China’s Village Bank Collapses Could Cause Dangerous Contagion

Local problems threaten to spread into a serious crisis.

By , a fellow for international political economy at the Council on Foreign Relations.
In this screengrab from video obtained by Reuters, demonstrators hold up signs during a protest over the freezing of deposits by some rural-based banks outside a People's Bank of China building in Zhengzhou, Henan province, China, on July 10. Text in foreground reads, "Henan Bank, return to us our legal deposits! The people's life-saving deposits!"
In this screengrab from video obtained by Reuters, demonstrators hold up signs during a protest over the freezing of deposits by some rural-based banks outside a People's Bank of China building in Zhengzhou, Henan province, China, on July 10. Text in foreground reads, "Henan Bank, return to us our legal deposits! The people's life-saving deposits!"
In this screengrab from video obtained by Reuters, demonstrators hold up signs during a protest over the freezing of deposits by some rural-based banks outside a People's Bank of China building in Zhengzhou, Henan province, China, on July 10. Text in foreground reads, "Henan Bank, return to us our legal deposits! The people's life-saving deposits!" Reuters TV via REUTERS

China just experienced its first wave of bank runs, triggered by frozen deposits in online accounts worth 40 billion yuan ($6 billion) and affecting 400,000 depositors. The scattered runs on small banks in central Chinese towns are not singular events but the precursor of a nationwide reshuffle of small and medium-sized banks (SMBs). Social media virality and dramatic stories of losses and protests are shaking savers’ trust in SMBs, presenting an urgent challenge to China’s banking regulators. China is fighting a war on multiple fronts against financial insecurity right now, from dubious online investment schemes to an ongoing property crisis. Preventing potential financial contagion and social unrest triggered by runs on small banks is a battle that Chinese regulators and policymakers have to win.

The recent bank runs started from three rural village and town banks (VTBs) in Henan province. Three more runs on VTBs happened within a month, including two in neighboring Anhui province. Five of the six troubled VTBs have the same major shareholder bank, Xuchang Rural Commercial Bank. Not being able to withdraw their life savings has led to protests by depositors, triggered panic over the solvency of small banks, and increased the nationwide risk of runs on small banks.

VTBs comprise 84 percent of China’s banking institutions but held just 13 percent of the total assets in the banking sector by the end of 2021. Chinese policymakers envisioned these banks as a pillar of microfinance supporting farmers and small businesses in rural China, and in 2006 they proposed pilot projects in six rural areas. Fifteen years of policy experiment has left the Chinese financial system with 1,651 VTBs that are now the most numerous entities in the banking system but individually are both small and very weak at risk management. The People’s Bank of China (PBOC), the central bank, has rated 186 rural cooperatives and 103 VTBs as the riskiest among all Chinese banking institutions. In other words, close to 7.5 percent of Chinese rural banking financial institutions are already at the highest level of risk—and the problems may go even deeper than that.

China just experienced its first wave of bank runs, triggered by frozen deposits in online accounts worth 40 billion yuan ($6 billion) and affecting 400,000 depositors. The scattered runs on small banks in central Chinese towns are not singular events but the precursor of a nationwide reshuffle of small and medium-sized banks (SMBs). Social media virality and dramatic stories of losses and protests are shaking savers’ trust in SMBs, presenting an urgent challenge to China’s banking regulators. China is fighting a war on multiple fronts against financial insecurity right now, from dubious online investment schemes to an ongoing property crisis. Preventing potential financial contagion and social unrest triggered by runs on small banks is a battle that Chinese regulators and policymakers have to win.

The recent bank runs started from three rural village and town banks (VTBs) in Henan province. Three more runs on VTBs happened within a month, including two in neighboring Anhui province. Five of the six troubled VTBs have the same major shareholder bank, Xuchang Rural Commercial Bank. Not being able to withdraw their life savings has led to protests by depositors, triggered panic over the solvency of small banks, and increased the nationwide risk of runs on small banks.

VTBs comprise 84 percent of China’s banking institutions but held just 13 percent of the total assets in the banking sector by the end of 2021. Chinese policymakers envisioned these banks as a pillar of microfinance supporting farmers and small businesses in rural China, and in 2006 they proposed pilot projects in six rural areas. Fifteen years of policy experiment has left the Chinese financial system with 1,651 VTBs that are now the most numerous entities in the banking system but individually are both small and very weak at risk management. The People’s Bank of China (PBOC), the central bank, has rated 186 rural cooperatives and 103 VTBs as the riskiest among all Chinese banking institutions. In other words, close to 7.5 percent of Chinese rural banking financial institutions are already at the highest level of risk—and the problems may go even deeper than that.

The Chinese authorities are concerned with not only the financial risks but also the potential social instability caused by the failures of VTBs and other SMBs. Chinese regulators have been seeking ways to improve the operations of small rural banks. Since 2018, they have dealt with 627 high-risk rural SMBs and disposed of nonperforming loans in the amount of 2.6 trillion yuan ($385 billion), which exceeded the total amount of the previous decade. The China Banking and Insurance Regulatory Commission (CBIRC), the Finance Ministry, and the PBOC injected 133.4 billion yuan ($19.7 billion) into 289 rural SMBs. The CBIRC has also encouraged high-quality banks, insurance companies, and other qualified institutions to participate in the mergers and restructuring of SMBs.

SMBs have become the most fragile part of the Chinese banking system. One of the key structural issues is the lack of capital replenishment channels for SMBs. They have low profitability, which makes them unable to generate replenishment capital internally. They are also unable to raise funds through external channels such as initial public offerings due to their small scale and poor credit ratings. But small banks found a natural ally as they competed with their peers for survival: online deposit platforms provided by fintech firms that were not licensed banks and thus unregulated.

These platforms, many of which made exaggerated claims about returns and some of which have turned out to be outright frauds, brought a steady stream of funds to small banks over a short period by listing deposit products online and selling them to their nationwide users. By the end of 2020, 89 Chinese commercial banks (84 SMBs) had attracted 550 billion yuan ($81 billion) worth of online deposits through such platforms, an increase of 127 percent compared with 2019. In some cases, online deposits sold to nationwide depositors even replaced interbank financing as the primary source of funds. The PBOC found that some high-risk small banks amassed 70 percent of deposits from nonlocal online deposit products sold by third-party platforms, whereas interbank financing as a percentage of total liabilities dropped from 30 percent to 3.2 percent.

In January 2021, Chinese regulators banned commercial banks from selling deposit products through third-party online platforms in a notice jointly issued by the CBIRC and the PBOC, citing concerns of increased hidden risks and the potential for financial contagion. The crackdown on online deposit products removed the life support for many SMBs with limited alternative capital replenishment sources. At that time, online deposits had reached an estimated amount of 1 trillion to 2 trillion yuan.

Although this number was a minute portion of the 90 trillion yuan ($13 trillion) in total household deposits, Chinese regulators feared the potential of financial contagion and resulting social unrest. At a press conference about the notice, Chinese officials commented that “bank deposits are the most basic form of financial services and require stricter supervision.” In the VTB context, the poverty of much of rural China means relatively small amounts can also be devastating household losses—creating a powerful motivation for the protests the authorities fear.

But there are also serious financial security concerns. The threat is not these online deposit products per se but rather the spillover impact on the increased funding costs to bankroll China’s debt-pumped economic growth. Online deposits have exacerbated the fierce competition for deposits among SMBs, directly raising their funding costs and eroding their profits. Rather than offering higher-quality financial products or better customer service, banks have thus been lowering fees and offering higher interest rates—often threatening their own financial stability as a result.

Before the crackdown in January 2021, online platforms displayed deposit products by interest rates in descending order, forcing banks to competitively raise deposit rates close to the upper limit allowed. Some banks even sweetened the deal by shortening the interest payment cycle, providing cash rewards, and issuing shopping vouchers. Apart from wooing clients, banks had to pay platforms a traffic diversion fee of about 0.2 to 0.3 percent on a monthly or quarterly basis of the average daily deposit balance on the platforms and greater fees if they wanted a more eye-catching spot. All these incentive measures raised the actual funding costs and fueled a downward spiral of competition among SMBs.

Higher funding costs have forced SMBs to venture into riskier activities beyond their modest risk management capacity to make profits. They often had to seek long-maturity, high-risk, and low-liquidity assets, resulting in both liquidity mismatch and maturity mismatch. These double mismatches have made small banks prone to bank runs in times of either a liquidity event or a credit event. Before the 2021 crackdown, small banks provided third-party online deposit products starting with amounts as small as 50 yuan (about $7) and allowed for withdrawal at any time. Such flexible terms of deposits meant small banks relied on extremely short-term funding and were constantly exposed to the risk of unexpected changes in demand for withdrawals.

The risk of financial contagion tripped by failures in online deposit products is not an exaggeration. Although small banks are licensed to serve a specified geographic region, they have become de facto national banks by taking online deposits from across the nation, an action prohibited by Chinese regulators. Problems at a small bank can directly affect clients nationwide, increasing the risk of a nationwide panic in times of liquidity shortage.

High-interest online deposit products offered by SMBs put pressure on the major commercial banks that dominate China’s banking system to raise their interest rates. This spillover effect increased borrowing costs for Chinese firms, many of which are state-owned enterprises (SOEs) and private Chinese companies. The increased funding costs were thus translated to higher borrowing costs for SOEs. While SOEs contribute less than a third of GDP, they account for more than half of the bank loans offered in China and about 90 percent of the country’s corporate bonds. An increase in funding costs for SOEs and private businesses dampens the government’s policies to stimulate the pandemic-hit economy. Maintaining low funding costs for SOEs is perhaps a more important motivation for the Chinese regulators to call off online deposits.

Online deposits also diverted Chinese retail investors with a higher risk appetite away from a financial product promoted by Beijing: local government special bonds. This type of bond is a way for local government to raise capital to finance large public projects such as public housing and energy and infrastructure projects. The nominal returns on investment from local government bonds have been less than for online deposits. The average yield of these bonds is 3.46 percent.

In contrast, on average, the annualized one-year interest rate for online deposits was 4.8 percent, with some special offers reaching above 10 percent. A ban on online deposits, combined with reductions in implicit guarantees on wealth management products, increases the relative attractiveness of local government bonds as an investment option.

In 2015, Beijing allowed local governments to issue special bonds on their own for the first time to encourage transparency in local government funding and end shadow borrowing through off-balance-sheet debt instruments. This policy change made it possible for local governments to directly raise funds to finance local projects, pay the interests, and pay back the principal upon maturity. Before the policy change in 2015, most local governments did not have direct access to bond financing because China’s 1994 Budget Law prohibited borrowing by most local governments. As a result, they relied on off-balance-sheet financing entities known as local government financing vehicles to raise capital. The piling up of hidden debt by local governments is a likely trigger for China’s next debt crisis, which is a primary reason for the Finance Ministry’s policy change. By the end of 2020, government off-balance-sheet debt hit an estimated 45 trillion yuan ($7 trillion, or 44 percent of China’s GDP), more than quadrupling the 9.6 trillion yuan at the end of 2010. By 2021, there were an estimated 3,060 local government financing vehicles—whose existing liabilities have to be cleared by 2028, as ordered by Beijing. The local government special bonds program is a way to refinance these debts through capital markets.

When the Finance Ministry introduced the special bonds program, it also encouraged retail investors to buy these bonds, signaling another significant policy change. Traditionally, China’s regulations only allowed institutional investors to participate in the interbank bond market. In the case of local government special bonds, investors in the primary market can choose to entrust their bond holdings with a securities registry. Retail investors can then buy special bonds at the stock exchange following the same procedures as buying stocks.

In February 2019, the Finance Ministry allowed retail investors to buy local government special bonds over the counter from commercial banks for the first time. Despite the ministry’s advocacy, retail investors have been lukewarm to such bonds. By 2021, the local government bonds balance exceeded 31 trillion yuan ($4.6 trillion), becoming China’s largest bond market and the world’s largest municipal bond market. However, over-the-counter investors only held 0.02 percent of the total local government bonds, as of this May.

Since Xi Jinping came to power, he has personally stressed the importance of financial security. Xi considers finance an “important component of the core competitiveness of a nation” and financial security an “important part of national security.” He has also called for making finance serve the real economy and the development of the nonfinancial sector. Outlawing online deposit products and preventing small bank runs are parts of bigger ambitions: mitigating China’s financial insecurity and sustaining China’s debt-fueled economy at low cost. The problem with China’s banking system today is not “too big to fail” but “too much to ask for.”

It is becoming increasingly costly for China to finance its economic growth through expanding government expenditure and firm investment because of rising funding costs in the banking sector and the lack of interest in unattractive local government special bonds among retail investors. Chinese savers’ hard-earned savings are not just deposits but also a source of leverage. All financial crises start locally. What is Beijing’s next move in the multifront war against financial insecurity? It is likely to crack down on more alternative investment instruments, such as online cross-border securities brokerage platforms, to address financial insecurity and channel savings to purchase local government bonds.

Zongyuan Zoe Liu is a fellow for international political economy at the Council on Foreign Relations. 

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