Note: This article originally appeared on Bizmology.
“Policymakers have learned a thing or two since [the US stock market crash of] 1929; we now know that the real damage in financial crises is done not by the crash itself, but by a collapsing banking sector. Stock markets are only a signal of credit contraction to come.”
I read this excerpt in a great article back in July, which paralleled China’s recent stock market rout with the days leading up to the 1929 crash in the US. The author wrote this as China’s stock market had lost 30% of its value — a staggering loss equal to the amount of the UK’s entire economic output last year.
As US investors can attest with the recent 580-point plunge in the Dow resulting from news from the East, China’s stock market hasn’t been much smoother since then. But, as the author said, it’s the health of the banking sector — not the stock market — that could lead to the real economic damage.
Storm Clouds Gather
While it’s not yet looking like a full-on collapse, three big storm clouds have been forming around China’s banking sector.
The first storm cloud is China’s slowing economy, and the “monetary easing” that has come with it.
The country’s central bank, the People’s Bank of China, has slashed interest rates five times since last November in an attempt to stimulate borrowing and boost the economy. Lower rates may be good for consumers, but bad for banks, as they can’t collect as much interest on every loan they make (a problem that’s been plaguing the US’s five largest banks).
The second storm cloud is also caused by poor economic conditions, and the staggering amount of bad loans that have come with them.
Before this year, China’s four largest banks — Industrial and Commercial Bank of China (ICBC), Bank of China (BOC), Agricultural Bank of China, and Bank of Communications (BOCOM) — had been growing profits at an annual clip of 10% since the financial crisis.
But in the first half of 2015, these banks (which also happen to be the world’s four largest banks) reported that net profits grew by no more than 1.5% over the period as they had to set aside more loan loss provisions for borrowers that were unable to pay back their loans.
Even more troubling is that ICBC, the world’s largest bank by assets, reported that its profits didn’t grow at all over the first half of the year as its nonperforming loans grew by 31% to a staggering $25.5 billion, mostly as China’s slowing economy has hurt businesses’ ability to repay.
Beyond the lending market, the third storm cloud forming over China’s banking sector comes from the country’s poor stock-market performance.
Yes, it’s true that the stock market doesn’t directly affect the bank, but it does affect the investors that use the bank’s investing-related services.
Take ICBC again as an example. Like many of its fellow banks in China, ICBC has been leaning on strong fee and commission growth from its brokerage, investment banking, and private banking businesses to offset revenue-eating interest rate cuts from China’s central bank. But if the country’s poor stock-market performance continues, ICBC and other banks’ noninterest-based businesses may be threatened as asset prices fall and investors flee the markets.
Simply put, it may be too soon to say if there’s a collapse coming, but China’s banks have been dealt a dangerous hand. With shrinking interest margins and bad loan debts mounting, banks will likely depend on their noninterest-based financial services for growth, but they will also be all but beholden to the health of the stock and bond markets.
And while the markets there have had some strong rebounds in recent days, much of that has been propped up by government funding. Needless to say, analysts at Bank of America are already doubtful that those will last forever …
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Christian Hudspeth is a company analyst for Dun & Bradstreet who researches and reports on more than 1,000 banks and financial firms for Hoover’s company database subscribers. Before joining Dun & Bradstreet, Christian was a managing editor, senior financial writer and analyst for a financial publishing company. His financial articles have been featured on MSN Money, Business Insider, Nasdaq.com, and several other well-known online publications. Before he was an editor, Christian worked in the commercial banking industry for seven years.