and government‐related lending. These distortions include inconsistencies in the way Chinese banks record exposures to off‐balance‐sheet acceptances and on‐balance‐sheet discounted bills when they serve as both the accepting and the discounting bank, and variations in risk weightings assigned to government‐related borrowers.

Chart 9 shows that despite a rise in the share of loans to total assets from end‐2008 to end‐H109, the average risk weighting for on‐balance‐sheet assets declined for most banks reporting data. Given the minimal amount of residential mortgage lending in H109 (and still small, albeit rising, corporate securities holdings, which are discussed under Rising Credit and Liquidity Risk in the Interbank and Investment Portfolios below), this discrepancy must be attributable to a shift in the risk profile of corporate borrowers from either: (1) a greater share of borrowers falling under the category “government‐related”; or (2) a greater share of corporate loans being comprised of discounted bills, which carry lower risk weightings as interbank exposures. 2

2 Interbank exposures carry a 0% risk weighting if less than 4 months in maturity and a 20% risk weighting for anything beyond this. Corporate entities invested in by the central government qualify for a 50% risk weighting versus 100% for other corporate loans.

Banks

Chinese Banks – Annual Review and Outlook December 2009  11 

‐5

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Chart 9: Share of Loans Up, But Average Risk Weighting of Assets Down Change from end‐2008 to end‐H109, no. of percentage points

Note: Comparable data for other banks is not available Source: Bank financial statements, Fitch

Similarly, Chart 10 shows a decline in the average risk weighting for off balance sheet items in H109 for those banks reporting data. Generally speaking, banks with larger gaps in Chart 10 tend to have larger off‐balance‐sheet positions and higher balances of acceptances, which are often assessed net of pledged deposits when calculating risk‐weighted assets. Because of this recent volatility in risk weightings, Fitch believes it is important for market participants to consider a range of metrics when examining Chinese banks’ capitalization rather than focusing solely on Tier 1 and total CARs, as these ratios can be heavily determined by internal decisions about how to categorize and weight different exposures.

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Chart 10: Average Risk Weighting of Off‐Balance‐Sheet Items also Down Risk‐weighted amount of off‐balance‐sheet items as % of total disclosed off‐balance‐sheet items

Note: Comparable data for other banks is not available Source: Bank financial statements, Fitch 

Key Themes in 2010 Few banking sectors in the world are undergoing as rapid change as China’s, and the list of areas to keep an eye on in the year ahead could fill this page. As discussed in the previous section, one of the foremost challenges facing Chinese banks and regulators in 2010 will be balancing continued brisk growth amid accelerating capital burn. In addition, there are two other areas that Fitch believes warrant close monitoring in 2010: the proliferation of unreported loan transactions and concurrent rise in hidden credit exposure; and rising credit and liquidity risk in Chinese banks’ interbank and investment securities portfolios.

Unreported Loan Transactions and Rising Hidden Credit Exposure Over the past two years, the most disconcerting trend Fitch has observed in China’s banking sector is the growing prominence of unreported loan transactions. In a special report in September 2008 (see Related Research on front page), the agency highlighted one type of this activity, which is the sale and re‐packaging of loans into wealth management products that are then sold on to investors. Since that time, Fitch has noticed the growing popularity of another type of transaction, which is the outright sale of loans to other financial institutions. In both instances,

Banks

Chinese Banks – Annual Review and Outlook December 2009  12 

the vast majority of activity is not recorded by Chinese banks on‐ or off‐balance‐ sheet, and therefore is invisible to investors and analysts.

While there are push and pull factors driving both types of activity, the overriding motivations are to help Chinese banks free up space to extend new loans, and to come into compliance with loan quotas and regulations on capital, liquidity, concentration and sectoral exposures. Whenever one or more of these parameters becomes more binding, activity tends to accelerate, eg in H209. Banks explain that they do not disclose these deals in their financial statements because the full credit risk of the loans has been transferred to investors/buyers, and therefore they face no direct exposure to losses. However, Fitch believes that Chinese banks could still be reputationally liable. Indeed, in the very few instances of default on loans underlying wealth management products to date, Chinese banks either have stepped in and completely covered investor losses, or are engaged in heated legal disputes.

While Fitch has major concerns about the transparency of this activity, it recognizes that to some extent it is a natural outgrowth of a rapidly developing financial system, where capacity to extend new credit is facilitated by active securitization markets. However, China is in the awkward position of having reached the point where greater securitization could be helpful precisely at a time when the reputation of all securitization activity has suffered a major blow. Nevertheless, allowing such activity to continue in an unregulated manner with extremely poor disclosure could lead to substantial hidden contingent liabilities, and is one of the major factors weighing on the Individual Ratings of Chinese banks.

Fitch’s concerns about these transactions centre on three core issues:

• A larger portion of Chinese banks’ capital may be exposed to credit losses than on‐ and off‐balance‐sheet exposures would suggest, and therefore current capital ratios may be even more strained than they appear.

• The growing popularity of these transactions is increasingly distorting credit growth figures at an institutional and systemic level, contributing to pervasive understatement of loan growth.

• Although there have been extremely few instances of asset quality problems with loans sold and/or re‐packaged to date, permitting banks to transfer all of the credit risk to third parties shields them from the consequences of bad credit decisions, which over time could foster the same type of recklessness witnessed with the securitization of subprime loans in the US.

Outright Sales of Loans While outright sales of loans have been taking place for some time in China’s banking sector, there are anecdotal reports that this activity increased noticeably in H209 as the authorities pressured banks to slow loan growth and raise capital ratios. Information on loan sales is extremely limited, and no public data whatsoever is available on the nominal amount of these transactions. However, there have been recent media reports citing a figure of CNY800bn in total loan sales in 2008 compared with CNY4.9trn in new loans. This figure is impossible to verify due to poor disclosure, but appears reasonable based on the very limited data Fitch has seen.

Because of the growing distortions caused to credit growth figures, loan sales have garnered an increasing amount of official attention in recent months. The China Foreign Exchange Trade System (CFETS) under the People’s Bank of China (PBOC) reportedly has submitted a proposal to the State Council to set up a formal trading platform for loan sales, which would be a very positive development and provide much‐needed transparency to this activity.

Banks

Chinese Banks – Annual Review and Outlook December 2009  13 

The principal sellers of loans tend to be China’s nationwide banks, while the buyers typically are small financial institutions with excess cash on hand, such as city commercial banks, credit cooperatives, trust companies and finance companies. Another large purchaser of loans is China Postal Savings Bank, which, as China’s fifth largest deposit‐taking institution, has abundant liquidity relative to its small lending operations.

Purchasing institutions typically pay 10%‐20% below the base interest rate for the loan, and selling banks record the income in fees and commissions. Typically, selling banks continue to service the loans, collecting payments from borrowers and passing these funds onto the institutions that purchased the loans. Selling banks will sometimes enter a counter‐agreement to re‐purchase the loan at a later date. In these instances, the loans may not appear on either the seller’s or the buyer’s financial statements, and the loan may temporarily vanish.

Sales and Re‐Packaging of Loans into Wealth Management Products Data on the sale and re‐packaging of loans into wealth management products is also sparse, but observers are able to track activity by the number of products issued each month. Chart 2 on page 2 of this report is re‐displayed below, and shows an acceleration in re‐packagings in the latter half of 2009 from 884 new products issued in H109 to 1,736 from July to November 2009. Broken out by bank, it shows that the institutions most heavily involved in this activity in 2009 are China Merchants Bank, China CITIC Bank, China Construction Bank and Bank of Communications (see Chart 11).

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Q107 Q207 Q307 Q407 Q108 Q208 Q308 Q408 Q109 Q209 Q309 Oct‐Nov 09

Loan‐only products Products with loans as a core component

Chart 2: No. of Loan‐Related Wealth Management Products Issued

Source: Wind, Fitch

No comprehensive information is available on the nominal amounts of loans underlying these products, though some small local data providers will publish such data from time to time. Usually these figures only cover a small subset of loan‐ related wealth management products, and therefore significantly understate the true nominal amount of transactions. Nevertheless, it is possible to derive from this information an estimation of the average size of products, which has risen

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Chart 11: No. of Loan‐Related Wealth Management Products Issued

Source: Wind, Fitch

Banks

Chinese Banks – Annual Review and Outlook December 2009  14 

noticeably recently from roughly CNY180m per product in H109 to CNY440m in Q309. Without more complete information, it is difficult to identify what is behind this increase, but some observers have attributed this trend to a rise in the scale of transactions conducted by state‐owned banks. This indeed may be the case, though it is worth noting that state banks’ share of the number of products issued has dropped over this period to 22% during July to November 2009 from 34% in H109.

In most re‐packaging transactions, Chinese banks sell a portion of their own loans to a third‐party, most commonly trust companies, which re‐package the loans into wealth management products. The products are then re‐sold by the bank and/or trust company to retail and corporate investors looking for relatively safe, higher‐ yielding investments. 3 The majority of products offer investors little to no diversification of risk, and are built around a single borrower (occasionally multiple borrowers if the underlying assets are discounted bills). Occasionally, product managers will include some non‐loan assets in the products, such as Ministry of Finance or central bank securities or commercial paper, to offer some diversification, though the majority of the product is backed by loan‐related assets. No secondary trading of the products is available, making them highly illiquid.

Additional key features include the following:

• The products have a wide range of maturities — one of the chief attractions for investors — from as short as a couple of weeks to as long as three years, and generally match that of the underlying loans (see Chart 12). Occasionally, when there is a maturity mismatch between the product and the loans, banks will use cash raised from new products to pay off old ones.

• The products typically offer yields 100bp‐200bp above respective deposit rates. In the past, banks often guaranteed the principal on the wealth management products, or pledged to unconditionally re‐purchase the products at maturity. Guarantees have since been banned, but in some cases, third‐party guarantees of the underlying loans remain present.

• In some cases, Chinese banks may also be exposed to the investing side of these transactions, having purchased such wealth management products from other banks and trust companies for their own investment portfolios (only two banks disclosed such holdings in H109: China Minsheng Bank and Industrial Bank).

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Chart 12: No. of Loan‐Related Wealth Management Products by Maturities

Source: Wind, Fitch

Due to the perceived high credit quality of the underlying loans and the fact that little to no direct exposure is retained once the product is sold, Chinese banks argue that they face minimal risk of losses from such deals. Nevertheless, in the event borrowers were to default, Fitch believes that banks could still be

3 In some cases, banks will sell products in which the underlying loans were originated by a trust company or other banks. Although the distributing bank has less involvement with the underlying loans in this latter type of transaction, Fitch believes Chinese banks’ role as distributors could still make them reputationally liable in the event of losses.

Banks

Chinese Banks – Annual Review and Outlook December 2009  15 

reputationally liable for some portion of losses, as it is unlikely the government would allow investors, many of which are retail, to bear the full brunt of losses — reference the recent Lehman Brothers minibond scandal in Hong Kong.

This is further underscored by the lack of clarity about product features in some disclosure statements provided to investors. It is not inconceivable to envisage a situation in which a large portion of investors could claim to have been misled about a wealth management product’s underlying assets or guarantees, arguing that they purchased the products based on the reputation of the bank.

In recent weeks, the CBRC has released for comment proposed guidelines governing this activity. The first version of the guidelines could have led to a significant reduction in transactions, and hence met strong resistance from participating financial institutions. The latest version appears to be less stringent and calls on trust companies to take more active ownership of and responsibility for the loan assets underlying the wealth management products. It also proposes an increase in the minimum investment required for a single investor, which often varies by bank but currently is in the neighbourhood of CNY50,000.

Rising Credit and Liquidity Risk in the Interbank and Investment Portfolios The interbank and investment securities portfolios of Chinese banks historically have been dominated by sovereign‐ or quasi‐sovereign‐related exposures, such as MOF, PBOC and policy bank instruments along with some holdings of US Treasuries etc. Because these assets are considered to have quite low credit risk and high liquidity, analysts often overlook the interbank and investment securities portfolios when assessing the overall risk profile of Chinese banks.

However, in the past couple of years, Fitch has noticed a number of banks purchasing larger amounts of corporate‐related securities in a search for yield, while at the same time it is becoming increasingly commonplace to see banks holding reverse repurchase agreement assets that are collateralized by loans or discounted bills (see Charts 13 and 14).

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Chart 13: Corporate Securities as Share of Total Investment Securities

(%)

Source: Bank financial statements, Fitch

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Chart 14: Breakdown of Interbank Portfolios, H109

Source: Bank financial statements, Fitch

Banks

Chinese Banks – Annual Review and Outlook December 2009  16 

The main implication of these developments is that the interbank and investment securities portfolios of Chinese banks are displaying greater credit and liquidity risk than in the past. Consequently, in a time of crisis, these portfolios may not provide the level of ready liquidity one would expect. This is further underscored by the sizeable amount of securities that are locked up in pledges at some institutions, which are as high as 25%‐35% of total investment securities at some of China’s smaller nationwide banks.

This is not to say that major problems are expected in the interbank or investment securities portfolios down the road. Indeed, some of the increased credit risk is already addressed through higher risk weightings for corporate securities holdings. Nevertheless, Fitch believes there are some potential fault lines in these portfolios that could become an issue in the event of a systemic disruption in interbank and fixed‐income markets.

ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS . IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEB SITE AT WWW.FITCHRATINGS.COM. PUBLISHED RATINGS, CRITERIA, AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE, AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE CODE OF CONDUCT SECTION OF THIS SITE.

Copyright © 2009 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries. One State Street Plaza, NY, NY 10004.Telephone: 1‐800‐753‐4824, (212) 908‐0500. Fax: (212) 480‐4435. Reproduction or retransmission in whole or in part is prohibited except by permission. All rights reserved. All of the information contained herein is based on information obtained from issuers, other obligors, underwriters, and other sources which Fitch believes to be reliable. Fitch does not audit or verify the truth or accuracy of any such information. As a result, the information in this report is provided "as is" without any representation or warranty of any kind. A Fitch rating is an opinion as to the creditworthiness of a security. The rating does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. Fitch is not engaged in the offer or sale of any security. A report providing a Fitch rating is neither a prospectus nor a substitute for the information assembled, verified and presented to investors by the issuer and its agents in connection with the sale of the securities. Ratings may be changed, suspended, or withdrawn at anytime for any reason in the sole discretion of Fitch. Fitch does not provide investment advice of any sort. Ratings are not a recommendation to buy, sell, or hold any security. Ratings do not comment on the adequacy of market price, the suitability of any security for a particular investor, or the tax‐exempt nature or taxability of payments made in respect to any security. Fitch receives fees from issuers, insurers, guarantors, other obligors, and underwriters for rating securities. Such fees generally vary from US$1,000 to US$750,000 (or the applicable currency equivalent) per issue. In certain cases, Fitch will rate all or a number of issues issued by a particular issuer, or insured or guaranteed by a particular insurer or guarantor, for a single annual fee. Such fees are expected to vary from US$10,000 to US$1,500,000 (or the applicable currency equivalent). The assignment, publication, or dissemination of a rating by Fitch shall not constitute a consent by Fitch to use its name as an expert in connection with any registration statement filed under the United States securities laws, the Financial Services and Markets Act of 2000 of Great Britain, or the securities laws of any particular jurisdiction. Due to the relative efficiency of electronic publishing and distribution, Fitch research may be available to electronic subscribers up to three days earlier than to print subscribers.