How China’s Property Crisis Is Testing Its Too-Big-to-Fail Banks

China’s giant banking system, the world’s largest, is heavily exposed to the real estate crisis: Nearly 40 percent of all bank loans are related to property. And pressure is building on those banks as dozens of real estate developers have defaulted or missed payments on overseas bonds, led by China Evergrande, the world’s most indebted developer.

The scale of China’s property problems — enormous levels of debt, an oversupply of apartments and consumers increasingly wary of buying — means the government could be forced in the coming years to spend huge sums of money bailing out banks.

Officials in Beijing have already taken some steps, underlining the difficult choices the real estate debt poses for policymakers. They have, for example, allowed banks to give extra time to borrowers before their loans come due, a step that risks doing little but kick the problem down the road. Yet that may send the message that both borrowers and lenders can continue pursuing incautious practices in the expectation of a bailout. And it delays the day when banks can lend to more productive ventures.

“If China fails to order the banks to write off bad loans in the property market, interest costs will continue to chip away at the economy, while too much capital will continue to be wasted on investments with no value,” said Andrew Collier, founder and managing director of Orient Capital, an economic research firm in Hong Kong.

Still, almost no one expects falling real estate prices in China to set off an out-of-control string of large bank collapses, similar to what the United States endured 15 years ago. China’s banking system, holding four-fifths of the country’s financial assets including most of the bonds, is far too big for the government to let fail.

The government directly or indirectly holds controlling stakes in practically all banks, giving it a powerful say over their fate even beyond having extensive regulatory powers. China’s financial system relies mostly on bank loans of a year or more, unlike the tradable securities that quickly tumbled in value in 2008, setting off the global financial meltdown. And regulators block most large movements of money in and out of the country, making China’s financial system nearly invulnerable to the kind of sudden departure of foreign money that touched off the Asian financial crisis in nearby countries in 1997 and 1998.

But the current troubles in Chinese real estate, which have their roots in years of wild lending and speculative overinvestment, pose a formidable challenge for policymakers.

Shortly before stepping down last March, Liu He, then China’s vice premier, warned in a speech of the dangers that real estate holds for China.

“If not handled properly, risks in the housing sector are likely to trigger systemic risks — that is why prompt steps must be taken to address them,” he told the World Economic Forum in January in Davos, Switzerland.

In interviews in recent weeks, four people in Beijing and Shanghai with knowledge of Chinese financial regulatory actions provided a detailed view of how regulators are trying to cope with risks related to real estate. All insisted on anonymity because they were not authorized to comment publicly.

For one thing, China’s regulators are giving banks much more leeway for when they declare loans to be nonperforming, meaning the borrower can’t make payments. That has allowed banks to delay having to report financial losses.

The policy of allowing banks to extend repayment deadlines for loans that debtors have trouble repaying actually started during the pandemic, the people familiar with the regulatory system said. That policy was intended to give banks wiggle room in dealing with companies that suffered nose dives in sales because of Covid outbreaks or lockdowns, without forcing the banks to set aside extra money for nonperforming loans. But this leniency has continued into this year and been applied to the far larger and deeply troubled real estate sector.

In addition, China’s central bank, the People’s Bank of China, has conducted an elaborate stress test on the balance sheets of China’s 20 largest commercial banks, said three of the people, to ensure their resilience in case of further real estate losses.

The stress test, conducted last winter, found that the banks, all of which are state controlled, could survive considerable further deterioration of China’s real estate market, the three people said. But at least half might require additional capital to make sure that they would continue to meet ever-tightening international standards for how much money they keep in reserve.

Acting separately from China’s central bank, central banks in Europe have set up a working group to collect and share information on how much money their countries’ commercial banks have lent in China, although so far they have found little exposure.

A key part of China’s strategy is to spread out the cost of handling real estate losses over more years, these people said. That could allow the banks to use potential future profits on other loans to offset losses on loans to real estate developers.

Nearly half of real estate-related lending in China consists of mortgages, mainly residential. Losses on mortgages are practically nonexistent as homeowners pay them on time or even early.

China has long required far higher down payments than Western regulators — at least 20 or 30 percent of the purchase price for first-time home buyers, and as high as 70 percent for second homes.

Households almost never default on mortgages, to avoid losing their down payments. So these loans have consistently been very profitable for commercial banks, which charge interest rates that are a couple of percentage points higher than the banks pay their depositors. The government has recently urged banks to reduce interest rates on mortgages to help households free up cash to spend, but banks have resisted doing so.

Loans to property developers are the biggest worry for commercial banks and regulators, but their role in banks’ overall finances is limited — Mr. Collier, the analyst in Hong Kong, estimated them at 6 to 7 percent of bank lending. China’s banks, with their strong government links, have influence to demand repayment from developers.

The other troubled category of customers for China’s banks lies in financial affiliates of local governments, which borrow money on behalf of local governments. The local affiliates have borrowed twice as much from banks as the country’s real estate developers.

The affiliates are almost all involved in real estate development and associated activities, like building roads, bridges and other infrastructure. They have spent heavily to buy land at local governments’ auctions as private-sector developers have run out of money to bid. Now the financial affiliates face heavy losses — but since they and the banks are ultimately controlled by Beijing, the problem moves slowly.

Banks, real estate developers and local governments are all hoping that Beijing will eventually help them. But the national government has shown scant enthusiasm so far.

“The system is carrying this forward, waiting and waiting and waiting for some kind of bailout, and it has not come,” said Lester Ross, managing partner of the Beijing office of the Wilmer Hale law firm.