Henan protests highlight concerns over China’s rural banking sector

Two weeks after the veteran regulator Liu Rong arrived in the central province of Henan, plain clothes security officials clashed with hundreds of protesters outside a local branch of the People’s Bank of China.

The protesters were desperate to recover about Rmb40bn ($5.9bn) in frozen deposits from four rural banks. Beijing’s deployment of Liu, a veteran of Chinese bank regulation, suggested the central government wanted a speedy solution to the stand-off.

A day after the rare outbreak of public dissent on July 10, Liu’s team doused the flames of unrest with a promise to reimburse funds the protesters had lost to fraud — but wider damage had already been done.

The protests in Henan drew national attention, partly because local officials manipulated the personal health apps of more than 1,000 depositors to imply that they were at high risk of Covid-19, and prevent them from protesting. Five officials linked to the case have been fired or demoted.

Whereas bank deposits should be the safest assets in any financial system, the Henan case — which also involves one more bank in Anhui province — has raised concerns over lax regulation in China’s massive rural banking sector and exposed gaps in the country’s system of deposit insurance.

The problems at rural banks, although not regarded as a systemic financial risk in themselves, have heaped more pressure on an economy reeling from Covid-19, a years-long property downturn and a broader slowdown in growth.

“We are not worried about the rural banks in Henan per se,” said analysts from Citi, the US bank. “However, the situation could worsen if the public were to start worrying about other banks, especially some larger financial institutions.”

A run on the banks began in April after local police opened an investigation into privately held Henan New Fortune, the largest shareholder in all four institutions. They accused a criminal gang led by Lü Yi, owner of Henan New Fortune, of defrauding the banks by falsifying loans and illegally transferring funds.

On July 11, the China Banking and Insurance Regulatory Commission (CBIRC) promised to start paying back individual investors with savings of up to Rmb500,000 ($74,000). That will cost about Rmb20bn, according to S&P Global Ratings.

Regulators hope their approach will placate the loud majority of smaller depositors. The initial payments will come from recovered criminal funds, said regulators, but it is not yet clear how larger accounts will be repaid nor who will pick up the final cheque.

Harry Hu, senior director at S&P, said how regulators resolve the case will have a “profound impact” as an example for other local governments and distressed borrowers.

Many people had deposited less than Rmb500,000 at each bank to ensure their savings were protected by the country’s deposit insurance scheme. However, this scheme has limited reserves compared with other countries, and the Chinese authorities have hitherto not been clear on the classification of the lost money — if they deem it was stolen by fraud, the insurance might not apply.

“As the nature of the missing funds remains unclear at this stage, it’s uncertain whether the deposit-protection scheme would be triggered,” said S&P’s Hu.

In the wake of the Henan protests, China’s central bankers have played down the idea of a systemic threat to the financial system. “Financial risks are largely under control, and 99 per cent of our banking assets are within a safe range,” said Sun Tianqi, chief of PBoC’s financial stability bureau.

Still, PBoC officials have also said that rural banks remain the country’s most stressed, accounting for one-third of the 316 institutions deemed as being at “high risk” over their financial health.

For the past three years they have been scrutinising the small banks and their shareholders, focusing on loans from the banks to their own investors, a practice reminiscent of the US savings & loan crisis in the 1980s.

Since 2019, the CBIRC has been “naming and shaming” unscrupulous bank owners, leading to a slew of mergers in weak regions such as Shanxi and Liaoning, as part of its bid to improve regional bank governance.

Yet the resurgence of frauds in rural banking has left a question mark about the complicity of local regulators and whether the CBIRC has done enough to insulate the system from pervasive moral hazard during an economic downturn.

Instead, Beijing is accelerating the issuance of special local government bonds to inject capital into smaller banks. A total quota of Rmb103bn ($15.3bn) of such bonds was granted to the provinces of Liaoning, Gansu and Henan, plus the city of Dalian, in the first half of 2022. The banking watchdog has said more bonds will be issued by August.