Can China's banks survive the financial storm?

By Michael Flaherty and Samuel Shen - Analysis

HONG KONG/SHANGHAI (Reuters) - With signs of cracks appearing across China's credit system, concerns are growing that the country's banks may be ill-equipped to handle a drop in the Chinese economy.

Corporate collapses and defaults in the last few weeks, together with a tightening interbank lending market, show that China's banks are hardly in the clear when it comes to negotiating their way through the global financial turbulence.

Some of the country's financial groups, including large, state-run institutions such as ICBC (601398.SS) and China Merchants Bank (600036.SS), have the benefit of government ownership and relatively small exposure to the West's subprime mortgage mess.

The main concern is focused on smaller commercial banks, whose regional concentration makes it harder to withstand a downturn than the larger, more diverse state-run banks.

There are around 8,500 rural financial institutions and 125 city commercial banks, with Bank of Shanghai, Bank of Nanjing (601009.SS) and Bank of Hangzhou among the big name city lenders.

"The main risk to China's banks is rapid slowdown in the economic growth and the crystallization of the latent credit risks," said Ryan Tsang, senior director of Greater China corporate ratings at Standard & Poor's.

Should smaller banks come under serious pressure or fail, that could lead to weakening depositor confidence and a chain reaction up the banking system.

"Depositors might move a significant portion of their deposits to state owned commercial banks and other banks that they consider as 'safe'," Tsang said. "That would put other Chinese banks that are facing tight liquidity in an even more difficult position."

RISING RISK

China's government this month toughened its guidance on capital ratios at some banks, a move seen as a pre-emptive step to prevent Chinese banks from repeating their near-bankrupt status roughly five years ago.

That was when the government bailed out some of China's largest banks that were hobbled by non-performing loans.

The recent collapse of privately held Jianglong Group, a major textile company in southern China, and loan defaults by steelmaker FerroChina (FERR.SI) was a grim sign for commercial lenders worried about bad loans piling up again.

Take, for example, export-focused Zhejiang Province where around 20 percent of small-and-mid sized companies made a loss during the first half of this year, according to GF Securities.

That's not encouraging for Bank of Ningbo, a midsized lender with a bad loan ratio of only 0.4 percent but whose clients are mostly small private firms concentrated in Zhejiang.

Loans overdue for up to 90 days jumped 53 percent to 2.292 billion yuan ($335.4 million) in the first half of the year at Fujian-based lender Industrial Bank (601166.SS). Those loans are often classified as non-performing loans.