On May 24, the Chinese government took over Inner Mongolia’s Baoshang Bank after citing “serious credit risks.” The last time such a thing happened in China was during the country’s last significant economic downturn, and adjoining non-performing loan cycle, 18 years ago. Back then, in 2001, the government took over Shantou Commercial Bank after a corruption scandal.

Local media reports have indicated that like Shantou two decades ago, Baoshang has questionable issues, regarding concentrated shareholder ownership and material lending exposures to that same shareholder.

China’s central bank, the People’s Bank of China (PBOC), and the country’s banking regulator, the China Banking and Insurance Regulatory Commission (CBIRC), have said that the Baoshang takeover was necessary to protect the interests of depositors and other bank clients.

It is further understood that this is a planned one-year takeover during which time the principal sums, and interest, on personal savings deposits will be fully guaranteed.

By any standard, this is exactly what a prudent regulator should do.

While the Chinese government has not taken over a banking institution since 2001, this is the second time in the last two years that Beijing has felt compelled to seize control of a significant financial institution.

In February 2018, the government took over Anbang Insurance, which had at the time amassed 1.97 trillion yuan (US$311.1 billion) in total assets after a debt-fueled global acquisition binge. Anbang’s founder, Wu Xiaohui, has since been imprisoned on fraud and embezzlement charges.

So, is Baoshang an isolated case of a corruption-related cleanup? Or can it be seen to signal the first of a long line of bank failures and government interventions?

First, in the current environment, it should come as no real surprise that a bank accused of unsound credit practices and excessive financial risk has been seized. There has been a clear and firm regulatory push in China during the past two to three years, both to reduce untoward leverage in the financial system and to reduce systemic risk.

Furthermore, as China continues to work to rid its financial system of unsound practices, the market should not be surprised to see more takeovers, as and when it is necessary.

As China continues to work to rid its financial system of unsound practices, the market should not be surprised to see more takeovers, as and when it is necessary

It also shouldn’t be a surprise if Beijing pursues a multi-pronged, yet primarily market-based, solution to deflating credit excess. In analogous situations elsewhere in the world, where credit excesses have needed to be addressed by governments, proper regulatory responses have often been the determining factor as to how painful a credit crisis became. A good example is the global consequences of the US government’s failure to keep Lehman Brothers alive.

Given this fact, it should be viewed as promising that the Chinese government is stepping in where a bank would otherwise fail. The important next steps now are the precedents that are set, from a process perspective, around the planned unwinding of a banking institution.

Baoshang is really not very large. When it was seized, it reportedly held 576 billion yuan ($83 billion) in total assets. By comparison, the Industrial & Commercial Bank of China, the country’s biggest bank, has more than $3.6 trillion in assets. But Baoshang is big enough to matter in terms of how its debts are settled and, most important, how counter-party risks are managed within the interbank ecosystem.

Which means the Baoshang takeover is an opportunity for China’s regulators, who can now demonstrate how well their processes work when dealing with the winding-up of a failed bank, and in such a way that both manages and reduces systemic risk.

More broadly, the subsequent resolution process could be a catalyst for improving overall risk assessment in China’s credit markets.

As mentioned, it seems there has already been a prudent undertaking by government that personal savings held with Baoshang will be fully guaranteed for at least a year.

With regard to the interbank market, there has always been the belief in China that there are implicit government guarantees in place that protect banks after such seizures.

However, with Baoshang, it’s the first time Chinese authorities have explicitly guaranteed interbank liabilities and corporate deposits, albeit only up to 100 million yuan.

And, as reported in well-regarded Chinese finance newsletter Wallstreetcn, the maximum “haircut” on Baoshang Bank’s obligations for a financial-institution counter-party (presumably including interbank exposures) will be 30% while the maximum for retail and corporate clients will be 20%.

As such, in a pre-emptive move, the PBOC has also said it will inject 270 billion yuan ($40 billion) into the interbank market, which would be its biggest open market operation this year.

In this regard, many analysts have been saying, for many months now, that more cuts to the PBOC’s required reserve ratio (RRR) mandates – which determine the minimum amount of reserves that a commercial bank must hold – are also needed, and these are likely to be coming soon on the back of the events around Baoshang.

The same day the regulators seized Baoshang, the PBOC also set up a new entity, the Deposit Insurance Fund Management Co Ltd, to manage a 100 billion yuan fund that is in place to protect depositors in failed banks.

China established a national deposit insurance fund in 2015 and has been collecting insurance premiums from depository financial institutions ever since, but to date there have been no payouts. The Deposit Insurance Fund Management Co, China’s first such deposit insurance company, was clearly established, in large part, because of the Baoshang seizure.

It is possible that the deposit insurance fund could inject capital into Baoshang, acquire the remaining liabilities – after any haircuts – and implement a market-based disposal of its remaining assets. However, the full power of this new agency, in taking over failed deposit-taking banks, is still unclear.

Regardless of whether the deposit insurance fund takes over Baoshang, it does seem likely that the resolution will be done in a market-oriented way, meaning the government will not be providing full bailouts, and creditors will have to take some of the pain. Many in the sector have maintained this all along and argued that it is indeed necessary to the rapid development of China’s non-performing-loan sector.

As such, the Baoshang Bank saga can be viewed not as an alarming development but a positive one. The Chinese authorities continue to view a market-based offloading of non-performing loans as the preferred approach to lowering risk in its banking system, while the government stands ready to step in when a particular bank failure could otherwise create broader systemic risk.

There is a deliberate government-driven process to move non-performing loans from banks’ balance sheets and also deleverage and de-risk the Chinese banking system. And this is a key fundamental driver of better risk assessment in the capital markets generally, and the bond markets more specifically.

As such, these are critical developments in attracting foreign capital into the Chinese bond market.