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Cap and gown

25 June 2015 By Peter Thal Larsen

China’s banks have taken a big step towards maturity. The government has scrapped a rule that capped loans at three-quarters of deposits, in a long-awaited reform that should remove distortions and may boost credit. More importantly, it’s a sign that China is closer to dismantling its rules and quota-based financial system.

The limit may sound prudent. After all, several Western lenders relied on wholesale funding to expand their balance sheets, only to get into trouble when markets dried up in 2007 and 2008. However, China’s cap has outlived its usefulness. Banks have gone to great lengths to find ways around it, for example dressing up loans to companies as exposures to other financial institutions, which don’t count towards the calculation. At the end of each month, banks scrambled for short-term deposits to make their ratios look healthier.

Removing the cap could provide a short-term boost to lending. Though China’s banking system had lent out just 66 percent of total deposits at the end of March, some lenders are almost maxed out. Bank of Communications and China CITIC Bank reported loan-to-deposit ratios above 75 percent at the end of 2014, though this includes lending overseas not subject to official constraints. Even then, regulators will keep a close eye on institutions’ ratios, even if it is no longer enshrined in law.

The bigger significance is symbolic. Removing the limit takes Chinese banks closer to the point when they are freed of crude restraints. The cap on interest rates paid on deposits– the last meaningful restriction – could be removed by the end of the year. At that point, banks will in theory be able to price credit according to supply and demand, rather than through official quotas imposed by planners.

The shift is dangerous. Few countries have successfully liberalised their banking systems without suffering a crisis. The People’s Republic is attempting the switch while grappling with the consequences of its post-2008 lending binge, and while also loosening restrictions on international capital flows. It will be up to regulators, rather than rules, to guide Chinese banks toward adulthood.

 

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