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Chinese Banks are Writing Off More Loans and That is a Good Thing

December 6, 2016

By Walter Yao

In recent years, Chinese banks have become more aggressive in writing off their nonperforming loans as a way to address their asset quality issues. In 2015, the 27 publicly traded Chinese banks collectively wrote off RMB 415.9 billion (USD 60.1 billion1) in problem loans, almost doubling the amount recorded in the previous year. In the past, Chinese banks’ ability to write off loans was hampered by strict rules stipulated by the Ministry of Finance (MOF). The recent acceleration in loan write-offs by Chinese banks was made possible by the relaxation of tax rules in China.

The process of loan write-offs

Typically, a bank will write off loans (or portions of loans) when available information confirms that these loans are uncollectible. A write-off (also referred to as charge-off) removes the loans from a bank’s balance sheet and reduces the amount of loan loss allowances. Loan write-offs do not impact a bank’s income because the loss has already been accounted for via an increase in loan loss provisions. After the write-offs, banks will usually continue their collection efforts. If there are payments received from the borrower, the bank will record the recovered amount in loan loss allowances. 

Importantly, a loan write-off should not be confused with loan loss provisions. Under current accounting principles, a bank must provide for loan losses when it determines that it is probable that there are additional losses inherent in the loan portfolio. Loan loss provisions are expenses and negatively affect the overall net profits of the bank. From a supervisory perspective, it is a good practice to write off a loan on a timely basis as soon as the bank identifies that the loan does not have any realistic prospect of collection or recovery. From a bank’s perspective, the prompt removal of problem loans will make its loan books look “cleaner” and its nonperforming loan ratio more accurate.

Tax treatment of loan write-offs

The timing and process of loan write-offs can differ between jurisdictions because of tax or other legal reasons. In the United States, after loan loss provisions are recorded in the bank’s income statement, the bank cannot deduct that provision expense in its tax returns until the loans are written off. That creates a temporary difference (between book and tax income), leading to the recording of deferred tax assets on a bank’s balance sheet. In the United States, banks are expected to establish internal loan write-off procedures as part of their overall credit risk management policy. The writing-off of loans in banks’ tax returns does not need to be pre-approved by the U.S. tax authority. In the event the tax authority has questions relating to the appropriateness of the deduction, the federal banking agency can issue an “express determination letter” to provide conclusive support that the loan write-off conformed with regulatory standards.

Prior to 2010, Chinese banks were required to get approval from the MOF before removing problem loans from their books. The strict rules over charge-offs allowed authorities to prevent premature loan write-offs from negatively impacting the state budget. In most cases, a court also had to declare the borrower bankrupt before the lender could seek that permission. That rule began to be relaxed when the ministry allowed Chinese banks to write off small business loans of less than RMB 5 million (USD 0.7 million) after one year of collection efforts. During China’s first Financial System Stability Assessment by the IMF and the World Bank in 2010, the assessment team2 focusing on compliance with Basel Core Principles on Effective Banking Supervision also opined that “(Chinese) banks do not have the flexibility to write off those loans that they deem are uncollectible.” The report presented an example of a financial institution which indicated that its reported nonperforming loans were primarily “legacy” loans that it was unable to write off due to the strict conditions set by the MOF.

The acceleration of loan write-offs in China

As indicated on Table 1 below, the amount of net charge-offs3 taken by publicly traded banks in China has continued to rise since 2011. This is likely a result of subsequent reforms that have made it easier to write off loans beyond those for small businesses as well as a significant deterioration in asset quality following a large increase in lending in 2009. From 2012 to 2015, the amount of write-offs increased more than tenfold from RMB 30.8 billion (USD 4.4 billion) to RMB 415.9 billion (USD 60.1 billion). 

Table 1: Net Charge-offs and Average Nonperforming Loan Ratio at Publicly Listed Banks in China

Net Charge-offs of Listed Chinese Banks (RMB Millions)

  2012 2013 2014 2015
Industrial and Commercial Bank of China 6,636 15,523 36,866 59,207
China Construction Bank Corporation 5,502 14,957 34,404 90,536
Agricultural Bank of China Limited 3,909 8,964 28,081 40,099
Bank of China Limited 3,543 8,368 24,977 43,875
Bank of Communications Co., Ltd. 2,327 11,343 15,370 14,768
Total Large State Owned Commercial Banks (5) 21,917 59,155 139,698 248,485
Total National Joint Stock Commercial Banks (9) 7,046 28,868 77,569 151,856
Total City/Rural Commercial Banks (13) 1,920 4,281 8,390 15,562
Total Publicly Listed Banks (27) 30,883 92,304 225,657 415,903

Average Nonperforming Loan Ratio

  2012 2013 2014 2015
Publicly Listed Banks (27) 0.75% 0.83% 1.04% 1.32%
Source: SNL

During the same period, the average nonperforming loan ratio for Chinese banks increased modestly from 0.75 percent to 1.32 percent, but without the flexibility to write off problem loans, the reported nonperforming loan ratio would have been much higher and distort efforts to determine the actual asset quality conditions of the banks. Although comparisons between countries are difficult, the net charge off rate for Chinese banks still lags behind that of U.S. banks even after the increase in loan write-offs (see Table 2).

Table 2: Net Charge-off Rates for U.S. and Listed Chinese Banks

Aggregate Net Charge-offs/Aggregate Loans (%)

Year 27 Chinese Banks All U.S. Commercial Banks
2015 0.67 1.06
2014 0.40 1.18
2013 0.18 1.68
2012 0.07 2.54
Source: SNL, Call Report Data for U.S. Banks

Summary

The change in rules by the MOF has prompted Chinese banks to accelerate their loan write-offs; this should be seen as a step in the right direction. The timely identification of loans for write-offs also enhances the credibility and transparency of financial statements as banks do not have to maintain loans on their balance sheets that are no longer collectible. This is particularly important given continued strong credit growth and signs of asset quality deterioration in China.

1. An exchange rate of RMB1 = USD 0.1445 is used in this blog post.

2. The author was a member of the IMF assessment team during the Financial Sector Assessment Program in 2010.

3. Net charge-offs defined as gross charge-offs minus recoveries.

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Walter Yao

is a Director in the Division of Financial Institution Supervision and Credit (FISC) at the Federal Reserve Bank of San Francisco.