There are 3 reasons China just took over a bank for the first time in 20 years, and 2 of them are a huge deal

AP

• China just took over Baoshang Bank, a small bank in Inner Mongolia that purported to have a pretty clean balance sheet. It's the country's first public bank takeover in two decades.
• There are three reasons China could've taken it over - because it was part of a huge "gray rhino conglomerate;" because it was a "credit risk" as regulators said; and/or because policymakers are trying to introduce moral hazard into China's debt-laden financial system.
• If the last two are correct, hold on to your hats.

The question isn't why the Chinese government took over Baoshang Bank - a small commercial bank in Inner Mongolia - but rather why the government told us it took over the bank at all, and what that rare disclosure means for China's banking system at large.

The Baoshang takeover is the first public government takeover of a Chinese bank since the country's financial crisis in the late 1990s, but it's certainly not the first takeover in general. Over the last two decades the government has many times recapitalized struggling banks or forced them to merge with state banks or other trusted corporations. When it has done this, though, it has done it quietly.

That's what makes this Baoshang situation so strange. The fact that regulators are injecting some fear into the market.

"One of the more unusual aspects of the Baoshang drama is that it's been reported - not only that, but high-level authorities have publicly expressed concern that there may be bank runs and financial institutions that 'disappear,'" J Capital Research, a China-focused investment firm, wrote in a note to clients.

"This is peculiar for an economy that claims to be growing at 6.5%, have average NPL rates under 1.5%, and that has buoyant construction and property markets."

What a fool believes

As J Capital notes, if you buy the statistics - China's financial system shouldn't have a problem.

Perhaps in the same way, if you look at Baoshang's latest numbers, it shouldn't really have a problem either. The bank hasn't published an annual report since 2016, but back then it showed a non-performing-loan (NPL) rate of 1.68%, according to the investment bank Nomura. That's up from 1.41% a year before - so not terrible on paper, especially not with $60.8 billion in assets and $27 billion in deposits.

This certainly does not appear to be a bank that poses "credit risks" as the Chinese government cited in its takeover decision.

But there are other peculiar, and perhaps equally important, things to note about Baoshang too.

• It was part of a massive conglomerate called Tomorrow Group, which is controlled by a fund manager named Xiao Jianhua.
• In 2017, Xiao, who used to run money for China's elite, was arrested for fraud and embezzlement in Hong Kong. Right after that, Baoshang's credit rating was downgraded.
• China has cracked down on similar huge financial conglomerates (like Anbang Insurance) over the past few years. These are so-called "gray rhinos" that the government believes are so large and opaque that they can hide issues.
• One source told Chinese business publication Caixin that Baoshang functioned as a "cash machine" for Tomorrow Holdings, and another said that it had helped Tomorrow put together at least $21.7 billion in funding through shadowy practices.

So is this takeover about Baoshang's parent company? Or Baoshang's balance sheet? Or is it about messaging to China's financial sector that moral hazard has been introduced?

How about a little of all three?

A wise man has the power to reason away

If the Baoshang takeover is about the parent company, consider this a continuation of the detangling of opaque "gray rhino" conglomerate assets that the government has been undertaking for some time. It is not, then, some kind of warning of some potential cataclysmic financial event.

If it's about Baoshang's balance sheet then consider it yet another example of the most dangerous tension in China's debt-riddled financial system. To keep the system growing, banks have to continue to extend more and more credit, but not all of that credit is going to be good. As J Capital noted, Baoshang "is involved in literally thousands of lawsuits seeking repayment of delinquent loans, with interest as high as 18%, or 24% with penalties, generally secured in side agreements."

What this tells us is that the balance sheets of Chinese banks are not to be trusted. On paper (at least the latest ones available for the public/media to see) Baoshang is healthy. The government is acknowledging that papers lie - a dangerous notion to introduce in a country where economists already question basic gross-domestic-product data.

Lastly, if this is about moral hazard, then perhaps regulators are telling the market to prepare for some losses. As Nomura pointed out, "regulators did not state they would guarantee all the liabilities of Baoshang Bank," adding that depositors and creditors with over 50 million Chinese yuan of assets at the bank "will need to negotiate with the takeover task-force for repayment."

Before you chock that up to China's trade war with the US, remember that the Chinese economy has been slowing for some time. At the end of last year and into the beginning of this year, policymakers were legitimately worried, and Xi Jinping has for months been warning that things were going to get more difficult economically. Trade war or not, deleveraging the financial system was going to be painful for China.

So perhaps policymakers are telling the market that there are too many balls in the air now, and some of them are going to have to hit the ground. Point is, at least they're letting us know.