China buys its banks

Advertisement

China’s Central Huijin is buying shares of Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China and China Construction Bank according to Xinhua:

Central Huijin Investment Ltd, an arm of China’s sovereign wealth fund, bought shares in four major Chinese State-owned banks on the secondary market on Monday, the company told Xinhua.

The four banks include the Industrial and Commercial Bank of China (ICBC), Agricultural Bank of China (ABC), Bank of China (BOC) and China Construction Bank (CCB), according to the company.

The move is aimed at supporting the steady operation and development of major financial institutions and stabilizing their stock prices, the company said.

It is not clear (to me anyway) whether they are acting on the A-share market in Shanghai or the H-share market in Hong Kong, but it doesn’t really matter.

Advertisement

FT Beyondbrics noted the following, which sounds uber-bullish:

For context, the last time China stepped in publicly to buy bank shares like this was in September 2008. The Chinese market bottomed shortly afterwards.

I am not as impressed. As the Chinese economy slows, the asset quality of banks will deteriorate. Given the lending spree post-financial crisis, we should be expecting increases in NPL going forward that will mean that Chinese banks, sooner or later, will need to raise fresh capital. Buying shares in open market does not increase the capital of banks.

Advertisement

And for banks with increasing bad assets in a challenging environment, shares may very well become an out-of-the-money call option.

At the height of the 2008 financial crisis, Knight Vinke, an asset management firm, Knight Vinke asked two professors at London Business School, Viral Acharya and Julian Frank, to consider banks under stress. The two professors replied with an interesting letter.

Regarding a failed or near-failed bank in bad times, they replied (emphasis mine):

Advertisement

The flat cost of debt is not a reflection of the low business risk of the bank’s assets but largely a reflection of the value of the Central Bank guarantees over some or all parts of bank debt, an issue we return to in some detail below. This flat cost of debt encourages a high level of leverage as is typically present in bank balance-sheets. This makes equity into a virtual “call” option on the underlying assets. Given this view, it is clear that as leverage increases, the equity of the bank resembles more and more an “out-of-the-money” option on bank’s assets. At these high levels of leverage, a small change in bank’s asset value will cause much more than a one-for-one change in bank’s equity value. In particular, a small business loss can wipe out a significant part of equity value (as witnessed recently). Put simply, with high leverage, equity is a highly levered bet on bank’s assets.

This view of equity is important because it implies that bank equity will have a low beta on its assets (and thus on the market) in good times when the equity option is essentially “in-the-money”, but a much higher beta in bad times when the option is out-of-money. A beta of (say) 1.0 to 1.3 for bank equity estimated in halcyon days significantly under-estimates the beta in a tempest, and by implication, the equity cost of capital. It is worth repeating that this high cost of equity applies to both the bank’s existing equity and any new equity although the latter may be especially expensive in bad times. As a result, banks and the market have tended to underestimate the cost of equity.

Hmmm…