Up until a few weeks ago the Baoshang Bank's prospects seemed bright enough.

Key points: China's central bank has pumped $125b into the financial system following the collapse of the Baoshang Bank

China's central bank has pumped $125b into the financial system following the collapse of the Baoshang Bank The collapse triggered the first ever intrabank default in China, strangling credit to small banks and driving up borrowing costs

The collapse triggered the first ever intrabank default in China, strangling credit to small banks and driving up borrowing costs There are fears the tighter credit conditions will further hit a slowing Chinese economy

According to Baoshang's most recent regulatory filing, the smallish lender based in Inner-Mongolia, made a $600 million profit in 2017.

It had assets of around $90 billion, non-performing loans were modest — under 2 per cent — and its capital buffers would fit comfortably with the global demands of a Tier1 bank.

Then it collapsed.

That set off a series of events rarely, if ever, seen in Chinese banking.

A 'Lehman moment'?

Regulators seized Baoshang, the first action of its type since 1998.

That may have shaken the foundations of Chinese banking, but of far greater significance was the collapse caused by China's first recorded interbank default.

The Baoshang Bank appeared sound, until it wasn't. ( REUTERS )

It is yet to be a "Lehman moment" — where the credit market freezes, banks stop lending to each other and the economy teeters above the abyss —but it has, as Societe Generale's Wei Yao noted, "triggered severe liquidity tensions in the interbank market".

"The Baoshang incidence has challenged one fundamental belief of China's financial system; interbank defaults are not possible thanks to 100 per cent implicit guarantees," Ms Yao said.

"Now that credit risks and counter-party risks have finally descended on this very core market in China's financial system, all the key players in the system have to figure out how to price risks in the new paradigm, and quickly."

Ms Yao said the understandable consequence was "a big and unpleasant wave of risk repricing", with major banks shying away from doing business with smaller lenders.

And that's a worry, as small-to-medium sized banks combined have balance sheets as big as the big banks combined, but are far more dependent on interbank funding.

The central bank (PBoC) immediately pumped around 600 billion yuan ($125 billion) into the system and halted a run on the banks by guaranteeing 100 per cent of all retail deposits.

The People's Bank of China has already pumped $125 billion into the financial system to free up lending, it may need to do more. ( REUTERS: Peter Kundzic )

It calmed nerves a bit, but credit has tightened and borrowing has become more expensive — not an ideal mix when the broader Chinese economy is slowing and under pressure from the ongoing battle with the US over trade.

Bad news for the Chinese economy is readily translated into worse news in Australia, given commodity exports to our biggest trade partner pretty well prop up otherwise rather uninspiring growth.

Whack-a-mole response

"Interbank borrowing rates for smaller banks rose after the Baoshang default, and China's central bank has been busily playing whack-a-mole by injecting cash," J Capital's Anne Stevenson-Yang wrote in a recent note to clients.

Ms Stevenson-Yang says authorities are clearly spooked by the Baoshang default and reports about threats to the solvency of other banks.

"The failure of Baoshang Bank surprised regulatory authorities, both because the takeover of a small bank had unanticipated systemic effects and because public data on the bank had made it look stable — until it wasn't."

For the record, the party line from Beijing is the collapse was an isolated case, with the Baoshang's majority stakeholder using the bank's funds illegally in another one of his investment businesses.

Economic slowdown

It might be just one bank (at the moment), but Societe Generale sees the real problem as the spill-over into the broader economy.

"While we think the PBoC can avoid a systemic liquidity crisis," Ms Yao said, "we are becoming increasingly concerned that the economy may pay the price of a more intractable slowdown in the coming quarters."

The central bank may still have some work to do beyond targeted cash injections in the financial system.

Interest rate cuts have been off the agenda, but are likely to be deployed if things turn ugly — such as a bad outcome in trade talks and another barrage of US tariffs heads China's way.

Societe Generale's Wei Yao says the collapse of Baoshang Bank and the interbank default goes to the "core" of the China's financial system. ( Supplied: Societe Generale )

"The central bank remains reluctant to step up headline easing, as it is probably waiting for the outcome of the G20 Summit," Ms Yao said.

"The trouble is that if it doesn't move soon enough, it may have to do much more later on to achieve the same goal of stabilisation."

A brief interbank credit squeeze back in 2013 may be a useful template to map out what happens from here. Back then, the real pain was felt well down the track.

"Compared with the economic momentum before that liquidity squeeze, one can even argue that the economy is in a more fragile state amid the confidence shock from the tariff war, among other things," she said.

"After this liquidity squeeze — even if it is over soon — financial institutions will keep adjusting to the new paradigm of non-zero counter-party risk in the interbank market, supposedly the safest segment of the financial system."

Debt mountain

Perhaps the most positive spin that can be put on the Baoshang collapse is, if it is a step to eroding the mountain of problematic debt in the Chinese financial system and tempering the cavalier approach to risky lending, it is a step in the right direction.

Certainly, Societe Generale's Wei Yao says China's interbank market will never be the same after its first ever default.

"It would not be an overstatement to say that Baoshang's fallout is a milestone in China's deleveraging reform and financial liberalisation."

She argues deleveraging will expose weak institutions along the way, and implicit interest rate guarantees need to be abandoned to learn the proper price of risk.

"Enduring such pain is the only way to improve the efficiency of credit allocation in the long run, making China less reliant on debt for growth," Ms Yao said.

"We still think China has a chance to pull through without a financial crisis, given the Chinese Government's control over many things."

However, it is not yet out of the woods.

"When the deleveraging process enters the very core of the financial system, the risk of things going terribly wrong rises," Ms Yao warned.

Something going terribly wrong in China is something Australia could ill-afford as it too battles with a slowing economy.