china chinese banks banks stay positive industry...

Deutsche Bank Markets Research

Asia China Banking / Finance Banks

Industry

Chinese Banks − Stay Positive

Date 17 September 2013

Industry Update

Unintended benefits from the next phase of financial sector reforms Asset quality concerns overdone; positive stance maintained

________________________________________________________________________________________________________________

Deutsche Bank AG/Hong Kong

Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 054/04/2013.

Tracy Yu

Research Analyst (+852) 2203 6191 [email protected]

Sukrit Khatri

Research Associate (+852) 2203 5927 [email protected]

Top picks

ICBC (1398.HK),HKD5.54 Buy

China Construction Bank (0939.HK),HKD6.14

Buy

Agri. Bank of China (1288.HK),HKD3.71 Buy

Bank of China (3988.HK),HKD3.60 Buy

Source: Deutsche Bank

Companies Featured

ICBC (1398.HK),HKD5.54 BuyChina Construction Bank (0939.HK),HKD6.14

Buy

Agri. Bank of China (1288.HK),HKD3.71 BuyBank of China (3988.HK),HKD3.60 BuyBank of Communications (3328.HK),HKD5.89

Buy

China Merchants Bank-H (3968.HK),HKD14.52

Buy

China CITIC Bank (0998.HK),HKD4.27 BuyChina Minsheng Bank (1988.HK),HKD9.67 HoldChongqing Rural Bank (3618.HK),HKD3.94 BuyChina Everbright Bank (601818.SS),CNY2.96

Hold

Source: Deutsche Bank

We believe asset quality concerns for the H-share listed banks, especially the big four banks, are overdone given the recovering economy. Our cash flow analysis does not suggest under-reporting of NPLs, an outcome further confirmed by interest receivables accounting for only 46bps of the banks' assets, comparable to the Hong Kong banks. In addition to the falling perceived asset quality risks, we expect the next phase of financial sector reform to drive market risks down, unintentionally benefiting the bank share prices, although selected joint stock banks like MSB might be more affected by tighter regulation on inter-bank exposure and deposit rate deregulation.

Unintended benefits from the next phase of financial sector reforms We believe that the new reform policies announced by regulators, such as the issuance of preferred shares, asset securitization and the formation of free trade zone in Shanghai, are positive developments for the H-share listed banks. In addition to the obvious benefits of newer businesses and reduced capital pressure on banks, we see the emergence of new market-driven benchmarks (e.g. lower-than-expected yields of preferred shares issued by the big four banks) driving the market risks lower and unintentionally benefiting the share prices of the banks. Our preferred shares are extremely long-dated and non-cumulative tier 1 debt instruments that are subject to investment risks such as skipping of payments and forced conversion if the earnings and core tier 1 (CT1) ratio fall short of target levels.

Cash flow analysis demystifies asset quality concerns of H-share banks In this report, we have extensively analyzed the asset quality of Chinese banks and, assuming a stable economy, expect risks to be low despite the growth of the shadow banking system. Most importantly, our cash flow analysis does not suggest under-reporting of NPLs, as the increase in PBT of the H-share listed banks from 2007 to 2012 is matched by the net increase in cash. The analysis is further confirmed by accrued interest income accounting for 46bps of the assets of these banks (versus 74bps for India, 57bps for HK), making us confident about the asset quality of listed banks.

Stay positive despite tighter regulatory atmosphere; we prefer big four banks Under pressure to sustain profitability despite weaker deposit franchises, joint-stock banks have been serving as intermediaries to the liquid banks and non-bank financial system, leading to a higher issuance of WMPs and increased financing for the shadow banking system through inter-bank transactions. Our analysis shows that if the CBRC were to raise the risk weighting of the financial assets sold and held under resale arrangements that were collateralized against bills to 75%, and that of trust beneficial rights to 100% to slow the flow, the CT1 for the H-share listed banks would be lowered by 23bps to 9.44%, with the bigger negative impact felt by joint-stock banks like MSB (-1.32%) to 6.54% and CRCB (-1.42%) to 9.5%. Hence, we maintain the big four banks as our top picks, with our estimates showing the sector trading on 5.8x 2013E P/E and 1.1x 2013E P/B. We identify a slowing Chinese economy as the key risk to the sector’s performance.

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Table Of Contents

Investment summary ........................................................... 3 Stay positive; the next phase of financial sector reforms to drive market risks down ..................................................................................................................... 3

Asset quality – Why things are better than they look ......... 5 Chinese banking system is highly concentrated, with the three policy banks being non-profit seeking ...................................................................................... 5 Reported NPLs, cash flow and interest accrual analysis on banks all suggest asset quality concerns are largely overdone ........................................................ 7

Shadow banking system – reasons, trends and risks ....... 10 Shorter loan duration, refinancing LGFV loans and role of joint-stock banks ... 10 Trust companies are playing a key role in growth ............................................. 11 Relationship between banks and shadow banking system ............................... 14 Joint-stock banks are more vulnerable to liquidity and credit risks of the shadow banking system ..................................................................................... 16 Our proprietary research trips in China suggest risks are high; but risk management seems effective amid stable economy ........................................ 17 Shadow banking is transforming the risk profile of the banking system – CBRC could effectively slow the flow ........................................................................... 19

Valuation and risks ............................................................ 21 Valuation of Chinese banks ................................................................................ 21 Key risks for Chinese banks ............................................................................... 22

Appendix A ........................................................................ 24 Major regulations and policies of the trust business ......................................... 24

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Investment summary

Stay positive; the next phase of financial sector reforms to drive market risks down

In this report we highlight that the new reforms announced by Chinese regulators recently, including the issuance of preferred shares, asset securitization and the formation of free trade zone in Shanghai, should be positive to the Chinese banking sector. As such, we expect the share price performances of the H-share listed banks to be supported by the announcements of policy details over the course of the next few months. These reforms are expected to further deregulate the financial sector, the RMB exchange rate and deposit rates.

In addition to the obvious benefits of creating newer businesses and reduced pressure on the issuance of common equities, we believe one of the most positive factors is the emergence of market-based prices to improve credit allocation and reduce distortions. In addition, we believe that some of the prices might become powerful benchmarks to evaluate the risks taken by the Chinese banks and indicate whether the current share prices are under- or overvalued.

In our view, the market yields for preferred shares issued by the big four banks are the most relevant benchmarks, as these prices should indicate long-term risks that institutional investors are willing to take in terms of skipping of payments and forced conversion into common equity when earnings and the target core tier 1 ratio fall short of a target level. Our preferred shares are extremely long-dated tier 1 debt that is non-accumulative and does not carry a voting right.

Given China’s high savings rate and strong demand for fixed income instruments and the relatively low yields cleared for the dim sum bond market in Hong Kong, we see a high possibility that the yields of the preferred shares for the big four banks might be cleared at a level that is not significantly higher than their dividend yields. In this case, we believe the H-share listed banks might be re-rated on falling perceived asset quality risks, given their low valuation of 5.8x 2013E P/E and 1.1x 2013E P/B, and given their ROAE of 19.1%. Our earnings forecasts for FY2013 already incorporate the negative impact of the deposit pricing band widening to 1.2x (current: 1.1x) of the benchmark deposit rates.

In this report, we provide detailed reasoning on why market concerns on the asset quality of the H-share listed banks seem to be overdone if China’s economy continues to be stable. A summary of our key points can be found below:

Our cash flow analysis suggests that NPLs are not under-reported by the H-share listed banks, and this is supported by the fact that accrued interest income accounts for only 46bps of assets, slightly better than that for the Hong Kong banks. As a result, we believe concerns about the asset quality of the H-share listed banks have been largely overdone.

Tighter bank regulations since 2009 has fueled strong growth in shadow banking, which we estimate to be at Rmb12.5trn as of June 2013 (or 21.9% of 2013E China’s GDP), a twofold rise in the last 2.5

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years. In particular, restrictions against bank lending to LGFVs and property developers have led to increased demand for credit from non-banking institutions. Property, local government and small and micro enterprise exposures likely account for the bulk of shadow banking exposures.

Our estimated size of the shadow banking system at Rmb12.5trn is smaller than forecasts by other commentators, as we primarily include credit granted by the non-bank financial institutions, which are riskier, and exclude issuance of corporate bonds and short-term corporate financing provided by banks through bank acceptance.

Our proprietary research trips in China, where we met government officials and over 30 non-bank credit operators in Beijing, Shanghai, Hangzhou, Xi’an, Shenyang, Hohhot, and Ordos, suggested that although the magnitude of default risk is higher for the less regulated non-bank financial system, the management of these risks seems entirely market-driven and generally effective.

The shadow banking system seems to be funded primarily through (1) issuance of wealth management products by banks, reaching Rmb9.1trn as of June 2013 (one-third is invested in trust and other loans); (2) inter-bank financing, as indicated by sharply rising financial assets held by H-share banks under resale arrangements, reaching Rmb5.2trn as of June 2013; and (3) some small proprietary investments made by the banks, totaling Rmb140.4bn by the H-share listed banks as of June 2013.

The largest segment of the shadow banking system is the trust sector, which has seen AUM grow to Rmb9.5trn as of June 2013 (of which 44% were trust loans), doubling in 18 months. Trusts are regulated by the CBRC, with key players backed by large financial institutions as their major shareholders.

The systemic concerns raised by the growth of shadow banking arise from the reliance of shadow banks on funding from the banking system, as this high connectivity means credit or liquidity risks in shadow banking could evolve into counterparty risks for the banks.

Amongst the listed banks, the largest commercial banks (ICBC, CCB, ABC, BOC and BoCom, which account for 45% of banking system assets) have proportionately the lowest exposure to shadow banking. The three policy banks, which account for about 8% of assets, have pure sovereign risk.

The risks appear to be greatest for the joint-stock banks (18% of assets), which are the main intermediaries between the banking system and the non-banks. They have disproportionately large exposures to WMPs and to inter-bank assets collateralized against bills and trust beneficial rights. Unsurprisingly, this group of banks was at greatest risk during the “Shibor shock” in June as wholesale funding dried up.

We believe the CBRC could effectively slow the flow to the shadow banking system by increasing the risk weightings on resale agreements. Our analysis shows that if the weighting on resale agreements collateralized against bills was raised to 75% and that of trust beneficial rights to 100%, the CT1 of the H-share listed banks would be lowered by 23bps to 9.44%, with the biggest negative impact felt by joint-stock banks like MSB (-1.32% to 6.54%) and CRCB (-1.42% to 9.5%).

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Asset quality – Why things are better than they look

Chinese banking system is highly concentrated, with the three policy banks being non-profit seeking

In the absence of a strong and liquid capital market, China’s financial system is heavily dependent on the banking system, which consists of a highly concentrated network of banks, finance companies and other banking institutions.

China’s regulated financial system, which has Rmb133.4trn in assets and Rmb1.5trn in profits, is dominated by the big five commercial banks (ICBC, CCB, ABC, BOC, and BoCom – partly state-owned, partly privatized), which enjoy over 50% of the system’s net profit, while employing 45% of the total system assets and 46% of listed equity (as of December 2012).

As Figure 1 shows, the next layer of the regulated financial system is made up of the national joint-stock commercial banks, 12 in total, which are neither wholly state-owned nor wholly private, and sometimes controlled by SOEs, with the help of minority foreign bank shareholders. These make up 18% of total assets, 15% of total equity and 17% of net profit. In addition, there exist smaller financial institutions in the form of city commercial banks (144) and rural financial institutions (2,411), which are dispersed throughout the country with influence restricted to their respective locations.

Figure 1: An overview of the regulated banking system in China (as of and for the year ending 31 December 2012) No. of legal

institutions Total assets (RMB bn)

Shareholders' equity (RMB bn)

Net profit (RMB bn)

NPL ratio Loss ratio

Total amount Mkt shr Total amount Mkt shr Total amount Mkt shr

Large Commercial Banks

5 60,040 45% 3,952 46% 755 50% 1.0% 0.1%

National Joint Stock Commercial Banks

12 23,527 18% 1,314 15% 253 17% 0.7% 0.1%

Policy Banks 3 11,217 8% 553 6% 74 5%

City Commercial Banks

144 12,347 9% 808 9% 137 9% 0.8% 0.1%

Rural Financial Institutions

2,411 15,512 12% 996 12% 161 11% 1.8% 0.1%

Foreign Banking Institutions

42 2,380 2% 256 3% 16 1% 0.5% 0.1%

Other Banking Institutions

1,130 8,599 6% 792 9% 116 8%

Total 3,747 133,622 100% 8,671 100% 1,512 100% 1.0% 0.1% Source: Deutsche Bank

There are also three policy banks (China Development Bank, Export Import Bank and Agricultural Development Bank) that are wholly government-owned, non-profit and primarily engaged in lending for infrastructure, trade and agriculture respectively. As a result, the LDR ratios of these banks are not comparable with the commercial banks in China, and the asset quality of the policy banks are not constrained by their ability to take deposits.

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Figure 2: Policy banks: Loans and deposits outstanding

vs. Gross loans as a % of GDP

Figure 3: Gross loans for policy banks in China (2009-

2012)

3.13.6

4.6

5.8

6.9

8.3

9.8

0.3 0.4 0.5 0.7 0.8 0.9 1.1

14.5%13.6%

14.5%

16.9% 17.2%17.6%

18.8%

8%

10%

12%

14%

16%

18%

20%

0.0

2.0

4.0

6.0

8.0

10.0

12.0

2006 2007 2008 2009 2010 2011 2012

Rmb tnLoans Outstanding (LHS) Deposits Outstanding (LHS)Loans as % of GDP (RHS) Rmb Bn 2009 2010 2011 2012

China Development Bank

3,708 4,510 5,526 6,418

Agri. Development Bank of China 1,451 1,671 1,876 2,185

Export Import Bank

592 708 914 1,183

Total 5,752 6,888 8,316 9,786

Source: Deutsche Bank ,CEIC, company data Source: Deutsche Bank, company data

As of December 2012, the three policy banks gave out Rmb9.8trn in loans, but made only Rmb74bn in profits. The bulk of these loans are LGFV loans, with losses to be absorbed by the state. Figures 4 to 6 provide loan breakdowns for the three policy banks as of FY12.

Figure 4: Loan breakdown of China

Development Bank (FY12)

Figure 5: Loan breakdown of Export

Import Bank (FY12)

Figure 6: Loan breakdown of Agri.

Development Bank of China (FY12)

Transportation, 1,942, 30%

Public utilities &

environment protection, 1,886, 30%

Petroleum, Petrochemical and chemical industry, 529,

8%

Others, 2,061, 32%

China Development Bank (FY12 Loans: Rmb 6,418bn)

Export seller's credit, 378 ,

32%

Export buyer credit , 159 ,

13%

Import credit, 270 , 23%

Others, 376 , 32%

Exim Bank (FY12 Loans: Rmb 1,183bn)

Grain and edible oil,

896.2, 41%Others,

1,288.8, 59%

Agri Development Bank of China (FY12 Loans: Rmb 2,185bn)

Source: Deutsche Bank, company data, CEIC Source: Deutsche Bank, company data, CEIC Source: Deutsche Bank, company data, CEIC

Operating in the “shadows” of the banking system in China are a host of other financial institutions which make up the non-traditional financial system, or the “shadow banking system”, and comprise both regulated (asset management companies, trust companies, money leasing and brokerage firms) and less regulated companies (pawn shops, peer-to-peer lenders, credit guarantee companies and leasing companies). The shadow banking system has grown rapidly in size and influence over the past few years, with total credit issued by these companies rising over two-fold in the last 2.5 years to reach Rmb12.5trn as of June 2013, according to Deutsche Bank estimates.

Our estimate for the size of the shadow banking system is smaller than forecasts provided by other commentators, as we primarily include credit granted by the non-bank financial institutions, which are riskier, and exclude issuance of corporate bonds and short-term corporate financing provided by banks through bank acceptance.

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Reported NPLs, cash flow and interest accrual analysis on banks all suggest asset quality concerns are largely overdone

Despite the strong asset quality displayed by the H-share banks in the 1H13 results, with NPL growth slowing to 3.3% qoq in 2Q13 (versus 4.97% qoq in 1Q13), market concerns continue to persist on the credibility of the NPL ratio of 0.97% for the sector.

To allay those concerns, we have undertaken a cash flow analysis, which does not suggest under-reporting of NPLs, as the increase in the pre-tax profit of the H-share listed banks from 2007 to 2012 was matched by the net increase in cash. This suggests that loans performed normally during that time, with asset quality concerns and doubts surrounding the credibility of the NPL ratio largely overdone.

If Chinese banks under-report a notable amount of NPLs by classifying them as normal loans, we expect the sector’s reported net profit to be higher than its cash profits, as interest income is accrued instead of paid in cash.

Figure 7: Chinese banks: Ratio of net increase in cash adjusted for dividends to profit before tax Rmb bn 2007 2008 2009 2010 2011 2012 Total

Profit before income tax 468 503 600 810 1,058 1,201 4,640

Net cash flow from operation 798 1,731 888 846 1,463 2,067 7,792

Net cash flow from investing -887 -195 -1,610 -792 88 -1,055 -4,451

Net cash flow from financing 88 20 32 237 90 55 522

Net increase in cash & cash equivalent -2 1,556 -690 290 1,641 1,032 3,828

Dividends -102 -156 -126 -212 -198 -252 -1,046

Net increase in cash adjusted for dividends 101 1,712 -563 502 1,839 1,318 4,908

Net increase in cash/PBT 21% 340% -94% 62% 174% 110% 106% Source: Deutsche Bank, company data Note: Companies covered include ICBC, CCB, ABC, BOC, BOCOM, CMB, MSB, CNCB, CRCB and CEB

Analyzing the ratio by bank, we see that the ratio is close to unity for the big four banks (ranging from 86% to 120%), while the smaller shareholding banks display more volatility.

Figure 8: Chinese banks: Ratio of net increase in cash to

PBT (from 2007 to 2012)

Figure 9: Volatility displayed by the ratio of net increase

in cash and PBT

199%184%

172%

120%103% 102%

86%

48% 46%

6%

106%

0%

50%

100%

150%

200%

250%

-400%

-200%

0%

200%

400%

600%

800%

1000%

2007 2008 2009 2010 2011 2012 Total

BoCom CMB MSB CNCB CRCB CEB

Source: Deutsche Bank, company data Source: Deutsche Bank, company data

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Our view is further supported by our analysis of accrued interest income (or interest receivables), which only accounted for 46bps of the assets of the H-share banks, with a range from 30bps (Minsheng Bank) to 52bps (CRCB). On a regional basis, Chinese banks performed better than banks in Hong Kong (57bps) and India (74bps), suggesting that there is nothing untoward about the asset quality of the H-share banks.

Figure 10: Chinese banks: Interest receivables as % of

assets (FY12)

Figure 11: Asia: Interest receivables as % of assets

(FY12)

0.52%0.50%

0.49%

0.46%0.45%0.44%0.44%0.43%0.42%

0.38%

0.30%

0.46%

0.25%

0.30%

0.35%

0.40%

0.45%

0.50%

0.55%

0.17% 0.18%0.24%

0.29%0.33%

0.39%

0.46%

0.52%0.57%

0.74%

0.00%

0.10%

0.20%

0.30%

0.40%

0.50%

0.60%

0.70%

0.80%

TH TW SG AU ID KR CH PH HK IN


Shadow banking system – growing in size and influence As mentioned above, the shadow banking system has grown rapidly in size and influence over the past two years, to reach a total of Rmb12.5trn in June, a twofold rise in the last 2.5 years. As Figures 12 and 13 show, trust loans make up the majority of the shadow banking system, comprising 34% of total loans, followed by unregulated private lending (33%).

Figure 12: Growth in credit issued by the shadow

banking system in China

Figure 13: Composition of credit issued by shadow

banking system

32 55 71 67912 1,300 1,460 1,547

2,4003,380 3,718 4,090

1,573

1,735

2,9994,215

198

392

592

704

700

930

1,550

1,900

5,814

7,791

10,390

12,524

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

FY10 FY11 FY12 1H13

RMB bn

Financial leasing company

Small-loan company

Trust loan

Private lending

Credit guarantees

Pawn loans

Unregulatedportion

0.6% 0.7% 0.7% 0.5%

15.7% 16.7% 14.0% 12.4%

41.3% 43.4%35.8%

32.7%

27.0% 22.3%28.9% 33.7%

3.4% 5.0%5.7% 5.6%

12.0% 11.9% 14.9% 15.2%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

FY10 FY11 FY12 1H13

Financial leasing company

Small-loan company

Trust loan

Private lending

Credit guarantees

Pawn loans

Source: Deutsche Bank, CEIC, PBOC Source: Deutsche Bank, CEIC, PBOC

In order to account for the additional credit provided to the financial system by the non-bank institutions, PBOC reports a broader measure of credit available to the economy, “total social financing” (TSF), which posted a CAGR of 23% over the past decade (2002-2012). While the banking component of TSF registered a CAGR of 17% during this period, non-bank financing witnessed a CAGR of 54%, and constituted 44% of the total new social financing in 1H13 (up from 5% in 2002).

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Figure 14: Absolute level of total social financing (2002-

1H13)

Figure 15: Breakdown of total social financing into bank

and non-bank financing

0.1 0.4 0.5 0.5 1.0 1.9 1.93.4

5.6 4.86.6

4.51.9

3.0 2.4 2.53.3

4.0 5.1

10.58.4

8.0

9.1

5.7

2.0

3.42.9 3.0

4.3

6.07.0

13.9 14.012.8

15.8

10.2

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 1H13

RMB trnNon-bank financing Bank financing

CAGR (FY02-FY12)Total social financing: 23%Bank financing: 17%Non-bank financing: 54%

512 16 17 23

33 27 2440 37 42 44

9588 84 83 77

67 73 7660 63 58 56

0

10

20

30

40

50

60

70

80

90

100


% Non-bank financing Bank financing

Source: Deutsche Bank, CEIC Source: Deutsche Bank, CEIC

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Shadow banking system – reasons, trends and risks

Shorter loan duration, refinancing LGFV loans and role of joint-stock banks

The unbridled growth in the shadow banking system has been primarily brought about by the shortening loan duration over the past two years. Over the past two years, the average loan duration of the banks has shortened from 2.43 years in 2010 to 2.22 years in 2012, reflecting a move towards shorter-dated bank loans. The trend is confirmed by the split of new loans, with only 53% of new loans being medium-to-long term in 1H13, as against 86% in 2010. (Figure 17)

Figure 16: The average loan duration of the H-share listed banks Years 2008 2009 2010 2011 2012

ICBC 2.47 2.70 2.83 2.63 2.57

CCB 2.47 2.68 2.85 2.69 2.63

ABC 2.07 2.27 2.43 2.36 2.33

BOC 2.42 2.55 2.63 2.53 2.54

BoCom 1.72 2.14 2.24 2.18 2.15

CMB 1.72 2.06 2.24 2.11 1.96

CNCB 1.63 1.78 1.91 1.76 1.61

MSB 1.78 1.90 1.77 1.63 1.40

CRCB 1.62 1.94 2.97 3.11 2.76

Average 1.99 2.22 2.43 2.33 2.22 Source: Deutsche Bank, company data

In the absence of changes in the underlying economy, the shortening corporate loan duration has forced corporates to rely on non-bank modes of financing (bonds, trust and entrusted loans, microfinance issued by small money lenders) to bridge the funding mismatch gap. As a result, alternative financing has steadily gained in importance, and as of June it made up 44% of the total new social financing entering the financing system (up from 5% in 2002).

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Figure 17: Mix change in the tenure of new bank loans in

China

Figure 18: Maturity profile of LGFV loans

41%27%

14%

55% 62%47%

59%73%

86%

45% 38%53%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2008 2009 2010 2011 2012 1H13

New short-term loan New medium-to-long term loan

1.21

0.85

1.391.5

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

2011 2012 2013-2015 2016 onwards

RMB trn

Source: Deutsche Bank, CEIC, PBOC Source: Deutsche Bank, NAO

The refinancing of the Rmb2trn of LGFV loans maturing in 2011 and 2012 (Figure 18) has also played a part in the growth of the shadow banking system, which is in part being fueled and funded by joint-stock banks burdened by the over-regulation of China’s banking sector and the maintenance of a 75% LDR cap. We explore this more under the heading “Relationship between banks and shadow banking system”.

Trust companies are playing a key role in growth

Over the past three quarters, trust loans have contributed over 10% of the new social financing in China (vs. average of 4.9%), indicating their importance in the growth and spread of the shadow banking system in China. While regulated by the CBRC, trust companies have been growing in financial importance over the past three years, and have seen AUM jump to Rmb9.5trn in 1H13 from Rmb2trn in 2009.

Figure 19: Trust loans as a percentage of total social financing

1.9%2.9%

4.5%3.1% 2.8%

1.6%

4.6% 4.1%

9.2%

14.6%13.4%

10.2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

2006 2007 2008 2009 2010 2011 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13

Trust loan as % of total social financing Average

Average (2006-2Q13): 4.9%

Source: Deutsche Bank, CEIC

Figures 20-22 show that the net profits of trust companies posted a CAGR of 38% between 2009 and 2012, to reach Rmb35.5bn as of December 2012, while equity saw a CAGR of 23% during the same period. Trust companies, which are usually backed by strong parents like CITIC, CCB, and Ping An, had

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total assets of Rmb252bn as of June 2013 (three-year CAGR of 21%), but managed assets worth Rmb9.5trn.

Figure 20: Net profit of trust

companies in China

Figure 21: Total equity vs. ROE Figure 22: Total assets vs. AUM

13.6 16.0

24.3

35.5

11%18%

52%

46%

10%

15%

20%

25%

30%

35%

40%

45%

50%

55%

10.0

15.0

20.0

25.0

30.0

35.0

40.0

2009 2010 2011 2012

RMB bnNet profit (LHS) YoY (RHS)

2009-2012 CAGR: 37.7%

108

132

163

203

225

12.6%13.3%

16.5%

19.4%

10%

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

100

130

160

190

220

250

2009 2010 2011 2012 1H13

RMB bnTotal equity of trust companies (LHS) ROE (RHS)

2009-1H13 CAGR: 23.3%

130

148

183

228

252

2.04

3.00

4.80

7.50

9.46

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

100

130

160

190

220

250

280

2009 2010 2011 2012 1H13

RMB trnRMB bnTotal assets of trust companies (LHS) AUM (RHS)

2008-2012 CAGR: 20.8%

Source: Deutsche Bank, China Trustee Association, KPMG Source: Deutsche Bank, China Trustee Association, KPMG Source: Deutsche Bank, China Trustee Association, KPMG

To understand the importance of trust companies to the growth of non-bank financing sector in China, we analyze the growth of the AUM of trust companies versus other non-bank financing sectors (insurers, brokers and funds). As Figures 23 and 24 show, the AUM of trust companies, which have risen close to 5x since 2009, are the highest in the non-bank financing sector (Rmb7.5trn for FY12). This compares with the AUM of Rmb7.36trn for Chinese insurers and Rmb1.9trn for Chinese brokers as of Dec 2012.

Figure 23: Growth of AUM by Chinese financial

companies (2007-2012)

Figure 24: AUM of trust companies vs. bank WMPs,

insurers, mutual funds and brokers (2011 and 2012)

1.01.2

2.0

3.0

4.8

7.5

2.9 2.9

4.1

5.0

6.0

7.4

0.1 0.1 0.1 0.2 0.3

1.9

3.3

1.9

2.6 2.4 2.2

2.9

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

2007 2008 2009 2010 2011 2012

RMB tn China Trust China Insurers China Brokers China Funds

4.59 4.81

6.01

2.19

0.28

7.107.47 7.35

2.87

1.89

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

Bank WMPs Trust companies Insurers Mutual fund Brokers

RMB trn2011 2012

Source: Deutsche Bank, Asset Management Association of China, CBRC, CIRC, Securities Association of China, China Trustee Association Source: Deutsche Bank, Asset Management Association of China, CBRC, CIRC, Securities Association

of China, China Trustee Association

As Figure 25 shows, assets managed by trust funds are primarily divided into single fund trusts and collective fund trusts. As of June 2013, the outstanding assets managed by single fund trusts amounted to Rmb6.7trn or 71% of the total trust assets. Another Rmb2.1trn or 23% were invested under collective fund trusts.

The risk weighting imposed on assets managed under collective fund trusts is generally higher than that for single fund trusts to reflect the more diversified ownership of risks amongst smaller investors. Approximately 69% of the assets managed under single fund trusts are made up of loans, followed by another 15% invested in available for sale & held to maturity investments (Figure 26).

17 September 2013

Banks



Figure 25: Assets under management of trust companies

– breakdown by business

Figure 26: Breakdown of new investments of single fund

trusts by product

0.3 0.3 0.5 0.6 0.8 1.0 1.1 1.4 1.5 1.6 1.7 1.9 2.1 2.21.9 2.4 2.3 2.3 2.3 2.6 2.83.3 3.6 3.7

4.35.1

6.16.7

0.20.1 0.1 0.1 0.1

0.2 0.20.2

0.2 0.30.4

0.5

0.50.5

2.42.9 3.0 3.0 3.3

3.7 4.14.8

5.3 5.56.3

7.5

8.79.5

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0RMB trn

Collective Fund Trust: compound growth rate of 16.6%qoqSingle Fund Trust: compound growth rate of 10.1% qoqManaging Property Trust: compound growth rate 9.7%qoq

8066

59 61 61 65

46 4151

65 68 69 73 69

2

46 3

5

6

1

2

2 1 22

2

6

1311

159

14

28

33 12

15 16 1414

15

29

10

5

3

33

3

2

55 3 2 4

2 3 105

15

710

9 26

2 1 2 1 18 10 8 7 10 5 7

146 10 9 10 8 9

0%

20%

40%

60%

80%

100%Others

Due from other financial institutionsLong Term Equity InvestmentAFS & HTM Investment

Transactional Financial Asset

Loan

Source: Deutsche Bank, CEIC. Source: Deutsche Bank, CEIC, PBOC, CIRC, SAC, AMAC

Figure 27 shows that investments for single funded trusts are primarily packaged loans lending to industry (29%), manufacturing (27%) and real estate (9%). Trust funds’ investments into the risky real estate sector have fallen from a high of 17% in 3Q11 to 9% in 2Q13.

Figure 27: Breakdown of trust investment by industry Figure 28: Trust funds’ investment in real estate

40 38 36 34 32 28 25 22 22 23 23 24 26 27

11 11 13 15 1617

1715 13 13 11 10 9 9

6 6 8 9 10 109

9 9 10 11 12 11 10

10 8 6 5 6 79

13 14 12 11 10 9 11

15 19 19 19 18 19 21 20 22 24 25 27 28 29

19 18 18 17 19 19 19 21 20 18 18 18 17 14

0%

20%

40%

60%

80%

100%Others

Industrial & Commercial EnterpriseFinancial Institution

Securities Market

Real Estate

Foundational Industry

235

315378

432487

605

680 688 687 675 677 688

770812

11%11%

13%15% 16%

17% 17%

15%13% 13%

11%10% 9%

9%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

0

100

200

300

400

500

600

700

800

900RMB bn

Trust fund invested to real estate (LHS) As % of total fund trust (RHS)

Source: Deutsche Bank, CEIC. Note: Foundation industry includes agriculture, manufacturing, light and heavy industries, infrastructure and services Source: Deutsche Bank, CEIC

These trust companies usually function on a cooperation model, with trust investments guaranteed by the other entity – be it a bank, local government or private entity. From 3Q10, government-trust cooperation has seen a CAGR of 7%, leading to strict monitoring and regulation of this relationship by the PBOC from 2012 onwards. Bank-trust cooperation, on the other hand, posted a CAGR of 1% over this period, and accounted for Rmb2.1trn as of June 2013, over one-fifth of the total trust cooperation, followed by Rmb0.80trn and Rmb0.26trn with the local government and private funds, respectively. In Appendix A, we mention the key policies and regulations that have affected the trust business since 2009.

17 September 2013

Banks



Figure 29: Cooperation between trusts and other entities

(3Q10–2Q13)

Figure 30: Cooperation between trusts and other entities

(2Q13)

1.89

1.661.53 1.61 1.67 1.67

1.79 1.77 1.842.03 2.11 2.08

0.38 0.36 0.32 0.29 0.28 0.25 0.25 0.33 0.390.50

0.650.80

0.10 0.13 0.14 0.14 0.14 0.17 0.18 0.20 0.22 0.26 0.27 0.26

0.00

0.50

1.00

1.50

2.00

2.50

3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13

RMB trn

Bank-trust cooperation; CAGR: 0.9% qoqTrust-government cooperation; CAGR: 7% qoqPrivate fund cooperation; CAGR: 9.1% qoq

Bank-Trust cooperation, 2.08tr, 22%

Govt.-Trust cooperation, 0.80tr, 8%

Private fund cooperation, 0.26tr, 3%

Others, 6.31tr, 67%

Total cooperation between trust and other entities (2Q13): Rmb 9.5trn

Source: Deutsche Bank, WIND, CEIC Source: Deutsche Bank, WIND, CEIC

Relationship between banks and shadow banking system

The recent SHIBOR squeeze displayed the uneven distribution of liquidity in China’s financial system, where the largest banks dominate deposit-gathering, while the smaller banks have been “crowded out” to look for other means of maintaining their liquidity. This has led to a system where the smaller joint-stock Chinese banks are financing the shadow banking system through two main channels – inter-bank lending and wealth management products (WMPs).

Banks’ cooperation with trust companies, which totaled Rmb2.1trn in 2Q13, is carried out by proprietary investments or selling third-party-issued wealth management products, which are retail deposit substitutes issued by banks’ asset management arms.

As of June 2013, the outstanding amount of WMPs issued by banks reached Rmb9.08trn, up from Rmb1.7trn in 2009, representing a fivefold increase. Out of this, Rmb2.78trn was categorized as non-standardized products, which are invested in non-tradable investment assets that are managed by the shadow banking system, such as trust loans, account receivables financing, bank acceptance and alternative credit.

Figure 31: Outstanding balance of WMPs issued by

Chinese banks from 2009 to June 2013

Figure 32: Composition of new corporate non-bank

financing

1.7

2.7

4.6

7.1

9.1

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

2009 2010 2011 2012 1H13

RMB trn

91418 457 505

971

1,948 1,882

3,390

5,589

4,786

6,643

4,495

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000


RMB bn Loans (entrusted & trust) Bank Acceptance Bill Bonds Others

Loans (entrusted and trust) up 130%yoy between 1H12 and 1H13

Source: Deutsche Bank, CEIC Source: Deutsche Bank, CEIC, PBOC

17 September 2013

Banks



In Figure 33, we provide a breakdown of non-standardized WMPs by H-share banks, totaling Rmb1.7trn. Given the CBRC’s new rules restricting the unchecked growth of non-standardized WMPs, only CNCB and MSB have no remaining capacity to issue more of these products, while the other banks have the collective capacity to issue WMPs worth Rmb224bn.

Figure 33: Exposure of H-share banks to non-standardized WMPs as of 1H13 RMB bn ICBC CCB ABC BOC BoCom CMB CNCB MSB CRCB Total

Non-standard credit WMP 408 305 229 192 123 139 202 120 3 1,721

WMP balance 1,200 1,016 718 600 674 400 412 300 27 5,347

Total asset - 1H13 18,723 14,859 14,223 13,256 5,718 3,811 3,437 3,410 488 77,925

Non-standard credit WMP

as % of total WMP 34.0% 30% 32% 32% 18% 35% 49% c.40% 10% 32%

as % of total asset 2.18% 2.05% 1.61% 1.45% 2.16% 3.64% 5.88% 3.52% 0.57% 2.21%

Remaining capacity of credit-backed WMPs

35% WMPs 12 51 22 18 113 1 0 0 7 224

4% of assets 341 290 340 338 105 14 0 16 17 1,396 Source: Deutsche Bank, company data

Figures 34 and 35 provide a breakdown of WMPs by type, with the total WMPs issued by H-share-listed banks reaching Rmb5.3trn or 6.9% of total assets and 114% of shareholders’ equity as of June 2013 . As a result of the deposit-gathering dominance of the big four banks, the joint-stock banks need to rely on issuance of WMPs as alternatives for their funding requirements. This explains why joint-stock banks like MSB, CMB and CNCB have the highest exposure to off-balance sheet WMPs, with the exposure exceeding over 10% of CMB and CNCB’s liabilities.

Figure 34: H-share listed banks: Non-standardized and

standardized WMPs as % of total assets (as of June

2013)

Figure 35: Off-balance sheet WMPs as a percentage of

total equity (as of June 2013)

5.9

2.23.6 3.5

2.1 2.20.6

1.6 1.4 2.2

6.1

9.6 6.95.3

4.8 4.2

5.0 3.4 3.1

4.7

12.0 11.8

10.5

8.8

6.8 6.45.5

5.04.5

6.9

0

2

4

6

8

10

12

14

CNCB BoCom CMB MSB CCB ICBC CRCB ABC BOC H-Share

%Non-standardised WMPs as % of assets Standardised WMPs as % of assets

9665

3165

35 31 29 298

37

99

123

13997

68 72 63 6272

77

195 188

170162

102 10292 91

81

114

0

20

40

60

80

100

120

140

160

180

200

CNCB CMB BoCom MSB ICBC CCB BOC ABC CRCB H share

%Non-standardized WMPs as % of equity Standardized WMPs as % of equity


Banks also provide inter-bank funds to the non-bank or shadow banking system through resale agreements between financial institutions, and these financial assets amounted to Rmb5.2trn for the listed banks as of 2012, of which Rmb1.25trn and Rmb122.1bn were backed by bills and trust beneficial rights, respectively. The corresponding exposure was Rmb4.58trn as of December 2012 and Rmb2.97trn as of December 2011.

17 September 2013

Banks



Figure 36: Reverse repo arrangements for listed banks Figure 37: Composition of reverse repo arrangements for

listed banks

1,6171,016

1,493 1,614 1,391

813 1,733 1,122

2,281 2,873123

123 48

1810

01 283

619

870

2,5712,888 2,977

4,584

5,225

0

1,000

2,000

3,000

4,000

5,000

6,000

2009 2010 2011 2012 1H13

RMB bn

Others

Lease payment receivables

Trust Beneficial Rights

Loans

Bills

Debt Securities

63%

35%50%

35%27%

32%

60%38%

50%55%

5% 4%2%

0%0%

0% 0%10% 14% 17%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2009 2010 2011 2012 1H13

Others

Lease payment receivables

Trust Beneficial Rights

Loans

Bills

Debt Securities


Joint-stock banks are more vulnerable to liquidity and credit risks of the shadow banking system

According to data reported by companies, we believe that joint-stock banks have been actively serving as intermediaries to obtain funds from the state-owned/city commercial banks and lending to other banks and non-bank financial institutions to make money on income spreads. In other words, the banking system has become increasingly exposed to the shadow banking system, and the credit risks of the latter might evolve into counterparty risks for the official banking system.

For example, the outstanding value of Minsheng Bank’s reverse repurchase agreement was as much as 57% of its customer base as of June 2013. Compare that to the big four banks, which saw a range between 1% and 11%.

Figure 38: Interbank exposure of Chinese banks (1H13) 1H13 (RMB mn) ICBC CCB ABC BOC BoCom CMB CNCB MSB CRCB H share CEB

Interbank Assets

Deposits with banks and non-bank fins

303,064 754,193 502,704 590,459 134,822 49,695 250,643 126,161 21,045 2,732,786 73,870

Placements with banks and non-bank fins

338,009 111,206 502,704 473,239 192,549 96,947 90,051 96,024 41,264 1,941,993 137,060

Financial assets held under resale agreements

462,000 335,442 785,652 110,286 190,833 426,088 217,677 842,719 53,704 3,424,401 181,384

Reverse repurchase analyzed by collateral:

Debt Securities 340,240 221,932 298,589 97,900 72,030 177,902 67,451 4,887 1,260 1,282,191 41,597

Bills 87,696 112,710 486,263 12,386 116,667 135,705 130,746 700,292 12,505 1,794,970 137,339

Loans 4,842 800 800 2,136 429 9,007

Trust Beneficial Rights 103,811 137,540 39,939 281,290

Lease payment receivables 0

Others 29,222 8,241 19,480 56,943 2,448

Total reverse repo (net) 462,000 335,442 785,652 110,286 190,833 426,088 217,677 842,719 53,704 3,424,401 181,384

Total inter-bank asset 1,103,073 1,200,841 1,791,060 1,173,984 518,204 572,730 558,371 1,064,904 116,013 8,099,180 392,314

Total loans 9,437,642 8,095,052 6,946,120 7,439,633 3,201,417 2,052,599 1,824,552 1,484,970 192,329 40,674,314 1,104,554

Reverse repo % of total loan 5% 4% 11% 1% 6% 21% 12% 57% 28% 8% 16% Source: Deutsche Bank, company data

17 September 2013

Banks



Our proprietary research trips in China suggest risks are high; but risk management seems effective amid stable economy

Our proprietary research trips in China this July, when we met government officials and over 30 non-bank credit operators in Beijing, Shanghai, Hangzhou, Xi’an, Shenyang, Hohhot, and Ordos, suggested that although the magnitude of the default risks is much higher for the less regulated non-bank financial system, the management of these risks seems entirely market-driven and generally effective.

We believe the tighter regulation and de-risking of the official banking system have resulted in the emergence of the non-bank financial system to finance the assets that are perceived to be risky by the CBRC/shareholders (for example, LGFV, real estates, micro companies with little financial track record/cash flow issues). As such, the shadow banking system is inherently more risky, given the weaker quality of its assets, its limited ability to absorb losses due to the thinner capital base, its limited access to a stable source of funds and the more fragmented nature of the market.

Similar to the official banking system, the key risks faced by the shadow banking system include liquidity risks, interest rate risks, credit risks and capital risks. However, given the key differences in the sourcing of funds and lending and risk management practices, these risks manifest differently in the shadow banking industry. The offsetting factors are (1) high lending rates charged by these companies to the borrowers to offset risks, (2) back-up by shareholders, and (3) policy intervention to avoid systematic risks.

Liquidity risks Participants in the shadow banking system, especially the trust companies, secure funds through WMPs sold by banks/other FIs and by accessing the inter-bank markets, with the joint-stock banks serving as a conduit. As such, the system is vulnerable to risks arising from investors not rolling over the WMPs and regulations restricting growth and issuance of WMPs and the investments of the proceeds. These companies face additional risks if commercial banks scale back their inter-bank lending to other financial institutions.

We believe liquidity risk represents the key risk to the shadow banking system, which might not be able to secure funds by paying up when risk aversion towards them rises. The liquidity risks will then magnify the default risks.

Interest rate risks As loans tend to be short tenor and charged at a high fixed rate (for example, approximately 20% is charged by private money lenders at Wenzhou), interest rate risk is not the key risk faced by the system. This can be concluded by looking at the minimal impact on the average lending rate despite the SHIBOR spike in June. As Figure 39 shows, the average rate for private lending in Wenzhou for June (20.18%) was fractionally less than the reported level in the three months preceding it (20.39%). Moreover, the volatility in the daily rate was not as pronounced as had been feared, showing perhaps that the lenders are already charging a premium.

17 September 2013

Banks



Figure 39: Wenzhou one-month private lending rate Figure 40: Wenzhou private lending composite rate

17.0

19.0

21.0

23.0

25.0

27.0

29.0

%

19.0

20.0

21.0

22.0

23.0

24.0

25.0

26.0%

Source: Deutsche Bank, PBOC, CEIC, WIND Source: Deutsche Bank, WIND, CEIC, PBOC Note: Date for Jan 11-Sept 11 is from news reports, 4Q11-3Q12 is from WIND, 4Q12 from PBOC, 1Q13-2Q13 calculated as simple daily average

Credit/default risk We believe the credit/default risks are inherently higher for the non-bank system, as their borrowers tend to be more risky, making the system more vulnerable to an economic downturn. However, we believe the credit risks might be better micro-managed, as the system is entirely commercially driven with the market determining lending rates. Given the limited capital and customer reach, there is a stronger profit incentive for the small money lenders to assess the risks of borrowers in order to avoid capital losses.

Our proprietary research trips in China (Shanghai, Hangzhou, Xi’an, Shenyang and Beijing), which covered more than 30 non-bank credit operators, also suggest that although the magnitude of the default risks might be higher, the management of risks seems effective.

Capital risk Amongst the different operations in the non-bank system, we believe the capital risk is the highest for the trust companies, as they set aside only limited capital for the assets under their management (a leverage ratio of 36x AUM/equity) as the intermediary between investors and borrowers. As such, the trust companies might not have sufficient capital to absorb losses if they are asked to by regulators. In the past, there have been precedents when the trust companies were asked to bail out sour investments. As a result, there is little clarity over the ownership of risks in the event of default for trust products.

17 September 2013

Banks



Figure 41: Adjusted leverage ratio of trust sector

(AUM/equity)

Figure 42: Total equity of trust companies vs. ROE

20.2

23.8

30.7

35.8

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

2009 2010 2011 2012

(x)

108

132

163

203

225

12.6%13.3%

16.5%

19.4%

10%

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

100

130

160

190

220

250

2009 2010 2011 2012 1H13

RMB bn Total equity of trust companies (LHS) ROE (RHS)

2009-1H13 CAGR: 23.3%

Source: Deutsche Bank, China Trustee Association, KPMG Source: Deutsche Bank, China Trustee Association, KPMG

Shadow banking is transforming the risk profile of the banking system – CBRC could effectively slow the flow

While tighter bank regulations have led to lower credit and market risks for the listed banks, it has also contributed to uncharted growth in the shadow banking system from Rmb5.8trn in 2010 to Rmb12.5trn as of June 2013. As a result of banks reducing exposure to risky sectors (LGFV, real estates and others) and shortening loan duration to match liabilities, the shadow banking system is absorbing the supply imbalance of corporate loans, in addition to its original function of lending to small and micro companies.

The systematic concerns raised by the growth of the shadow banking system arise from the reliance of shadow banks on funding from the banking system, as this high connectivity means credit or liquidity risks in shadow banking could evolve into counterparty risks for the banks. Amongst the listed banks, the largest commercial banks (about 45% of banking system assets) have proportionately the lowest exposure to shadow banking. The three policy banks, which account for about 8% of assets, are pure sovereign risk.

The risks appear to be greatest among the joint-stock banks (18% of assets), which are the main conduits/intermediaries between the banking system and the non-banks. They have disproportionately large exposures to WMPs and to inter-bank assets collateralized against bills and trust beneficial rights. It was this group of banks that was at greatest risk during the “SHIBOR shock” in June as wholesale funding dried up.

We believe the CBRC could effectively slow the flow to the shadow banking system by increasing the risk weightings on resale agreements. Our analysis shows that if the weighting on resale agreements collateralized against bills was raised to 75% and that of trust beneficial rights to 100%, the CT1 of the H-share listed banks would be lowered by 23bps to 9.44%, with the biggest negative impact felt by MSB (-1.32% to 6.54%) and CRCB (-1.42% to 9.5%).

17 September 2013

Banks



Figure 43: Change in CT1 ratio of banks if risk weighting

of reverse repo backed by bills and trust beneficial rights

rises to 75% and 100% respectively

Figure 44: New CT1 ratio of banks if risk weighting of

reverse repo backed by bills and trust beneficial rights

rises to 75% and 100% respectively

-1 -4 -7-15

-24 -25

-51

-132-142

-23

-160

-140

-120

-100

-80

-60

-40

-20

0

bps

10.59 10.44

9.99

9.509.26

8.86 8.68

7.49

6.54

9.44

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

10.0

10.5

11.0%

Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates, company data

17 September 2013

Banks



Valuation and risks

Valuation of Chinese banks

We value Chinese banks based on an ex-growth valuation (2018 onwards), computed using a three-stage Gordon Growth Model (PV= (ROE-g)/(COE-g)). Our ex-growth prices assume zero growth in book value from 2018 in perpetuity, and our target price calculations are based on 2013E book values.

On our estimates, H-share-listed Chinese banks are trading at a 2013E P/B of 1.1x and 2013E P/E of 5.8x, offering 35% and 27% potential upside, respectively, assuming the sector trends back to its average historical valuation of 1.4x P/B and 7.4x P/E (2009-12).

Our top picks are the big four Chinese banks, and the key downside risk to our view is that the banking sector’s improving liquidity, driven by capital inflows, proves to be a necessary but insufficient condition for China’s economy to recover.

Our valuation assumes a near-term (2013-15E) ROE of 13-19%, medium-term (2016-18E) ROE of 12-16%, and terminal ROE of 9-12%, with COE of 11-12%.

Figure 45 highlights our valuation comparisons for listed banks.

Figure 45: Chinese banks’ valuation summary

Ticker Rating TP Price Upside Mkt. Cap

(%) (US$mn) 12A 13E 14E 13E 14E 13E 14E 13E 14E 13E 14E 13E 14E

ICBC-H 1398.HK Buy 6.80 5.54 22.7% 232,948 6.5 6.1 6.5 1.2 1.1 4.1 4.0 20.7% 17.1% 1.35% 1.14% 4.92% 4.61%CCB-H 0939.HK Buy 7.45 6.14 21.3% 129,235 6.4 5.9 6.6 1.1 1.0 3.9 4.0 20.1% 16.1% 1.39% 1.14% 5.06% 4.57%ABC-H 1288.HK Buy 4.49 3.71 21.0% 197,366 6.7 6.0 6.7 1.1 1.0 3.7 3.6 19.4% 15.1% 1.18% 0.94% 4.98% 4.37%BOC-H 3988.HK Buy 4.28 3.60 18.9% 141,070 5.8 5.6 5.5 0.9 0.8 3.6 3.4 15.7% 14.4% 0.99% 0.92% 5.28% 5.05%BCOM-H 3328.HK Buy 6.90 5.89 17.1% 55,904 6.0 5.7 5.3 0.8 0.7 3.6 3.2 15.1% 13.8% 1.08% 0.99% 5.27% 5.32%CMB-H 3968.HK Buy 18.97 14.52 30.6% 47,865 5.6 5.9 6.4 1.1 0.9 3.9 3.8 20.8% 15.6% 1.36% 1.12% 4.23% 3.88%CITIC Bank-H 0998.HK Buy 5.65 4.27 32.3% 29,361 5.2 4.8 4.2 0.7 0.6 2.8 2.6 15.4% 15.6% 1.04% 1.07% 4.75% 5.44%Minsheng-H 1988.HK Hold 9.82 9.67 1.6% 44,777 5.9 5.2 5.3 1.1 1.0 3.2 3.2 23.0% 19.2% 1.20% 1.07% 4.32% 4.24%CRCB 3618.HK Buy 5.00 3.94 26.9% 1,277 5.5 4.9 5.6 0.8 0.7 4.2 4.0 17.2% 13.7% 1.25% 0.97% 6.06% 5.34%H-share sector mean 6.3 5.8 6.2 1.1 0.9 3.8 3.7 19.1% 15.8% 1.23% 1.04% 4.96% 4.63%

Note: Closing price of

ROAA Div. Yield (%)

Sep 16, 2013

P/E (x) P/B (x) P/PPOP ROAE

Source: Deutsche Bank estimates, Bloomberg Finance LP

17 September 2013

Banks



In Figure 46, we highlight the valuation methodology used to derive our target prices for the listed banks under our coverage.

Figure 46: Valuation methodology of Chinese banks ICBC CCB ABC BOC BoCom CMB CNCB MSB CRCB

Stage 1 (2013E-2015E)

ROE 19% 18% 19% 15% 13% 18% 15% 19% 15%

Growth 13% 12% 13% 11% 10% 14% 11% 15% 11%

COE 11% 11% 11% 11% 11% 11% 11% 11% 12%

Payout ratio 30% 30% 30% 30% 20% 20% 25% 20% 30%

Stage 2 (2016E-2018E)

ROE 16% 15% 14% 12% 12% 14% 13% 13% 12%

Growth 11% 9% 9% 6% 8% 10% 9% 10% 7%

COE 11% 11% 11% 11% 11% 11% 11% 11% 12%

Payout ratio 30% 35% 30% 50% 30% 30% 30% 25% 45%

Terminal stage

ROE 11% 11% 11% 10% 10% 12% 9% 10% 11%

Growth 5% 4% 4% 4% 5% 5% 4% 4% 4%

COE 11% 11% 11% 11% 11% 11% 11% 11% 12%

Payout ratio 60% 60% 60% 60% 50% 60% 60% 60% 65%

Target P/B 1.5 1.4 1.4 1.1 1.0 1.5 1.0 1.1 1.0

Estimated value (HK$) 6.80 7.45 4.49 4.28 6.90 18.97 5.65 9.82 5.00

Upside from current price 23% 21% 21% 19% 17% 31% 32% 2% 27%

Current price 5.54 6.14 3.71 3.60 5.89 14.52 4.27 9.67 3.94Source: Deutsche Bank; Closing price as at Sep 16, 2013.

Key risks for Chinese banks

Sector risks Downside risks: 1) improving DGR proves unsustainable; 2) consensus

earnings downgrades on the back of: a) the policy move by the PBOC, b) asset quality deterioration, and c) slowing loan growth in 2H13.

Upside risks: 1) strong and coordinated global policy easing; 2) larger-than-expected stimulus package in China; and 3) a more relaxed policy on capital and provisioning.

Additional company-specific risks ICBC – Key downside risks: rising competition that undermines its

number one market position. Overseas M&A is also a key risk.

CCB – Downside risks are more intense competition for mortgage loan pricing and higher-than-expected operating cost growth, resulting in negative jaws. In addition, CCB is vulnerable to sector risks such as asset quality deterioration and policy risks translating into lower spreads, and higher provisioning and capital requirements.

ABC – Key downside risks: factors leading to slower economic growth in the country areas and asset quality deterioration.

BOC – Key downside risks: we believe BOC is vulnerable to slower export growth, a slower-than-expected rate of RMB internationalization, and M&A.

BOCOM – Key downside risks: we believe BoCom is most vulnerable to renewed market concerns over inflation or any other factors that

17 September 2013

Banks



could lead to a meaningful rise in China’s interbank rates, given its disproportionately large exposure to interbank liabilities.

CMB – Key downside risks: equity-raising overhang; asset quality deterioration. Key upside risks: slower-than-expected margin compression; RRR cut; and improvements in operating efficiency.

CNCB – Key downside risks: greater-than-expected increase in deposit costs negatively affecting the bank’s NIM given its relatively poor retail franchise; and one-off provisions to meet the gross loan coverage ratio of 2.5%.

Minsheng – Key downside risks: MSB is vulnerable to credit and economic risks and any policy changes that could result in lower loan pricing and service charges for SMEs, given its loan mix. Other risks include policy risks, deteriorating asset quality, and asymmetric rate cuts. Key upside risk: better-than-expected asset quality in SME business.

CRCB – Key downside risks: a high concentration in Chongqing, making the bank vulnerable to natural disasters and the regional economic slowdown, and making it hard for the bank to deploy capital more efficiently in other high-growth areas; execution risks; and earnings misses.

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Appendix A

Major regulations and policies of the trust business

Trust companies are regulated by the CBRC and tend to absorb losses and help clients restructure if a credit event occurs. While the net capital of trust companies should satisfy the following criteria: (a) ≥ Rmb200mn; (b) ≥ 100% of total risk capital; (c) ≥ 40% of net assets, the other major policies and regulations are:

Principal business For its own business (principal business), trust companies are allowed

to invest in financial companies, financial products and self-use real estate assets. However, principal assets are prohibited from being invested into industrial sectors.

While trust companies can engage in interbank deposits/borrowing, loans, leasing and other financial investments, they are not allowed to conduct any liabilities business other than ‘placement from other financials’, with the balance of the placement not exceeding 20% of its net assets.

The outstanding balance of guarantee business should not exceed 50% of its net asset.

Transactions between related parties such as borrowings, property transfer or guarantee are forbidden.

Trust companies are allowed to use principal assets to invest in private equity with an upper limit of 20% of net assets.

Trust business Trust companies that meet the rating requirements of regulators (C+)

can allocate up to 50% of total trust funds to loans, but the outstanding balance of the loans should not be more than 30% of total AUM.

No trust scheme can have more than 50 natural-person investors. However, there is no restriction on the number of qualified investors if the single invested amount is >Rmb3m. Moreover, a trustor should be a qualified investor and the only beneficiary in a trust scheme.

Funds used for financing can't exceed 30% of the outstanding amount of bank-trust cooperation. Off-B/S items should be rolled back to the B/S of banks and meet the provision coverage ratio of 150%. Banks are asked to ensure that their risk reserve meets a total CAR of 11.5% (for big banks) and 10% (for small and mid-sized banks).

The trust benefit should be divided into equal units.

Since 2012, the CBRC has strictly regulated the government-trust cooperation to control risks arising from this business.

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Appendix 1

Important Disclosures Additional information available upon request For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr Analyst Certification

The views expressed in this report accurately reflect the personal views of the undersigned lead analyst about the subject issuers and the securities of those issuers. In addition, the undersigned lead analyst has not and will not receive any compensation for providing a specific recommendation or view in this report. Tracy Yu/Sukrit Khatri Equity rating key Equity rating dispersion and banking relationships

Buy: Based on a current 12- month view of total share-holder return (TSR = percentage change in share price from current price to projected target price plus pro-jected dividend yield ) , we recommend that investors buy the stock. Sell: Based on a current 12-month view of total share-holder return, we recommend that investors sell the stock Hold: We take a neutral view on the stock 12-months out and, based on this time horizon, do not recommend either a Buy or Sell. Notes:

1. Newly issued research recommendations and target prices always supersede previously published research. 2. Ratings definitions prior to 27 January, 2007 were:

Buy: Expected total return (including dividends) of 10% or more over a 12-month period Hold: Expected total return (including dividends) between -10% and 10% over a 12-month period Sell: Expected total return (including dividends) of -10% or worse over a 12-month period

55 %

37 %

8 %23 %21 %

10 %0

50100150200250300350400450

Buy Hold Sell

Asia-Pacific Universe

Companies Covered Cos. w/ Banking Relationship

17 September 2013

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Regulatory Disclosures

1. Important Additional Conflict Disclosures

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GRCM2013PROD030264

David Folkerts-Landau

Global Head of Research

Marcel Cassard Global Head

CB&S Research

Ralf Hoffmann & Bernhard Speyer Co-Heads

DB Research

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Research

Richard Smith Associate Director Equity Research

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