China Consolidates Rural Banking Sector in Unprecedented Merger Wave

China has witnessed its largest-ever wave of rural bank mergers last year, according to a Reuters analysis of official data. This move aims to address risks within the small banking sector, but analysts warn it may lead to further challenges in the future.

Many of China's estimated 4,000 small banks receive support from indebted provincial governments and rely heavily on short-term interbank borrowings, jeopardizing financial stability if they experience failures. Amidst a slowing economy and property crisis, these smaller banks have faced dwindling loan growth and rising bad loans.

Reuters has identified at least 290 rural banks and cooperatives merged into larger regional lenders in 2024, underscoring the extent of the issue in China's crucial financial sector. This consolidation marks the most sweeping since the transformation of China's rural commercial banks from socialist cooperatives to serve underbanked communities in the early 2000s.

Despite the scale of the merger wave, the Chinese rural banking sector remains significant, comprising approximately 3,700 firms with assets totaling 57 trillion yuan ($7.8 trillion) as of June 2023. This size is nearly double that of Australia's banking sector and one-third of the United States'.

"The banking system, after years of clean-up, is in relatively good health despite the weakening economic backdrop," said Jason Bedford, a former Asia analyst with Bridgewater and UBS known for his research on China's banking sector. However, he cautioned that mergers could simply create "larger troubled banks" by combining insolvent institutions.

China's banking regulator, the National Financial Regulatory Authority, has not responded to Reuters' request for comment.

Escalating Non-Performing Loans

Over the past decade, many small banks have borrowed aggressively from property developers and local government financing vehicles, leaving them vulnerable to the economic downturn and property market turmoil. As a result, rural commercial banks' bad loan ratio reached 3.04% in the third quarter of 2023, almost double the overall banking sector's 1.56%. Notably, analysts believe the financial health of smaller lenders is significantly worse.

For instance, Liaoning Rural Commercial Bank, a product of the government's merger efforts, absorbed 36 struggling small rural lenders in 2023. One of these institutions, Liaoning Dengta Rural Commercial Bank, reported a staggering 21.54% bad loan ratio in 2021, far above the sector average of 1.73% at the time.

Furthermore, Lanzhou Bank recently acquired two rural banks, according to the country's banking sector regulator. The financial details of the acquisition remain undisclosed, but the acquired banks' assets will be transferred to Lanzhou Bank, which had 453 billion yuan in assets and a 1.73% bad loan ratio as of end-2023.

Bank Mergers as a Solution?

The rural banks merger drive forms part of broader reforms launched by Chinese authorities in 2022 to overhaul the sector and address struggling institutions. However, these consolidations may not fully resolve the underlying issues, including high levels of bad assets and operational weaknesses.

"The problem is that there are so many small regional banks that the banking regulator clearly doesn't have the capacity to monitor them all," said Christopher Beddor, deputy China research director at Gavekal Dragonomics.

While the mergers create fewer, larger institutions that can be supervised more effectively, they may not eliminate the fundamental challenges facing the Chinese banking sector.