China’s Frankenstein banking system keeps growing

Financial regulation in China is quite a mess. China seems to be the world testing ground for some of the most ridiculous banking rules. With all their related unexpected consequences.

Take this recent story: some time ago, Chinese regulators found it clever to cap Chinese banks’ loans/deposits ratios at 75% by the end of each quarter (it isn’t). The goal was to ensure that banks have enough liquidity to face large cash withdrawals. Nevermind that loans/deposits only take into account loans from the asset side of the balance sheet and that banks can use depositors cash to invest in many different sorts of assets (from liquid sovereign bonds and short-term repos to very illiquid securities). Perhaps Chinese banking rules forbid some of those investments (I am not an expert on the Chinese banking system). The fact that the rule was only enforced at quarter-end seemed not to be a problem either (arbitrage anyone?), or that the news that a bank hadn’t complied with the rule could trigger a panic.

Nevertheless, as usual with China, the spontaneous financial order reacts. As the FT reports:

In recent years, the final few days of each quarter have become a nervous time for banks. As liquidity has tightened and many depositors have shifted their savings into higher-yielding substitutes such as Alibaba’s online money-market fund, Yu’E Bao, many lenders have struggled to attract enough traditional deposits to stay below the maximum 75 per cent loan-to-deposit ratio.

That regulation, intended to ensure banks keep enough cash on hand to meet withdrawal demand, is enforced at the end of each quarter – providing an incentive to window-dress deposit totals. This was exacerbated by the desire to prettify quarterly reports to shareholders.

To meet the deposit challenge, many banks resorted to an all-hands-on-deck approach, requiring employees to meet a deposit target. That meant urging clients – and even family and friends – to transfer funds into the bank, typically only for a few days covering the quarter-end period.

Typical example of a rule that, not only introduces opacity, but also creates unintended consequences.

But the story isn’t over.

Chinese regulators didn’t really appreciate that bankers were trying to bypass their well-thought-out rule. They came up with another very ‘clever’ rule to fix the flawed rule:

Regulators will suspend business approvals to banks whose month-end deposit total deviates by more than 3 per cent from the daily average over the previous month.

Problem solved. Not.

To the uncertainty and unintended consequences of the previous rule, they added further uncertainty and unintended consequences. Nevermind that such a rule would limit competition for deposits (Chinese banks are for now forbidden to compete on price – this is about to change –, but can well use other means and advantages). A larger deposit inflow could well happen for any reason (run on a competitor, or simply good news about the financial strength of a bank leading to an inflow of new customers). Penalising banks for such reason sounds rather dubious to say the least.

One of the consequences is that banks now turn away deposits…

The rule can also easily trigger instability, as the FT adds:

A light-hearted commentary circulated among bankers on social media on Wednesday, carrying the headline “If there’s a bank you hate, send them all your money before 12 tonight”.

I’m sure Chinese people, with their usual banking rule-avoiding ingenuity, will soon enough find a way to use all the loopholes created by this combination of definitely very clever regulations. And that regulators, in turn, will come up with another rule to patch the rule that patched the rule. The Frankenstein experiment continues.