The seizure of a small bank in China has spooked investors and other banks, adding pressure to shares of small lenders already trading at historically low valuations.

A Bloomberg index of Hong Kong-listed Chinese banks dropped to a four-month low on Monday after regulators assumed control of Baoshang Bank citing «serious» credit risks, «Bloomberg» reported (behind paywall). Baoshang Bank was part of the investment conglomerate led by financier Xiao Jianhua, known as the Tomorrow Group, which is probed by regulators. 

The move is likely to heighten investor concerns about the true quality of Chinese lenders’ assets, and what may lead to the next seizure, according to analysts at China International Capital Corp (CICC). «We foresee visible share price pressure on city commercial banks with similar asset scale or those focusing on Baoshang Bank’s neighboring regions,» wrote CICC analysts led by Victor Wang in a note Monday.

Concerns Over True Quality of Assets

The downfall of Baoshang came from off-loan-book transactions as a means to get around rules that restrict lending to weak borrowers, as well as evasion of capital and provisioning requirements. On Monday morning, Baoshang's bonds were suspended from trading after yields were notched up by about 70 basis points. 

Some lenders' shares already trade at distressed valuations - Heilongjiang’s Harbin Bank is trading at about 0.34 times book value, while Liaoning’s Shengjing Bank is at 0.41 times, according to data compiled by Bloomberg. The average price-to-book ratio at Chinese banks listed in Hong Kong is only 0.7 times.

Warning Signs

Most of the city and rural commercial banks listed in Hong Kong have declined this year, led by Bank of Gansu Co., which plunged 27 percent, and Jilin Jiutai Rural Commercial Corp., which is down 36 percent. The falls are huge compared to the 1.9 percent fall for the country's five largest lenders.

S&P Global warned on Monday that some aggressive small banks are «susceptible to an economic slowdown because their risk management capability can’t keep up with their breakneck pace of growth.»