China banks:DES,Trade-off between capital and provision

Of all the queries we received on debt-equity swap (DES), the focus hasbeen on: 1) the likely mechanism of DES; 2) potential impact on banks’ NPL,provision, capital and loan allocation; as well as 3) the role it could play inChina’s supply-side reform and overcapacity exit.

    DES most likely to be direct swap between banks and selected nonzombieSOEs, with limited upfront write-down. DES via WMPs orsubsidiaries of banks could face technical barriers for large swaps, inour view

    Compared to DES via asset management companies (AMCs) as we saw inlast round of NPL digestion in 1990s (Fig. 1), or DES via wealthmanagement plans (WMPs) of banks, or DES via subsidiaries of banks, wesee DES via banks the most likely this time, as it leaves banks with the mostflexibility on pricing and doesn’t trigger additional liquidity pressure with nocash purchases (vs. the last round of DES when AMCs purchased NPLsfrom banks at par value first before swapping it into equity). Further, theloans to be swapped are probably not NPLs yet