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Shares in Chinese banks dropped sharply on Tuesday after the Washington Post reported that a US judge had found three Chinese banks in contempt for refusing to comply with subpoenas in an investigation into violations of North Korean sanctions. The order triggers for the first time a provision that could cut off Chinese banks from the US financial system at the demand of the US Attorney General or Treasury Secretary.

Background to the news

The three banks were not specified in the latest ruling, but the news report cited a US civil forfeiture action two years ago which alleged that Bank of Communications, China Merchants Bank and Shanghai Pudong Development Bank worked with a Hong Kong front company that was accused of laundering more than $105 million for North Korea’s sanctioned state-run Foreign Trade Bank. 

The subpoenas were issued in December 2017 as part of a US investigation into violations of sanctions targeting North Korea’s nuclear weapons program, and demanded a wide range of bank records from the Chinese banks dating back to January 2012. According to the US judge, the banks refused to hand over the related information and comply with these subpoenas.

The report said each of the three unnamed banks argued that it acted in good faith under Chinese banking customer privacy laws. The third bank has challenged the U.S. court’s jurisdiction to find it in contempt while it appeals the subpoena, the report added, while it has simultaneously continued to ask authorities in China for permission to turn over documents. 

Consequently, the US judge may send the order to impose the sanctions and could terminate the banks’ US accounts, end their ability to process US dollar transactions, or order them to pay specific fines.

What this ruling could mean for investors

As stated above, the relevant case against these three Chinese banks is not new but we acknowledge the importance of the timing of the report ahead of this week’s G20 meeting in Osaka, where US President Donald Trump and China’s President Xi Jinping are expected to meet. Against this backdrop, any meaningful escalation of the trade war to include financial or capital sanctions could lead to counter measures and would be extremely negative for all concerned. However, at the moment we see the chance of such an escalation as low and expect the impact would likely be short-lived.

Despite the news and today’s sell-off, the fundamental impact on Chinese banks and the financial system is likely to be contained due to the related banks’ limited overseas business exposure, low reliance on foreign debt and relatively strong balance sheets. 

All three Chinese banks are primarily running domestic business and have little exposure to the US. For China Merchants Bank (CMB), its US branch accounts for less than 1 per cent of its total assets; the overseas branches for Bank of Communications account for less than 6 per cent of total assets and Pudong Development Bank has no US branches. 

As to the liability side, Chinese banks are funded mostly by deposits, domestic bonds and domestic interbank liability, rather than by foreign debt. 

In the case of potential fines, the amounts remain unknown and the impact on the current year’s balance sheets uncertain, but we can use previous cases against other global banks to estimate what they might be. In this current case, using the alleged transaction violation amounts for the three related banks and assuming a fine of ten times those amounts, the impact on the banks’ total 2018 profits would be manageable. 

Catherine Yeung

Catherine Yeung