Banking reforms a qualified success

Chinese authorities need to implement measures that amplify positive impact and contain risk at the same time

On international rankings, China's banks are booming. Once again, Chinese state-owned banks filled the top three spots at the end of May when Forbes published its annual Global 2000 list, a ranking of the biggest, most powerful and most valuable companies in the world.

The rankings of the world's largest banks by S&P Global Market Intelligence, released at the same time, showed that 11 of the world's top 50 banks are Chinese, compared with six from the United States.

My own study into the evolution of the Chinese financial system concluded that government measures to reform the banking sector over the last decade have proved, for the most part, successful.

Through a gradual and piecemeal approach, the Chinese government has transformed a system once subject to tight centralized controls into one that can be described as commercially oriented and financially sound.

Ever since three big state-owned banks listed in 2006, substantial improvements have been identified in the structure, performance, oversight and transparency of the financial sector.

Key developments have included the strengthening of corporate governance and the decision to lift operational restrictions on city-based commercial banks to allow them to expand into other areas. The launch of Tencent's Webank in 2015 - the first private bank in China - was an important step toward stimulating more competition and efficiency in the sector, and dragging underground lending from out of the shadows.

The listing of Chinese banks has greatly improved transparency. It is telling that since China Construction Bank's IPO its annual report has increased from 70 to about 300 pages, reflecting the greater amount of information now available to the public.

Yet international indices do not tell the whole story. They do not account for the fact that the profitability of Chinese banks owes much to artificially high interest rate margins, which remain significantly higher than those in the West.

The aftermath of the 2008 financial crisis and China's changing economic environment have put substantial pressure on the sustained growth of the sector. Profitability has flattened out. As the economic environment in China has deteriorated, the net profit of all major commercial banks was up by just 2.4 per cent year-on-year in 2015, the slowest growth for a decade. The rapid rise of competition in the form of internet-based financial products and services, the government's lifting of the cap on interest rates and surging bad debt and write-offs have further eaten into profits.

Compared with developed nations, China still has a long way to go to establish a well functioning and fully liberalized financial system and as it continues to undergo wide-ranging structural adjustments, new challenges are emerging.

The credit risk of the banking industry is measured by non-performing loans. After years of steady decline, the NPL ratio of China's banks has picked up again, rising from 1 percent at the end of 2013 to 1.75 percent in March this year.

French investment bank Societe Generale claims Chinese banks are at risk of 8 trillion yuan ($1.21 trillion; 1.07 trillion euros) in losses, equivalent to 60 per cent of capital in China's banks.

The last time the Chinese government moved to cancel non-performing loans and restructure the Big Four state-owned banks, it ended up costing in excess of 4 trillion yuan. This came at a time of explosive economic growth. However, China's Big Four now have a much larger asset base. Even if the government wants to bail them out again, it may not have the capacity to do so.

The government has already announced three key policy interventions to support the sector and the success of these measures will prove crucial. The deposit insurance scheme, introduced last year, protects savings of up to 500,000 yuan for businesses and individuals. The scheme allows the government to extricate itself from an implicit guarantee of all banks, demonstrating that it is prepared to see some smaller commercial banks fail.

It is also launching a vast securitization program (or debt-for-bond swap) to sell billions of dollars of non-performing loans to global investors.

Although the US subprime crisis had a devastating effect, banks were able to transfer the risks associated with subprime mortgages into the whole financial system via asset securitization. Using these new financial mechanisms wisely will be crucial to the further development of the Chinese banking sector.

The third key measure is a debt-for-equity swap program that allows banks to exchange bad loans for equity in companies they lend to.

The resurgence of the NPL ratio is a result of the lending boom that followed the 2008 financial crisis. In 2008, the Chinese banking sector was lucky enough to be able to decouple from the rest of the world and sustain a healthy level of growth. However, this happened not because Chinese banks were superior in risk management compared to their foreign peers. It was simply because they had little exposure to the securitized financial products offered by US banks.

As globalization continues apace, the financial sector in China will become increasingly integrated with the rest of the world and will be more vulnerable to external shocks. It is therefore vital that Chinese commercial banks continue to learn from Western banks on risk management and that will require greater foreign involvement in the Chinese banking sector.

The second issue that promises to challenge the long-term sustainability of the Chinese banking sector is its limited income generation capacity. Welcome reform measures in the aftermath of the financial crisis liberalized the bank-lending rate, further opened up the Chinese financial sector to foreign banks and encouraged the emergence of private internet-based banks. The upshot, in the short-term, is a squeeze on banks' profitability.

Chinese commercial banks can no longer rely solely on a wide interest margin to generate easy profits. Instead, they have to become more proactive in exploring other income generation opportunities, moving into overseas markets, embracing innovation and fully engaging in technologies new to the Chinese market such as online and telephone banking.

Bank of China branches are seen around the world but their overseas offering is limited. In the UK though, Bank of China, backed by its Beijing head office, offers one of the most competitive mortgage rates on the UK market - a sign that it is finding ways to compete.

The third key challenge is to ensure greater independence for the central bank. The People's Bank of China is required to meet two conflicting targets through its monetary policy: promoting economic growth and maintaining price stability.

Lessons from the past show that the PBOC has placed far more emphasis on achieving the first target, leading to price volatility and even social instability. In response, unlike Western countries that rely purely on the interest rate channel, the PBOC has employed a basket of monetary policy instruments to curb excessive inflation.

However, the unique savings and consumption habits of Chinese citizens, the limited investment channels available to Chinese investors and the government's market interventions have made it difficult for these monetary instruments to achieve the desired result.

Therefore, further liberalization of the interest rate is necessary to improve market efficiency and the PBOC should be empowered to ensure that no other regulatory bodies can intervene or compromise the effectiveness of its policies.

The fourth key conundrum facing the Chinese authorities is how to manage the healthy development of its shadow banking sector. For all the concerns surrounding the proliferation of non-bank financial institutions, research has shown that they have also made a contribution to China's economic growth, providing much-needed lending to small and medium-sized enterprises.

The shadow banking sector is also providing competition for Chinese banks. As it continues to develop more diverse financial products and services it is spurring Chinese commercial banks to innovate and restructure their business models in order to achieve long-term sustainable growth.

On the other hand, the rapid expansion and the "hidden" nature of the sector have placed the country's regulatory bodies under significant pressure. Many are worried that a US-style financial crisis will be replicated in China.

The future is uncertain but the current scale of the shadow banking sector and the limited innovation of securitized products decreases the likelihood of a crisis of equivalent magnitude occurring in China. That said, the Chinese authorities still need to move quickly to implement a set of measures that amplify its overall positive impact on the financial sector while ensuring risk is contained.

The author is assistant professor of economics and finance at the School of Contemporary Chinese Studies, Nottingham University. The views do not necessarily reflect those of China Daily.

(China Daily European Weekly 06/24/2016 page10)