China jolted markets in 2019 with three high-profile bank rescues that imposed losses on some investors. The appetite for experimenting with greater market discipline has been crushed by the coronavirus pandemic.

2020 has become the year of stealth rescues as authorities try to preempt bank failures and ensure stability for an industry at the forefront of cushioning the virus-induced economic slump. Local governments are identifying the weakest lenders among more than 4,000 rural and city banks, and drafting plans -- at the request of the cabinet -- to merge them into bigger and, hopefully, stronger banks, according to people familiar with the matter.

So far, at least six mergers in five provinces have been engineered since May. The behind-the-scenes manoeuvring has kept crucial credit flowing through local economies, but also allows risks to persist in China’s vast network of regional banks. The sector, which accounts for 80 trillion yuan ($12 trillion) of banking assets, has been plagued for years by scandals, complex ownership structures, rampant off-book dealings and poor risk control.

“The government wants to maintain financial stability and they need banks to lend to the real economy,” said Harry Hu, a Hong Kong-based analyst at S&P Global. “Will they kick the can down the road? They have more immediate priorities right now.”

The stealthier approach comes after Beijing learned some hard lessons last year when it seized control of Baoshang Bank Co., the first state takeover in over two decades. The move spooked investors, causing funding costs for smaller banks to surge. Regulators followed up by having state-run entities inject billions of dollars into teetering lenders such as Bank of Jinzhou Co. and Hengfeng Bank Co.

Now battling its worst economic slump in four decades, the support has been widespread and varied but under the radar. A plan drafted in May by the State Council, China’s cabinet, and issued in July put the onus on local governments to take point on stabilizing lenders, the people said, ensuring any trouble was cleaned up before it can emerge in public.

Five banks in cities in the northern Shanxi province last month announced plans to combine into a provincial bank even though their financial statements didn’t point to any obvious signs of stress.

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Pan Gongsheng, vice-governor of the People’s Bank of China, said at a press conference this month that regulators are dealing with some troubled institutions in Shanxi due to risks from the economic slowdown, poor corporate governance and corruption. Pan didn’t name the banks.

In southwestern Sichuan province, authorities are planning to merge two city banks to create Sichuan Bank Co. after carving out 15 billion yuan in non-performing loans, according to a person familiar with the matter.

The China Banking Regulatory Commission didn’t respond to a request seeking a comment.

“Letting a bank fail is extremely risky if mishandled, whereas consolidation of troubled small banks is a much more cost-effective way to resolve risks from the perspective of regulators and social stability,” said Zhang Shuaishuai, a Shanghai-based analyst at China International Capital Corp. “This will continue to be the formula to reform China’s banks going forward.”

Financial backing via debt

The financial backing for this will largely come through debt. China is allowing local governments to use about 200 billion yuan from bond sales to help smaller banks shore up their capital, while the lenders themselves are raising more of the riskiest kind of bank debt.

The moves so far may only scratch the surface. Central bank stress tests last year identified 586 “high risk” banks and financing firms, most of which are smaller rural institutions.

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That was based on a scenario where economic growth slowed to 4.15 per cent, an almost unthinkable deceleration before the pandemic. Growth is predicted at 2.1 per cent this year. Tax revenue is dwindling and some local governments are scrambling to make ends meet. A few local government financing vehicles, established to fund infrastructure projects, have already defaulted on trust loans.

Loading the troubles of private shareholders onto local governments doesn’t resolve the fundamental problem of loans going bad, the US-China Economic and Security Review Commission said in a report earlier this year, warning US investors of investing in Chinese banks.

Another issue is the lack of corporate governance. The CBIRC has since last year uncovered over 3,000 violations at small banks and cleaned out more than 1,400 shareholders by forcing some to sell their stakes. In a recent government audit of the 2019 results of 43 small banks, 16 were found to have bad-loan ratios double their stated numbers.

Meanwhile, depositors are on edge. Worried savers descended on three banks over June and July to withdraw funds amid rumors of cash shortages that were later dismissed as false. In all three incidents, local regulators and governments publicly vouched for the soundness of their lenders, while the police halted the run.

While bad debt has soared to records, ample liquidity from both local governments and Beijing, as well as the central bank, is helping paper over the difficulties. But with even the biggest banks facing steep drops in profit, authorities may eventually need to exit stealth mode and again test investors appetite for more public failures.

“The pressure will comes gradually from this year to next,” said Shujin Chen, Hong Kong-based head of China financial research at Jefferies. “More non-performing loans will show up and that will lead to a higher probability of small bank failures. The weaker players should be allowed to fail. That’s natural.”

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