Problem loans are a big issue in China, and no one has a good understanding of just how bad the banks' loan books really are. One analyst suggested that Chinese banks could work through their loans in just two years in the worst-case scenario, but others believe the problems may be deeper.

In this clip from Industry Focus: Financials, The Motley Fool's Gaby Lapera and Jordan Wathen discuss how policy changes affect Chinese bank reporting, and why rules intended to prevent capital flight are likely to be related to Chinese banks' bad loans.

A full transcript follows the video.

This podcast was recorded on Dec. 12, 2016.

Gaby Lapera: It's interesting, because it does seem like China is starting to realize that this is not good for them. Sheng-Fu Lin, who is China's top banking regulator, said that the hidden credit risk that's associated with investment receivables and other types of investments like this, it could be really bad for China's financial security. Which is crazy. Normally, top Chinese officials don't say, "Hey, we might have made an error in judgment, and this could be bad."

Jordan Wathen: Yeah. It's a particularly big deal because, when you think about banking and China, it's a totally different world. Many of the loans that are underwritten there are underwritten on the basis of political favors, or because a company has an implicit guarantee from the government. In a lot of cases, these loans weren't made because someone thought, "Hey, this is a great credit risk." These loans were made because, "Oh, well, you know what, the government will probably bail this out later." Right? It's just -- I don't even know how to describe it -- it's just a heaping problem, a tangled web of bad incentives.

Lapera: Yeah. So, now that we've brought you down about China, things could be a-changing. But it's not super certain, so don't get excited. I was joking with Jordan earlier that I am the best person for this show because I'm so risk-averse that I just fit in with all the financial stuff perfectly. So there's a company, PineBridge Investments, has said that China's big five banks could absorb the hit even if 15.5% of its loans are bad. Technically, the official number for how many loans are bad in China is 1.8%, but like we said, we don't really know what the number is. So, good news: They could sustain a loss of up to 15.5% of their loan value. Bad news: We have no idea what it actually is.

Wathen: Yeah. One of the things you have to understand is, what kills banks isn't necessarily solvency. There have been plenty of examples, even in the United States, where banks have been insolvent. It's pretty much well understood that Citigroup, at one point in time or another, has been insolvent several times over the last century. What kills banks is a liquidity crisis. It's when people take out their deposits. So as long as the government says, "Hey, deposits are fine," and as long as the Chinese people think there's no risk to these banks going under, they can exist and basically earn enough money over time from their good loans to basically paper over their losses. As long as there's no run on the banks, so to speak, then these banks will exist -- whether or not they're good investments is a totally different matter.

Lapera: Yeah. And the idea of a run on the banks in China is a little bit more difficult, because the Chinese government could just say, "Sorry, the banks are closed." I mean, you can do that in the United States, too, but they can also trap all the foreign investments and everything in China and just be like, "It's all ours now. Don't worry about it."

Wathen: Exactly, and that goes back to what we were talking about earlier. Basically, China has, through a number of ways, made it much harder for capital to leave the country. If it doesn't leave the country, no one is going to take it out and put it in their closet or under the mattress; they're going to keep it in the banking system or securities or whatever. Preventing that capital flight, in some ways, flows through to the banking system.

Lapera: Yeah. Another thing that is a positive development, although it might not seem so at first on the surface, is that the Ministry of Finance in China is allowing banks to write off more bad loans. Originally, it was really difficult to write off a bad loan. You had to go to the Ministry of Finance and ask permission for each loan you wanted to write off. But, they've made it a lot easier, which is, I guess, bad in the sense that we're suddenly seeing them right off a lot more loans -- it's doubled in the last couple years. On the other hand, it means that banks are getting better at identifying bad loans quickly, and potentially, it could help out credit risk, because banks are going to be less likely to make bad loans, in theory, potentially.

Wathen: I think the thing here, too, is that investors don't necessarily demand of great performance all the time. But they do demand honest reporting. If a bank is coming out and saying its books are perfect all the time, no one wants to invest in it because obviously everyone knows that banks write bad loans, it just happens, it's part of the business model that some loans will go bad. So if anything, investors are more fearful of the bank that reports no losses than the bank that reports a reasonable level of losses over time.