How a China bank foxed regulators and may force a market rethink

[SHANGHAI] For years, a branch of a mid-sized Chinese bank outshone rivals by reporting zero bad loans at a time others were struggling with rising soured debt.

Financial indicators at Shanghai Pudong Development Bank Co's branch in the western Chengdu city were healthy, officials raised no red flags, and Fitch Ratings upgraded the parent last July citing tighter support and supervision by local authorities. Unknown to most, however, regulators had been probing the lender for a fraud that may reverberate across China's financial industry.

"It is not just about Pudong Bank," analysts at Guangfa Securities Co, led by Ni Jun, wrote in a report. "The underlying issue is that the market may conduct a systemic review and re-rating on the bad loan ratios of those highly-leveraged Chinese banks that had gone through a round of balance-sheet expansion." The bombshell dropped late on Friday, when the China Banking Regulatory Commission slapped a 462 million yuan (S$95.3 million) fine on the Pudong Bank branch, accusing it of hiding non-performing assets with a web of fresh lending. Not only is this one of the stiffest penalties imposed in the industry, it's also an unusual level of disclosure by a regulator that has historically chosen to deal with malpractice away from the public gaze.

"This is a well-organized fraud engineered by Pudong Bank's Chengdu branch," the CBRC said in a strongly-worded statement. "It involved a massive amount of money, used hidden schemes, and had profoundly damaging implications." Pudong Bank's headline numbers showed little stress because officials at the branch spent years cooking the books, the CBRC said. Their boldest trick was to funnel 77.5 billion yuan of illegal loans through 1,493 shell companies, and these entities in turn bought out Pudong Bank's original borrowers to conceal the fact the loans had turned sour.

In a separate statement soon after, Shanghai-based Pudong Bank said it booked the fines in its 2017 financial results and vowed to strengthen compliance and internal controls. Senior executives also face prosecution.

As of September, the lender had repaired its books and is back to stable operations, the CBRC said. The bank had earlier reported net income of 54.2 billion yuan in 2017.

This case may be the first of many, as CBRC Chairman Guo Shuqing intensifies his campaign to root out malpractice.

"We would be seeing more investigations by the regulators and they may continue to disclose the details in such a manner," said Chen Shujin, a Hong Kong-based analyst at Hua Tai Securities Co. "This is the right thing to do."

The Pudong Bank fraud has also raised fresh doubts over the accuracy of China's bad-loan data. The official NPL ratio across the banking industry was 1.74 per cent on Sept 30, the latest figure available. But 80 per cent of bank respondents in a 2016 survey said China's NPL figures are artificially low. According to analysts at CLSA Ltd, the true figure for 2015 was between 15 per cent to 19 per cent in 2015.

Particularly at risk are smaller banks. Analysts will probably scrutinize those that have seen rapid asset growth, with some already suspected of evading regulatory checks and under-reporting bad loans.

Warning signs would be use of complicated wealth management products to buy their own bad debt, or disguising transactions through trusts or asset-management plans. These deals would record the money as funds to be received rather than as loans, which helps lenders avoid provisioning and capital charges.

Pudong Bank paced declines among smaller Chinese lenders in Shanghai on Monday, after falling as much as 4 percent, the steepest intraday drop since June 2016.

BLOOMBERG