Outside a Baoshang Bank branch in Beijing, China, on May 28, 2019. Giulia Marchi | Bloomberg | Getty Images

Chinese authorities' takeover of the distressed Baoshang Bank — the first such case in nearly 20 years — has spooked the banking sector in the country, with banks finding it more difficult to borrow money from large lenders in the past month. China's central bank and the country's banking and insurance regulator announced in late May that they would seize control of the unlisted Baoshang Bank for a year, highlighting the serious credit risks posed by the bank. Since then, risk aversion has spread among China's big banks considering loans to smaller financial institutions. The interbank market — where banks lend to one another — has been hit, causing cash flow issues for borrowers. That has raised concerns about risks to the financial sector against the backdrop of rising defaults and a slowing Chinese economy. Beyond liquidity issues, the risk is also set to spill over to China's domestic bond market, as lenders are becoming reluctant to accept corporate bonds from smaller firms as collateral, according to analysts. "The fallout from last month's regulatory takeover of Baoshang Bank has intensified ... liquidity conditions among regional banks have tightened significantly since (the takeover)," Julian Evans-Pritchard, senior China economist at Capital Economics, wrote in a note last week. The People's Bank of China has reacted, however, taking steps to support small banks. It injected more money into the system in June, lending 500 billion yuan ($72 billion) to institutions through its medium-term lending facility.

The takeover

The PBOC and the China Banking and Insurance Regulatory Commission said they would take control of Baoshang Bank, an Inner Mongolia-based commercial lender with 291 branches, for a year from May 24. The latest available records showed the bank's debts surged in recent years. It owed 156.5 billion yuan ($22.7 billion) in outstanding loans at the end of 2016 — a 65% jump from the end of 2014, according to its last filing on its assets and liabilities. Baoshang has not published any annual reports since 2016. China Construction Bank, one of China's largest state-owned lenders, was appointed to handle the bank's business operations. China's central bank said at the time it would guarantee all principal and interest of corporate deposits and interbank liabilities below 50 million yuan, which analysts said helped to contain the market reaction.

Banks and other financial institutions facing a squeeze

Shortly after the takeover, banks and other financial institutions have faced problems in borrowing money as fears spread. Two regional lenders, the Bank of Jinzhou and Great Wall West China Bank, had difficulties issuing negotiable certificates of deposit, which are short-term debt instruments traded in China's interbank market and used by smaller banks to borrow from larger lenders. Such tools have been increasingly important sources of funding for banks, particularly smaller ones. The PBOC eventually stepped in to provide guarantees for the Bank of Jinzhou. But the risk aversion isn't contained to just banks. Earlier this month, one Beijing-based mutual fund house, New China Fund Management, needed to sell assets after it defaulted on several products, Reuters reported. "Banks are becoming more reluctant to lend to non-bank financial institutions," Yulia Wan, senior analyst at ratings agency Moodys, wrote in a note on Monday. "(The takeover) has led to concerns of potential liquidity risks in the market, particularly for small banks and non-banking financial institutions," added Goldman Sachs analysts in a report on Tuesday. J.P. Morgan called such city and rural commercial banks the "weakest link" in China's banking system in a May report following the Baoshang takeover. The American investment bank said the non-performing loans ratio of that group of banks has been rising "significantly ahead" of commercial banks overall. It cited data from the China Banking and Insurance Regulatory Commission. In a potentially worrying signal, as many as 19 small Chinese banks, including Baoshang and Jinzhou, have delayed releasing their 2018 annual reports, the Wall Street Journal reported, citing a May analysis by Barclays.

Impact on China's bond market