In 2019, Inner Mongolia-based Baoshang Bank collapsed after its controlling shareholder, Tomorrow Group, take advantage of weak governance to siphon off 156 billion yuan (US$21.3 billion) in unpaid loans.

Rural banks, especially village banks, face the highest level of risk.

These banks, which account for most of the 357 banks the PBOC classifies as high risk, emerged nearly two decades ago as part of Beijing’s push to support rural development. By the end of 2023, China had 1,636 village banks, which collectively accounted for less than 1% of total banking sector assets, according to the PBOC. Each bank had an average of about 1.4 billion yuan in assets. Banks are often controlled by a variety of small shareholders, including local rural banks, local state-owned enterprises, and private companies.

In April 2022, savers at several rural banks in central China’s Henan and Anhui provinces were denied access to their accounts, prompting many to protest against local banking authorities .

Beijing has been trying to de-risk small banks by allowing local governments to issue special bonds to replenish their capital while allowing larger banks to merge with smaller ones.

The PBOC said in its stability report that it would accelerate efforts to reform small banks in provinces with a high concentration of risks.

“This reflects the government’s focus on maintaining financial stability,” said Nicholas Zhu, banking analyst at Moody’s Ratings. “Central government and local governments don’t want to see a systemic banking crash.”

However, with declining revenues in recent years due to falling property and falling land sales, some local governments may not have the financial capacity to provide additional funds to strengthen the capital of these banks, said Zhao of Renmin University.

A villager works in the production of soybean paste in Lanxi City, east China’s Zhejiang Province, Dec. 5, 2024. Photo: Xinhua alt=A villager works in the production of paste of soybeans in Lanxi city, east China’s Zhejiang province, on December 5, 2024. Photo: Xinhua>

Consolidation among small banks can ease the regulatory burden, allowing watchdogs to better focus their resources on small banks’ internal controls and governance, said Xu with Fitch Ratings. “But (mergers and acquisitions) alone may not permanently address the risks facing small banks, as challenges will still be faced by the surviving entities,” he added.

“The Chinese authorities have accelerated the reform of rural financial institutions by 2024, and we expect the reform process to accelerate further this year,” said Ryan Tsang, managing director of S&P Global Ratings in Hong Kong. “The key question is whether the risky practices or problematic business models of weak rural financial institutions can actually be corrected or improved under the new framework. Simply replacing some people or restructuring operations is not enough to solve deep-rooted problems.”

It will take considerable time to build a strong culture of corporate governance, he said, adding that it is “not something that can be achieved overnight”.

“You will see negative headlines from time to time in different regions,” said Dong Chen, chief Asia strategist and head of Asia research at Pictet Group in Hong Kong. “That won’t be a surprise. But I wouldn’t expect it to deteriorate into systemic risk.”

However, Renmin University’s Zhao believes there are risks.

“It’s about trust,” he said. “Once a financial institution encounters risks, those risks can spread and cascade from one institution to another.”

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