Hong Kong: China’s central bank is preparing regulations that would allow commercial lenders to swap non-performing loans of companies for stakes in those firms, two people with direct knowledge of the new policy told Reuters.

The sources, who spoke on condition of anonymity, said the release of a new document explaining the regulatory change was imminent. The People’s Bank of China (PBoC) did not immediately respond to requests for comment.

Non-performing loans (NPLs) surged last year as China’s economy grew at its slowest pace in a quarter of a century. Official data from the China Banking Regulatory Commission showed banks held NPLs and “special mention" loans, or debts that could potentially turn sour, in excess of 4 trillion yuan ($614 billion) at the end of last year.

The new regulations would reduce NPL ratios at commercial banks, requiring them to set aside less cash to cover losses incurred by bad loans. Funds could then be freed up for fresh lending for investment in a new wave of infrastructure products and factory upgrades that the government hopes will rejuvenate the economy.

“Such a rule change shows banks’ bad loans have risen to such a level that this issue has to be tackled now before it’s too late," said Wu Kan, Shanghai-based head of equity trading at investment firm Shanshan Finance.

State banks have extended a lot of loans to government financing vehicles and to state-owned coal and steel producers, so this policy can help give lenders time to deal with their non-performing assets as China pushes supply-side reforms, Wu added.

The quality of assets held by banks is worse than it looks, analysts have said. To avoid stumping up capital and to protect their balance sheets, some Chinese banks have under-reported bad loans and under-recognised overdue debt, they say.

The top banking regulator has warned commercial lenders to pay special attention to risks.

China’s bank shares fell more than 2% on Thursday, with Industrial and Commercial Bank of China down 2% and Bank of Communications losing 2.7%.

“Banks fell mainly due to a technical correction, but there’s also investor uncertainty over how those non-performing assets would be valued, and disposed of eventually," said Wu at Shanshan Finance.

Cabinet approval

The sources said the new regulations would get special approval from the State Council, China’s cabinet-equivalent body, thus skirting the need to revise commercial bank law, which prohibits banks from investing in non-financial institutions.

Previously, Chinese commercial banks usually dealt with NPLs by selling them at a discount to state-designated asset management companies which, in turn, would try to recover the debt or re-sell, at a profit, to distressed debt investors.

The sources did not have further detail about how the banks would value the new equity stakes, which would represent assets on their balance sheets, or what ratio or amount of NPLs they would be able to convert via this method.

On paper, the move would also represent a way for indebted companies to reduce their leverage, cutting the cost of servicing debt and making them more worthy of fresh credit.