China’s Small Banks Face Funding Crunch

China’s small banks are struggling to raise funds through short-term instruments as a regulatory squeeze combines with tight liquidity ahead of the quarter-end and Golden Week holiday.

With few options for funding, some banks have returned to issuing negotiable certificates of deposit, a form of non-collateralized short-term funding that regulators have tried to discourage in their battle against speculative financing, Reuters reported.

The premium paid by lower-rated Chinese banks over higher-rated ones for NCDs spiked last week, highlighting risks to the country’s smaller lenders. The spread between three-month AAA- and AA-rated NCDs hit 51 basis points, the highest on record.

While the spread has narrowed, analysts say it points to a trend of higher financing costs for weaker lenders.

“What you see there is a reflection of the fact that (small banks) are forced to seek more expensive liquidity,” said Alicia Garcia-Herrero, Asia Pacific chief economist at Natixis. “No matter how much they chase for new markets, they will always be penalized.”

A trader at an asset-management firm in Shanghai said tight liquidity reflects ongoing central bank efforts to reduce leverage combined with looming quarter-end tax bills.

Adding to the pressure is the week-long National Day holiday starting on Oct. 1, and NCDs worth 2.3 trillion yuan ($34.88 billion) that have been maturing this month following a surge in issuance in June.

NCDs are priced with reference to the Shanghai Interbank Offered Rate or SHIBOR. The three-month SHIBOR was at 4.361% on Friday, up 107 basis points since the beginning of the year.

As liquidity tightens, market demand for lower-rated NCDs has also been affected by new rules from the China Securities Regulatory Commission, announced in early September, that limit the exposure of money-market funds to lower-rated assets. The rules take effect Oct. 1.

NCDs have been in the regulatory spotlight this year as the authorities try to shut funding loopholes, most recently banning those with maturities longer than one year. Some analysts said the move marked the beginning of a new tightening cycle.

The People’s Bank of China has not yet exempted banks with less than 500 billion yuan ($75.8 billion) in assets from including NCDs in quarterly assessments.

Interbank borrowing by small and regional banks has risen to almost 16% of their total funding sources from 12% in 2015, BNP Paribas senior economist Chi Lo said in a research note, compared with about 2% for large commercial and state-owned banks.