China’s financial regulators are stepping up penalties on banks and asset managers caught hiding bad debts as Beijing grows increasingly wary of the country’s opaque cache of unpaid loans.

The strengthened enforcement underlines authorities’ rising concerns over a potential runaway bad debt problem at smaller banks in the country, a trend that China’s top leaders fear could spawn financial and social instability.

Fines for banks and asset managers that help mask the bad debt are on the rise, with at least five large institutions, including a branch of the Industrial and Commercial Bank of China, receiving penalties over the past month. While the amounts are relatively small, the penalties are intended to deter other institutions from doing the same, analysts said.

Last year, disposals of bad debt were already running at a two-decade high as regulators forced banks to fully recognise their positions. Non-performing loan rates have hit more than 40 per cent at some small banks, signalling further undiscovered bad debt.

Such statistics are a hurdle to maintaining financial markets stability — a top priority for the country’s leaders.

For years, smaller Chinese banks routinely masked their NPLs by classifying them as “special mention loans” — loans that were late but not yet considered non-performing. As a result of that practice, banks typically reported upwards of 20 per cent special mention loans but low rates of NPLs.

In 2018, regulators forced banks to recognise the bad debt disguised as special mention loans, resulting in Rmb1.75tn ($258bn) hitting the market for bad debt sales last year, the highest level in 20 years.

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“The aim of such tight policy is to expose the problems at the banks to the regulators, because banks have been able to use various means to hide non-performing assets,” said Wang Ke, a vice-president at Shanghai-based conglomerate Win Group, and an expert on China’s provincial asset management groups.

Regulators are now shifting their focus to how local asset managers help disguise bad debt.

Asset managers controlled by local governments have been tasked with resolving some of the country’s massive bad debt load, but they also sometimes work against regulators’ efforts to expose the true size of the problem.

In some situations, banks have been caught injecting liquidity into asset managers, with the funds used to buy up the banks’ bad debt and temporarily remove it from the balance sheet, according to people familiar with the practice. The arrangement often includes an agreement for the asset manager to later sell the toxic asset back to the bank at a profit.

The banking regulator in April issued fines for such activities to ICBC, China Minsheng Bank, Tianjin Rural Commercial Bank and Shengjing Bank, a move that coincided with a warning from the National Audit Office over the risks of covering up bad debt.

However, the crackdown is forcing more bad debt on to the market than investors have capacity to buy, noted Wang Yingyi, a partner at Bald Eagle Asset Management. “In the long term, it is certainly a good thing to run with the rules, but in the short term it will have great impact on the [non-performing loan sales] industry,” he said.

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Via Financial Times