The 2024 Central Economic Work Conference in China has highlighted a critical directive for the financial sector, emphasizing the need to effectively prevent and resolve risks in key areasThis includes a firm commitment to avoid systemic risks while also managing the threats posed by local small and medium-sized financial institutionsIn this context, the importance of risk management within small and medium-sized banks (SMBs) has become increasingly obviousThese banks, characterized by their smaller asset size, limited capacity to withstand risks, and inadequate corporate governance, are particularly vulnerable to risk buildupThus, a comprehensive understanding of the causes behind the financial risks faced by SMBs, along with the identification of viable solutions, is paramount for elevating local economies and averting systemic threats.

To begin, an overview of financial risk pertaining to SMBs is warranted

In China, the classification of banks typically hinges on asset sizeSMBs include national commercial banks, regional share-holding commercial banks, and city commercial banks, all of which are not part of the "Big Five" banks, namely the Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China, China Construction Bank, and Bank of CommunicationsThe total assets of SMBs represent a significant portion within the entire banking sector, as they are deeply rooted in grassroots communities, equipped with distinct regional characteristics, and play a crucial role in maintaining local financial stability and optimizing resource allocationImportantly, they serve as the backbone for Small and Micro Enterprises (SMEs) and advocate for inclusive finance.

Since the end of 2020, the People’s Bank of China has established a risk monitoring and early warning system that classifies institutions into 11 tiers based on risk levels, ranging from low to high

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The ratings span several categories, with the "green zone" encompassing ratings 1 to 5, indicative of a relatively safe state, and the "yellow zone" consisting of ratings 6 to 7. Conversely, ratings classified as the "red zone," including 8-10 and "D" for institutions that have closed, been taken over, or revoked, denote a high-risk status.

Understanding the causes of risk within SMBs reveals a combination of internal weaknesses and external pressuresThe first internal factor involved is the contraction of both domestic and external demand alongside a decline in interest margins, inevitably reducing asset quality and profitability for banksFor instance, escalating international trade frictions compounded by geopolitical factors have weakened foreign demand, painting a bleak picture for export-oriented small enterprises that are intimately tied to the balance sheets of these banksAdditionally, the Chinese economy faces slower growth, diminishing investment, and sluggish consumption have curtailed the credit demand for banks, while factors like an ongoing real estate market correction are leading to a shrinking in quality mortgage loan assets, positioning non-performing loan ratios for real estate loans at persistently high levels.

Moreover, in an environment where household income growth seems stagnant, depositors exhibit a keener interest in locking away their deposits, which inadvertently raises liabilities costs for banks, while the effective interest rate on existing loans continues to decrease significantly

For example, the five-year Loan Prime Rate (LPR) has dwindled from 4.85% in 2019 to a current low of 3.6% as of October 2024, leading to a significant contraction of net interest margins for these SMBs.

In addition to these internal pressures, SMBs possess a unique characteristic tied to local economies, making credit risk diversification an arduous taskPrimarily, SMBs are often concentrated in specific regional markets, with clients largely consisting of local SMEsRecent economic challenges, however, have exacerbated conditions for these local enterprises, inevitably pressing on the quality of banking assetsFurthermore, due to the need to support local governments or maintain client relationships, SMBs tend to allocate significant portions of their investments toward local credit bonds and non-standard productsThis behavior poses a risk since during local debt resolution processes, the bank's rights typically become subordinate, compromising the quality of their assets.

Structural deficiencies regarding the liability side present additional vulnerabilities for SMBs

They often show an alarming inclination towards short-term individual deposits while relying heavily on interbank borrowings, leading to steep liabilities costs and heightened liquidity risksIn contrast, larger state-owned banks are able to access more stable low-cost liquidity injections through accounts from government agencies and enterprises.

The realm of governance also reveals troubling patternsIn SMBs, internal control systems are often underdeveloped, with weak risk management protocols and insufficient technical toolsHistorically, governance structures within these institutions have lacked rigor, resulting in a situation where external influences from local governments or major shareholders can intervenePast incidents show that internal control failures have led to egregious losses due to irregular shareholder conduct, where notorious cases associated with rogue entities have further contributed to the vulnerability of SMBs and underline the inadequacy of corporate governance within this sector.

To mitigate and manage risks associated with SMBs, a systematic approach involving early prevention strategies and robust response frameworks is crucial

First, enhancing the precision of risk assessments through comprehensive data collection and harnessing artificial intelligence for in-depth analysis can significantly improve risk evaluation accuracyBy creating detailed client profiles utilizing big data and modeling techniques, banks can refine their risk assessments.

Secondly, there is a pressing need for SMBs to capitalize on their local strengthsEmphasizing traditional credit operations that focus on their specific regional markets can enable banks to streamline their growth strategies away from mere scale expansions towards deeper community engagementsAdditionally, increasing investment in risk management capabilities and promoting digital transformations can better prepare these institutions to handle non-performing assets.

Furthermore, the governance structure within SMBs requires enhancements through stricter equity management practices

Given their complex formation and ownership structures, it is essential to enforce standardized information disclosures while instituting robust incentive mechanisms to ensure accountability among major stakeholders and executives.

Widening capital replenishment avenues is equally vital for fortifying SMBsEncouraging self-sustaining growth will complement the structural advantages gained through more accessible capital tools, including innovative financing options to ensure these regional banks can enhance their capital bases adequately.

Moving onto the necessity for a well-defined risk response framework, the handling of SMB risks generally follows a four-tiered approach: capital supplementation, mergers, external takeovers, and, as a last resort, liquidationInitially, capital infusion becomes critical for institutions whose risks are manageable and carry low systemic importance, emphasizing self-rescue through capital boosts, management changes, or active involvement of asset management companies to tackle bad debts.

Mergers and restructurings have emerged as primary methods for addressing SMB issues; in fact, this strategy is often employed

Specific forms of mergers include absorbing weaker banks by stronger counterparts, or the creation of new entities through the merger of several institutionsNotable examples from recent years include the "township bank reform" wherein village banks are absorbed into larger institutions, or the establishment of new regional banks formed from various organizations coming together.

Nevertheless, post-merger considerations must include the prudent management of accumulated bad assets and sufficient capital reinvestment, which can often become challenging as the assets of a merged entity expand, thereby necessitating immediate capital supplements from various channelsExternal takeover by regulatory authorities may become necessary for institutions that face debilitating challenges, designed to secure depositors' interests and ensure accurate assessments of financial standingsLastly, if risk mitigation efforts yield unsatisfactory results, liquidation remains a final and drastic option, albeit rarely employed and typically viewed within a historical context.