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| The Impact of Breaking Local Implicit Guarantees on the Risk of Small and Medium-sized Regional Banks |
| SHU Shaowen, CAI Qingfeng, CHEN Dong, ZOU Jingxian
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| School of Finance, Shanghai University of International Business and Economics; School of Economics, Xiamen University; National Academy of Development and Strategy, Renmin University of China |
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Abstract For a long time, China's bond market has operated under the belief of an implicit “guarantee” for bonds issued by state-owned enterprises (SOEs), whereby investors generally expect local governments to provide implicit guarantees for the debts of local SOEs. Breaking this implicit guarantee is an essential requirement for standardizing market discipline, optimizing resource allocation, and clarifying risk attribution, holding significant positive implications for the market. However, during the dismantling of these implicit guarantees, financial risk prevention for entities with weaker risk resilience cannot be overlooked. This paper focuses on small and medium-sized banks (SMBs) as one such entity.Theoretically, the net directional impact of removing local implicit guarantees on the risk of local SMBs is ambiguous. On one hand, for SMBs and large banks coexisting within the banking system, the removal of local implicit guarantees may alter the competitive landscape between these two types of banks, potentially exacerbating the risks faced by SMBs. A relevant background is that China's banking and financial system has long maintained a tiered structure for financial service provision: large banks primarily serve SOEs and large enterprises, while SMBs focus on serving small and medium-sized enterprises (SMEs) and the private economy. The removal of implicit guarantees would significantly reduce the attractiveness of SOE credit business for large banks, an effect likely to spread strongly among SOEs. As large banks become inclined to reduce their SOE-related credit business, the traditional segmentation of the banking market is disrupted, prompting large banks to expand their services downward. This “horizontal” structural adjustment in banking operations may affect SMBs through the following channels: (1) Intensified Regional Bank Competition Effect: Increased banking competition itself can elevate bank risks, particularly for SMBs. (2) Diversion of High-Quality Clients Effect: The downward expansion of large banks may directly siphon off high-quality clients and loans originally served by local SMBs, a practice commonly referred to as “cream-skimming”, thereby worsening the asset quality of SMBs. (3) Expansion of High-Risk Business Effect: Under competitive pressure, SMBs may be forced to shift towards higher-yield, riskier business areas such as shadow banking, which are harder for large banks to enter.
Beyond being affected by the “horizontal” competition and cooperation among banks, the reshaping of the relationship between local governments and SMBs will also “vertically” influence the risk level of SMBs, primarily due to the reduced intervention of the local government's “visible hand” in economic activities. However, the direction of this impact is not straightforward. This is because prior to the removal of local implicit guarantees, government intervention could have a dual effect on SMB risk. On one hand, local governments might increase SMB risk by interfering with their market-oriented operational decisions and distorting market resource allocation. On the other hand, local governments could also act as a “helping hand (or supporting hand)” for SMBs, which often have strong local ties but weaker competitiveness, thereby enhancing their risk resilience.
Given these intertwined forces, determining which force ultimately dominates requires rigorous empirical analysis. Accordingly, this paper uses the first occurrence of local SOE bond defaults in various regions as a proxy for the removal of local implicit guarantees. By constructing a staggered difference-in-differences model, the study finds that the removal of local implicit guarantees significantly exacerbates risks for local SMBs. The reason is that once the belief in “implicit rigid repayment” for SOEs collapses, large banks, which originally primarily served SOEs and large enterprises, shift their business focus downward, creating competitive overlap with SMBs. This leads to intensified local competition, diversion of high-quality clients, and expansion of high-risk activities among SMBs. The paper also finds that the removal of local implicit guarantees has a certain mitigating effect on SMB risks, which may be partly attributed to the weakening of the local government's “interventionist hand” in market resource allocation. However, this risk-mitigating effect is outweighed by the risk-increasing effect. Heterogeneity analysis indicates that this risk-exacerbating effect is more pronounced in SMBs with a higher proportion of collateralized loans (high-quality loans) and weaker prudential management practices. This research not only enriches the study of risks faced by SMBs but also provides policy insights for addressing local government debt risks and preventing systematic financial risks.
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Received: 28 April 2025
Published: 24 April 2026
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