There once was a bank called Minsheng. Minsheng used to be an investor’s dream: growing earnings consistently above 30% per annum, benefiting from the boom that was the Chinese economy. But times have become tougher for Minsheng of late: Minsheng just printed its first year-on-year decline in pre-tax profit since the global financial crisis.
You see, Minsheng is still growing its loan book at a steady rate of 13 percent per annum. But lending in China is not what it used to be. Net interest margins are being squeezed from both directions: (i) interest rates on new loans are not what they were as too much credit chases too few economic businesses; and (ii) deposit rates have been deregulated meaning Minsheng actually needs to compete with other banks for deposits.
Furthermore, Minsheng is being forced to rapidly book impairment allowances (which reduces profit) for existing loans that are deteriorating in credit quality. Consider the chart below: the proportion of the total loan book that is now classified as poor quality (impaired and “special mention”) has accelerated sharply to over five percent, from around three percent last year.
Minsheng is not even booking enough allowances in its income statement to meet these poor loans – suggesting Minsheng’s earnings and book value are likely overstated.
So, as the profitability of lending deteriorated, Minsheng needed a new game. Enter fees and commissions from “asset management”. Not a new trick at all – indeed many banks in the world are favouring these sorts of earnings streams as they are less capital intensive and, therefore, carry with them higher returns on equity.
This strategy has (just) plugged the gap, as the chart below illustrates. One can see the annual contribution (or detraction) to earnings from lending versus from fees and commissions. It does not take a genius to figure out that if lending profitability continues to deteriorate at this rate, then fees and commissions will not be enough to offset it.
From where did these earnings magically appear? Well, Minsheng, along with many of his peers, have got into the wealth management product (WMP) origination business. WMPs are short-term (e.g. 1-3 months), high-yielding pieces of paper that have become popular with Chinese investors in place of deposits. The WMPs are typically backed by very long-term assets, including property and infrastructure projects. (You can see immediately the inherent mismatch of funding long-duration assets with short-duration funding).
While this might sound risky (and we believe it is), investors are less concerned if the WMPs have been sponsored by a “reputable” bank. The reason is that investors believe they are granted an implicit guaranteed by the bank on the return of their capital. This idea remains untested, though we can get an insight into the credibility of any potential guarantee by looking at the size of the outstanding issues relative to Minsheng’s book value of equity.
Shown below, the combination of WMP trust products sponsored by Minsheng and others (where Minsheng retains an interest), combined with other off balance sheet guarantees equates to nearly 8x book value. Said another way, it would take only a 12.5% loss on the underlying assets to completely wipe out Minsheng’s equity rendering it insolvent. And these are just the exposures off Minsheng’s balance sheet.
The sharp growth of more than 70% per annum has been motivated by the need to fill an increasing hole in Minsheng’s income statement from the sharp reduction in profitability on lending, in our opinion. Is there a limit to this growth? We surely hope so.
Minsheng has even been eating its own cooking. On the one hand this is positive to the extent Minsheng believes in the quality of its trust assets. On the other hand, these assets have been a clever way for Minsheng to skirt capital and credit testing requirements that would normally apply to loans. Regulators have allowed Minsheng not to apply these rules to trust assets, though this now looks to be changing.
Minsheng is looking at some tough times ahead, in our view. As China slows, demand for loans will slow; net interest margins are already narrowing; credit quality of existing loans are deteriorating at an accelerated rate; and the sharp growth in fee and commission income that was being used to plug the gap may well be coming to an end. Earnings must decline. And that is the best case scenario. Worse could be a string of defaults in the underlying assets that back the WMPs – though let’s not go there for now.
Montaka is short the shares of China Minsheng Banking Corp (HKEx: 1988)
Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.