*5.2. Determinants, Adverse Selection, and Moral Hazards in Chinese Banking* 5.2.1. Adverse Selection

The risk exposure determinant, measuring the quality of loans, can be used to test adverse selection problems. These problems are mainly concerned with securitization transactions between the originator and investors. Generally, the originator has more and superior information about the underlying assets than investors. If a securitization transaction involves serious information asymmetry, where the investor is not clear about the underlying quality of an asset, the securitization originator can move low-quality loans into SPV and sell them to investors. Thus, the quality of underlying assets is key in studying adverse selection problems. If large amounts of low-quality underlying assets are moved from banks and sold to investors, investors are more likely to buy 'lemons' from an originator, resulting in adverse selection problems. Based on the background of banking in China as well as our regression results, this paper shows that the securitization transactions made in this setting are related to adverse selection problems for the following reasons.

(1) Writing off non-performing loans, asset management companies (AMCs), 'debt-toequity' swaps, and non-performing loan (NPL) securitization are four main ways to tackle non-performing loans in China. They are allowed and supported in banks in China; however, the effects of those approaches in practice are questioned.

The traditional way to tackle non-performing loans is writing them off. This approach is widely used with lower non-performing loans, but it is at the expense of banks' net profits and decreases the bank's profitability.

AMCs are another way to tackle NPLs. They acquire distress debt from banks and then progressively restrict and repack those acquisitions in the flowing. The four major AMCs play a critical role in tackling NPLs (Deloitte 2018a). Building on this, recent reforms allow AMCs, with 35 currently in operation, to take on bad debt. They also permit AMCs to sell bad debt to third-party investors rather than simply acting as warehouses for NPLs (Foreign and Commonwealth Office 2017). However, there are signs that those corporations rely heavily on bank loans to finance their purchases in order to expand their scale; given the circular relationship with the banks, some local AMCs are simply perpetuating loans to zombie firms (Foreign and Commonwealth Office 2017). The effects of AMCs are doubtful; those credit risks might be moved from balance sheets but essentially are not eliminated and could even increase risk exposure.

'Debt-for-equity' swaps were initiated by the State Council in 2016 to replace bad loans with an equity stake in the relevant companies, becoming another solution to China's cooperation debts. In theory, debt-for-equity swaps could act as a relatively growthfriendly route to incorporate deleveraging that can decrease the problems of corporate debt problems (Martin 2016). In other words, 'debt-to-equity' swaps aim to decrease high corporate leverage and lower debt risks directly, which could indirectly lower banks' credit risks. However, in practice, 'debt-to-equity' swaps face implementation risks, because banks are compelled to swap bad loans for equity to keep failing 'zombie' companies alive (Fitch 2016). In addition, the 'debt-for-equity' swap scheme is unlikely to reach a scale at which it addresses corporate sector leverage in a meaningful way, given the lack of investor interest and the capital constraints of banks (Nolet and Wong 2017). If 'debt-to-equity' swaps cannot deal with high leverage and NPLs efficiently for corporations, then this approach indirectly fails to decrease NPLs in banks.

With the diversification of underlying assets in terms of securitization, non-performance loan securitization has become a new way to deal with NPLs. The mechanism is similar to loan securitization, but the underlying assets are replaced by non-performing assets. In this way, more investors participate in the market to help optimize non-performing assets and increase banks' non-performance asset disposal (KPMG 2017b). However, the high risks of these underlying assets could affect the confidence of investors. In order to overcome this issue (Daniel et al. 2016), banks tend to retain large amounts of high risk tranches. Thus, the high cost of NPL securitization could make tackling credit risks difficult.

(2) The official data from CBRC and other financial institution estimations jointly indicate that credit risks in the banking context in China have been boosted in the past few years, and the financial system is on a dangerous trajectory. If the approaches of tackling non-performing loans are less efficient as discussed above, banks will be encouraged to transfer their risks via loan securitization directly.

Even though exposure to credit risks slowed down after 2016 (KPMG 2017a), NPLs have increased extraordinarily in recent years with the slowdown of the Chinese economy. According to the information disclosed by the CBRC, the various loan balance of commercial banks' asset portfolios was RMB 98.029 trillion at the end of 2017, representing an increase of RMB 11.121 trillion compared to the end of 2016. The NPL ratio is as high as 1.74% and has risen extraordinarily since 2012 (DBS 2018). However, foreign institutions have estimated that the NPL ratio would be much higher than is indicated by the official data. Fitch (2017) estimated that the NPL ratio could be in a range from 15% to as much as 21%, equivalent to around 11–20% of China's economy. The IMF (2016) estimated a similar ratio, i.e., a total debt at risk, based on individual firm level data on interest coverage ratios and liability ratios, at 15%.

The high NPLs result in increased stress costs and a threatened stability. However, securitization with 'true sale' transactions and the 'bankruptcy-remoteness' mechanism provide banks with credit risk transfer opportunities. Generally, because of the market

mechanisms in securitization, such as lender reputation concerns, the lenders retain highdefault-risk loans in their portfolio; while financial risks grow, lenders change dramatically and retain low-default-risk loans in their portfolios (Agarwal et al. 2012). Thus, when banks are under pressure of high credit risks, they are more likely to share large amounts of low-quality loans via securitization.

It can be summarized that NPLs have increased dramatically in the past few years, but approaches tackling NPLs in practice are doubtful. With a rising risk exposure without efficient methods to tackle risk, high-risk exposure could motivate banks to transfer credit risks from balance sheets via loan securitization directly. In addition, our study indicates that risk exposure presents statistical significance in relation to securitization transaction volume. Higher credit risks in banks drive larger amounts of loan securitization. As mentioned previously, the quality of underlying assets is key to studying adverse selection problems. We conclude that banks tend to pack those low-quality assets from their portfolios and move to SPV to protect themselves against high credit risks. Once a large amount of low-quality or low-performance loans are packaged without efficient information disclosure, investors are more likely to buy low-quality securitizations. This will hurt investor protections and even drive the securitization market down. There are consequences of adverse selection in securitization.

#### 5.2.2. Moral Hazards

In this paper, liquidity, profitability, and capital requirement determinants are used to study moral hazards in bank securitization. Moral hazards are mainly concerned with the relationship between borrowers and banks (originators) or the bank itself. They mainly show that banks use securitization to take on more risks. Specifically, once a bank's risks are incurred by investors without enough information to supervise the bank's operations, the bank will take more risks, which results in financial instability. We found, by comparing two periods' securitization determinants, that moral hazards tended to decrease because these three determinants had a lower influence on securitization issuance. Before 2017Q4, liquidity contributed to serious moral hazard problems in securitization, while the profitability and capital requirement determinants presented a lower association to such problems. However, the capital requirement presented a greater association to moral hazard problems after 2017Q4.

#### Liquidity

Liquidity is considered an important determinant contributing to moral hazard. Moral hazards in securitization with regard to liquidity are mainly present in lax screening by lenders. Securitization is used to increase bank liquidity according to multiple variable analysis. Banks can acquire additional and sufficient liquidity through securitization. Sufficient liquidity generally encourages banks to offer a larger amount of loans to borrowers and pursue higher profitability. The supply of loans is increased, while the demand is unchanged, and lax screening by lenders can stimulate a higher demand for loans. Lax screening also increases a bank's financial risks and results in the instability of the financial system, especially for so-called 'too-big-to-fail' financial institutions. Additionally, the regulatory scheme also encourages banks to provide more loans to support economic development. The regulatory authorities (China Banking and Insurance Regulatory Commission) released a regulatory scheme aiming to ease the higher amount of liquidity. The specific operation is the relaxation of their bad loans to a range of 120–150% from the current minimum of 150% (WSY 2018). This move can help commercial banks improve their capability in guarding against liquidity risks, serve the real economy, and maintain the safe, stable operation of the banking system (Xinghua 2018). Clearly, banks with the encouragement of a liquidity regulatory scheme lead to large amounts of liquidity from banks to support economic devolvement. This could result in lax screening to a certain degree. We conclude that, before 2017Q4, banks were able to acquire sufficient liquidity and encourage borrowers to take larger loans and that they were more likely to lax-screen

borrowers and even offer loans to ineligible borrowers. Therefore, if authorities are not able to acquire enough information to supervise efficiently, lax screening would lose control.

However, Chinese authorities, over the three years prior to the study period, asked banks to restrict the loan supply, especially property loans, to ward off an economic bubble. Banking regulators paid attention to the rebound of the proportion of property loans among their new loans (Nasdaq 2021). Lax screening by lenders decreased under prudential supervision. We inferred that such regulators reduce moral hazards in securitization.

#### Profitability

Profitability is not associated with moral hazards in securitization, because profitability fails to drive securitization under our analysis. Even though profitability presents statistical significance in relation to securitization transaction volumes in the majority of banks, the correlation coefficient values are almost zero, which reveals that their effects are limited. This could be explained by that fact that securitization can increase liquidity, lower credit risks, and improve risk management, which can improve performance jointly but not directly. In addition, the tax standard of securitization in China is not mature enough, which is reflected by the lower tax incentives and limits the ways in which performance can be improved via securitization. Before the tax reform, securitization generated taxation problems that did not fully reflect the tax neutrality principle (Liang 2015). The pilot program for replacing the business tax with a value-added tax (VAT) abolished the business tax in 2016. However, how the application of a VAT affects the securitization is still ambiguous, because it is not relevant to purely domestic securitization transactions (Phua 2020). Therefore, we conclude that it is difficult for banks to improve their profitability via securitization transactions due to the tax issue and to take more risks. The profitability determinant cannot result in moral hazards in securitization transactions.
