China's banks are playing a game of cat-and-mouse with the Beijing authorities, window-dressing deposit numbers at the end of each quarter to meet regulatory requirements on how much funds they must hold.
This practice, which started last year, exaggerates the size and stability of banks' liquidity and masks any stresses on the country's financial system at a time when the world's second-biggest economy is expanding at the weakest pace since 2009.
"If there was a list of things that could destabilise China's financial system, bank liquidity would be it," said Diana Choyleva, a Hong Kong-based director at Lombard Street Research.
The government limits the amount of money that banks can dole out as loans at 75 percent of deposits. With deposit growth slowing, banks must seek new funds to meet the requirement or reduce lending, which would go against current government policies on loosening credit to stimulate the economy.
To meet the loans-to-deposit rule, banks are selling short-term wealth management products (WMPs) that mature in the final days of each quarter, when the investment is then automatically converted to cash and deposited into investors' regular accounts.
Banks are also resorting to "deposit brokers" - individuals or businesses with large cash deposits that are able to transfer their money between banks at whim and often to the highest bidder.
The scrambling for deposits plays out in China's money markets, where rates on short-term interbank loans often surge in the final week of the month. The spikes are even more pronounced at the end of each quarter.
On June 27, the benchmark weighted-average seven-day bond repurchase rate jumped to 4.40 percent, the highest since February 24, from 2.55 percent on June 12. The pattern repeats itself every month, soaring then collapsing.
Reflecting this volatility, retail deposits surge at the end of every quarter. A day or two later, the numbers plummet as this money is quickly withdrawn by customers and channelled back into higher-yielding WMPs.
Officials at the country's so-called "Big Four" lenders declined to comment on such practices, but said they abided by all rules set by the China Banking Regulatory Commission.
SLOWING DEPOSIT GROWTH
China's banks have traditionally enjoyed a seemingly endless flow of cheap deposits, allowing them to extend loans freely and insulating them from poor lending decisions. That is changing.
With deposit rates capped by the government at 1.1 times benchmark rates, deposit growth is slowing as savers move their money into mutual funds, real estate and the WMPs being sold by banks.
Banks have suffered month-on-month declines in yuan deposits five times since last year. Between 2002 and 2010, there was only one such monthly outflow.
This is worrying for China's banks, which rely heavily on local savers. Deposits account for 82 percent of liabilities at Industrial and Commercial Bank of China Ltd (ICBC), the world's biggest bank. At JP Morgan, it's only 53 percent.
Banks began selling WMPs - short-term, higher-risk investment vehicles that offer returns of as high as 10 percent compared with about 3.5 percent for deposits - to retain and attract new customers.
WMPs have ballooned from a few hundred in 2009 to nearly 20,000 today, now equivalent to more than $3 trillion in deposits. About 22 trillion yuan of such products are set to be issued this year, according to Barclays.
Now, banks are using WMPs as a means of boosting deposit numbers to satisfy regulatory requirements. The problem is WMPs tend to be less "sticky" than regular deposits. That means savers are more likely to move their money between banks in search of higher yields.
"What has happened is that there is money shifting on and off balance sheets," said Alex Lee, an analyst at DBS Vickers in Hong Kong. "When an investor buys a WMP, it comes off the bank deposit records, which then affects the bank's ability to lend."
Money market dealers say the "big four", the largest net lenders in the interbank market, have turned cautious about lending at the end of each month.
With their huge nationwide branch networks, ICBC, Bank of China Ltd, Agricultural Bank of China Ltd and China Construction Bank Corp boast the strongest deposit bases.
But knowing their smaller rivals will use overnight fees and other tactics to draw in short-term deposits near the end of the month, the big banks cut down on interbank lending to protect themselves from a liquidity crunch.
"Demand (for interbank loans) is pretty fixed, but if the big banks are pulling back their supplies, then you will see a spike in the seven-day repo rate," said Ethan Mou, rates strategist at Bank of America-Merrill Lynch in Hong Kong.
"At month-end or quarter-end, the small banks are trying like crazy to attract deposits. Even the big banks are afraid they may lose deposits to their competitors. So that's why at the end of the month, they are cautious about lending too much."
DUBIOUS NUMBERS
The balance sheet massages are undermining the loan-to-deposit limit put in place to ensure that banks finance their lending through deposits, rather than short-term funding, which can quickly evaporate in times of market stress.
The concern about the lack of stickiness in WMPs - set to equal 10 percent of China's official deposits - is compounded by worries that the funds raised through the products are used to finance long-term loans and other illiquid assets, all of which would be difficult to sell at short notice, analysts say.
This raises the risk of a sudden liquidity crunch at a bank, which could be triggered by a run on WMPs if losses start to appear.
"Any single default would freeze liquidity and eventually jeopardise (the trust) business," Nomura analyst Lucy Feng wrote in a research report on the Chinese trust industry. "The industry cannot afford to have any non-performing loans that could create a systemic crisis."
The first signs of credit problems at some of these products have begun to surface. Last week, China's No.3 trust company, which sold a bank-trust product, admitted that a loan from one of its funds was at risk.
China's regulators have issued repeated warnings and tighter regulations over the last year to improve the visibility of bank lending practices, particularly at small and medium-sized lenders.
Regulators have called for WMP sales to be accounted for on bank balance sheets, and told banks to assess an investor's financial strength.
China last month also granted banks some flexibility to raise deposit interest rates above the official benchmark, a move aimed at helping them to lure some customers back to traditional deposits.
In a sign of existing strain on the system, the central bank cut interest rates for a second time in a matter of weeks on July 5 to bolster the economy. The People's Bank of China (PBoC) also gave banks more leeway to set lending rates in a move that analysts say was aimed at stimulating borrowing by creating a more competitive landscape.
"The central government and regulators have learnt from the mistakes of the 2008 crisis," said Victoria Mio, a fund manager at Robeco, which has about 177 billion euros in assets under management. "They are taking real action before things happen, using very measured moves."
