Exclusive: China’s top banks tighten exposure to smaller peers to curb credit risk. According to three sources, several of China’s largest banks have increased their monitoring of smaller peers’ asset quality and tightened interbank lending rules to reduce credit risk as the country’s property debt crisis worsens.

According to the sources, two of China’s largest state-owned banks and a critical joint-stock bank have increased their assessments of smaller lenders in recent months to identify those with poor asset quality and a high risk of default. According to two sources, the two state-owned banks have decided to lower interbank lending ceilings and establish shorter maturity terms for smaller counterparts deemed high-risk.

All of the sources who spoke on the condition of anonymity due to the sensitivity of the subject had firsthand knowledge of the situation.

The decision comes amid mounting concerns over the stability of the world’s second-largest economy’s smaller banks, as a worsening property sector crisis and ballooning local government debt make them the weakest link in the financial system.

The cautious stance taken by certain large banks in dealing with their smaller counterparts may compound capital issues for the latter since they have fewer viable fundraising choices, forcing Beijing to intervene with further supportive measures.

While the bigger Chinese banks mainly utilize client deposits—a secure and long-term funding source—to make loans, smaller lenders have been actively borrowing from local competitors to raise capital in recent years.

According to statistics from the China Foreign Exchange Trade System (CFETS), which the central bank regulates, China’s mid-sized and smaller banks account for nearly half of the trading activity in the interbank lending market.

According to one of the individuals, a senior executive at a prominent joint-stock bank that is among those reviewing loan exposure to smaller rivals, the bank has tightened its lending standards to smaller banks.

According to the source, it has banned acquiring bonds issued by smaller banks with total assets of less than $40 billion.

The People’s Bank of China (PBOC) and the National Financial Regulatory Administration, which oversees all parts of China’s $63 trillion financial industry, did not reply to a request for comment from Reuters.

GAP IN LIQUIDITY

As China wrestled with the impact of the slowing economy on the financial system, local governments took steps to assist the banking sector, particularly the smaller ones, in maintaining financial stability.

Last year, as part of similar financial risk-prevention efforts, some of China’s local governments sold unprecedented sums of so-called special bonds to infuse money into ailing small regional institutions.

According to the official media, it was required to successfully handle problems in small and medium-sized banks last month, citing the Central Economic Work Conference conducted on December 11–12, at which senior leaders set economic objectives for 2024.

Although 4,000 tiny banks are not considered a systemic risk in and of themselves, the fear is that enough of them have mainly supported themselves through short-term money market borrowing, creating a collective risk if a few collapses.

Banks become increasingly susceptible to counterparty risk when using interbank lending for funding.

While the country’s Big Five banks dominate the market, notably Industrial and Commercial Bank of China (601398. SS) and Bank of China (601988. SS), smaller banks still account for a quarter of assets, according to regulatory statistics.

According to a second source at one of the large state-owned banks, some of the small lenders his business had assessed and considered dangerous were located in heavily indebted areas such as northeast China, the Inner Mongolia region, and Henan province.

Rates for negotiable certificates of deposit (NCDs), a common source of funding for small lenders, have been gradually rising since August, partly due to a liquidity imbalance amid a high debt supply in recent months.

According to a research report from Chinese brokerage TF Securities, the interest rate on one-year NCDs offered by small and medium-sized rural commercial banks reached 2.84% in mid-December, the highest level since August.

Ten small and medium-sized banks defaulted on commercial paper at least three times in six months last year, according to a statement posted on the Shanghai Commercial Paper Exchange website on Nov. 30.

According to the announcement, the banks include regional lender Ningxia Helan Rural Commercial Bank Co. Ltd., situated in northwest China’s Ningxia area, and Shaanxi Baoji Weibin Rural Commercial Bank Co. Ltd., based in northern Shanxi province.