China's small banks face funding crunch as regulations, liquidity tighten

SHANGHAI (Reuters) - China's small banks are struggling to raise funds through short-term instruments as a regulatory squeeze combines with tight liquidity ahead of the quarter-end and Golden Week holiday.

With few options for funding, some banks have returned to issuing negotiable certificates of deposit (NCDs), a form of non-collateralised short-term funding that regulators have tried to discourage in their battle against speculative financing.

The premium paid by lower-rated Chinese banks over higher-rated ones for NCDs spiked last week, highlighting risks to the country's smaller lenders. The spread between three-month AAA- and AA-rated NCDs hit 51 basis points, the highest on record.

While the spread has narrowed, analysts say it points to a trend of higher financing costs for weaker lenders.

"What you see there is a reflection of the fact that (small banks) are forced to seek more expensive liquidity," said Alicia Garcia-Herrero, Asia Pacific chief economist at Natixis. "No matter how much they chase for new markets, they will always be penalized."

A trader at an asset-management firm in Shanghai said tight liquidity reflects ongoing central bank efforts to reduce leverage combined with looming quarter-end tax bills.

Adding to the pressure is the week-long National Day holiday starting on Oct. 1, and NCDs worth 2.3 trillion yuan that have been maturing this month following a surge in issuance in June.

NCDs are priced with reference to the Shanghai Interbank Offered Rate (SHIBOR). The three-month SHIBOR was at 4.3611 percent on Friday, up 107 basis points since the beginning of the year.

As liquidity tightens, market demand for lower-rated NCDs has also been affected by new rules from the China Securities Regulatory Commission (CSRC), announced in early September, that limit the exposure of money-market funds to lower-rated assets. The rules take effect Oct. 1.

UNDER THE GUN

NCDs have been in the regulatory spotlight this year as the authorities try to shut funding loopholes, most recently banning those with maturities longer than one year. Some analysts said the move marked the beginning of a new tightening cycle.

The People's Bank of China has not yet exempted banks with less than 500 billion yuan ($75.8 billion) in assets from including NCDs in quarterly assessments.

"For the smaller (banks), this should be treated as a signal that their positions will also be included at a later stage," said Becky Liu, head of China macro strategy at Standard Chartered.

But with fewer options than their higher-rated counterparts, smaller banks may not yet be responding. The value of outstanding NCDs rose by 843.2 billion yuan from June through August, Shanghai Clearing House data showed.

Interbank borrowing by small and regional banks has risen to almost 16 percent of their total funding sources from 12 percent in 2015, BNP Paribas senior economist Chi Lo said in a research note, compared with about 2 percent for large commercial and state-owned banks.

Banks that have tried to diversify out of NCDs by turning to money-market funding may find their moves stymied by the new CSRC rules.

Garcia-Herrero says the rising pressure may indicate a larger end-game for China's regulators: banking sector consolidation.

"I wouldn't be surprised that you see banks being absorbed by others," she said.

($1 = 6.5935 Chinese yuan)

(Editing by Jacqueline Wong)