While investors fret about a jump in bad loans from China's local government entities, the country's so-called Big Four banks are busy squirreling money away for the day when borrowers start defaulting in large numbers.

Having been warned by Beijing in 2009 to beef up their risk management systems, these lenders boast more cash than many of their European and U.S. peers did before the global financial crisis.

That cash pile may see its first major test since the financial crisis -- indeed, since the lenders were recapitalized by the government starting more than a decade ago -- on increasing signs many entities created by local governments to finance infrastructure projects could face trouble repaying their loans.

Investors have already beaten down bank shares.

Hong Kong shares of China Construction Bank <0939.HK> have fallen over a fifth since June, far worse than the 8 percent decline in the Hang Seng Index <.HSI>. Shares of Industrial and Commercial Bank of China (ICBC) <1398.HK> are down 15 percent and both Bank of China <3988.HK> and Agricultural Bank of China <1288.HK> have lost about 20 percent.

The banks, however, show little sign of worry just yet, and many analysts said worries over their health have been blown out of proportion.

China's banking system has a bad loan coverage ratio of about 220 percent, or 1.2 trillion yuan ($186 billion), to cover any losses, up from 80 percent at the end of 2008 and compared with 150 percent last year.

On top of shoring up their capital bases, lending procedures have also been tightened, with sources at ICBC, the world's largest bank with a market value of $240 billion, saying that all loans above 10 million yuan now have to be approved by its risk department in Beijing before the money is handed over.

The current fear we see out there is just unbelievable, said Paul Schulte, head of financial strategy at the investment banking arm of CCB <601939.SS>, China's biggest mortgage lender.

It's almost like a child dropped his ice cream cone and there's no more ice cream left in the world.


The big Chinese banks boast some of the lowest loan-to-deposit ratios and some of the highest coverage ratios on bad loans in the world. Non-performing loans have fallen consistently, even as their books grow and the banks set aside more money in case of bad loans.

Standard & Poor's said last week that strong economic growth in China would likely limit the credit costs of local government debt and cushion any blow to the country's major banks, and that it does not expect any of them to report a loss if growth keeps up.

For example, CCB had a loan-to-deposit ratio of 62 percent at the end of 2010. By comparison, Lloyds clocks in at 155 percent while Spain's BBVA stands at 152 percent.

The China Banking Regulatory Commission (CBRC), which overlooks the industry, requires banks in the country to have a loan-to-deposit ratio of no higher than 75 percent.

On lending to local government financing vehicles (LGFV), which are said to be a potential hotspot for a possible spike in loan defaults, the Chinese banks say they have set aside a healthy buffer should they go sour.

China's national audit office says LGFVs borrowed some 10.7 trillion yuan ($1.6 trillion) at the end of last year, while Moody's says the real number is closer to 14.2 trillion yuan. All agree that a significant portion will go sour, with Moody's worst-case scenario putting the figure at 12 percent.

ICBC says it had a bad loan coverage ratio on LGFV loans of 1,009 percent at the end of last year. This means that even if the number of LGFV bad loans jumped 10 times tomorrow, the bank would still have a comfortable enough buffer to cover them all.

The regulator is now closely monitoring local government debt, said Victor Wang, an analyst at Macquarie Securities. The setting up of new local government financing vehicles is almost mission impossible.

More likely to buckle under the pressure of LGFV loans are smaller regional lenders that typically have their operations only in one particular province or city.


Under Moody's worst-case scenario, it would mean that banks could be liable for about 1.7 trillion yuan worth of bad loans.

While that number is high, China's high bad loan coverage ratio of about 220 percent, or 1.2 trillion yuan, suggests banks already have more than two-thirds of the necessary funds needed to pull through the worst-case scenario spelled out by Moody's.

All the bad loans that are being talked about right now doesn't worry me too much, said Schulte at CCB International. The system has enough reserves to sustain itself.

The banks themselves are also trying to avoid non-performing loans as much as possible, having been bailed out by Beijing from the late 1990s at a time when they were technically insolvent after decades of government-directed lending.

Many of the banks have taken to carrying over loans that are due or looking for other means to get their money back, instead of repossessing the underlying asset, said Jim Antos, an analyst at Mizuho Securities in Hong Kong.

What bank would like to repossess a toll road? Antos said.

The first thing to realize is banks are trying to avoid repossessing the underlying property to the extent that they can, and that's rational behavior. Seizing a hospital, a school, a housing complex, an irrigation project - this doesn't solve anybody's problems.

However, there are some worries. From designated loans to bank acceptance bills and trust loans, Chinese banks are pushing out a wide variety of off-balance-sheet loans, and weakening Beijing's efforts to contain lending.

These city or provincial lenders, while still large on a global scale, have a higher proportion of loans made to LGFVs that could potentially threaten their survival if defaults spiral and Beijing chooses not to step in.

For example, Shenzhen Development Bank <000001.SZ> had more than 20 percent of its loan book given out to LGFVs about a year ago, the lender's president said, although it has since brought this number down to 5.5 percent within a year.

When your operations are all concentrated in one area, there may be more pressure on you to lend to companies that have close ties to the local government, said Sheng Nan, an analyst at UOB Kay Hian in Shanghai. That may catch up with the banks if projects go bad or if the economy slows down drastically. ($1 = 6.463 Chinese Yuan)

(Editing by Jason Subler and Anshuman Daga)