The Revolution of the Banking System in China Finance Essay

When discussing the impact of Basel A¡ on banking risk management in China, the liberalization process and considerable reform of banking industry in China will significantly interpret the establishment of modern banking industry and the environment of risk management in banking industry in the past thirty years. Furthermore, this section will indicate particularly significant problems which banks face during the implementation of risk management. This section will introduce the history of liberalization process of banking industry in China and the overall picture of banking risk management in China.

As Open Door policy implemented in 1978, the banking sector has experienced the series of specific reforms and other important corresponding deregulation and regulation processes.

Early Stage

Prior to the economic reforms in 1979, China's banking system, as a product of centrally planned economy, was not modern; the role of banks was only for collecting revenue from state-owned enterprises and allocating investment through budgetary grants (Huang 1992). Mainly, the large-amount of funds states-owned enterprises (SOEs) required were supplied by the Ministry of Finance; the People's Bank of China, established in 1948, issued cash simply for the reason of providing extra credits needed by the SOEs to cover labour cost and purchases of working capital. Also, the PBC was responsible for the execution, supervision and accounting of the country. The crucial institutional changed was brought by the former leader Deng Xiaoping who transformed China from a command to a 'socialist market' economy, With parallel to the economic reconstruction, the government introduced the two-tier banking system in February 1979. The monopolistic position of PBC ended after the setup of four stated-owned commercial banks. The Agricultural Bank of China was formed to take over PBC's rural banking business of a network of 60 000 credit cooperatives.

The Bank of China focused foreign currency transactions; the China Construction Bank

focused on the construction industry; the Industrial and Commercial Bank of China focused on commercial lending and borrowing. The PBC become entirely a central bank in 1994, of which all the commercial banking activities were transferred the forth SOB, the Industrial and Commercial Bank of China (International Monetary Fund, 1996). After that, the People's Bank of China no longer dealing with deposit and loan business and only functioned for planning of monetary policy and for supervising the financial system. But it was acknowledged that PBC was not an independent regulatory body, which was under the State Council, and it implied that setting monetary policy was subject to the approval of the Council (Sayuri Shirai 2001). In addition, the problems of PBC were authorized to allocate loans under the aggregate credit ceiling, while this autonomy left a room for the collusion between branch officers and the local governments who wished for more money.

Under the reform, those state-owned banks, on top of commercial business, furnished policy loans to those SOEs, which were not for the purpose of profit making. That was, even it was known that a state-owned enterprise suffered from massive losses, and the loss would be continued, the specialized banks still had the obligation to supplied them loans. Providing loans to money-losing SOEs was the main reason why the non-performing loans grew so fast in the 1990's as these policy loans nearly constituted one third of total loans. China International Trust and Investment Corporation (CITIC), as well as other international trust and investment companies, was found in the 1980s, which functioned as a channel of raising funds from foreign sources. At the same time, there were local trust and investment companies planted by the four SOBs as affiliates to expand another form of business, and by the local governments that required a higher return of deposits and that needed to finance priority projects.

Also, it was acknowledged that other banks started such as China Investment Bank and CITIC Industrial Bank. On top of that, there were very distinctive non-bank institutions, rural and urban credit cooperatives, which were unique to the command economy (S). The rural credit cooperatives (RCCs) were small financial institutions jointly owned by farmers through equity stock to receive deposits and grant loans to the rural areas. Similar to RCCs, the urban credit cooperative (URRs) provided saving and lending services in medium- and large-size cities. Despite the fact that these cooperatives were controlled by the government, they were able to enjoy a certain degree of autonomy.

Reforms since 1990

The major reconstructions of China's banking sector were in the aspects of privatization of banks, financial liberalization, strengthening of accounting and regulation and the management of non-performing loans.

Separating from policy-lending to commercial activities

Owing to the issues of policy-lending that pushed up banks' bad debt, the Peoples' Bank of China implemented a major reform in 1994, whose focus was on the separation between commercial business and policy-lending (International Monetary Fund 1996). Nearly all the policy loans from the four SOBs were transferred to the three newly-instituted policy-lending banks, Agriculture Development Bank of China, Export-Import Bank of China and China Development Bank. It was intended that the state-owned banks were transformed into commercial banks with acceptable capital adequacy ratio and better management. As the Commercial Banking Law was promulgated in 1995, the commercial banks were subject to more vigorous regulations on working capitals and human resources. For instance, the minimum registered capital of state-owned commercial banks and share-type commercial banks was set at RMB 1 billion. Senior managers were required to possess, at least, a university degree in finance and 8 years of experiences in the financial sector.

This was, in addition, the first time for China to introduce macro-economic control. As the deficiency of PBC in controlling credit allocation and in monitoring non-bank institutions induced funds shifted from banks to unregulated sectors, bubbles in real estate and stock markets were formed. As a result, the tightening policy was executed to reduce the decline in banks deposits on one hand, and to solve the liquidity squeeze on the other hand. Yet, the installation of policy-lending banks did not solve the question that the big four still extended credit to many non-profitable state-owned companies. It was true that some of those SOEs with very unacceptable performance became more difficult for extra funding since the state banks gradually turned into more prudent and were more flexible in choosing their clients. Policy-lending, for all that, existed in the state-owned banks, which in principle, only dealt with commercial activities (Cao 2000). Though it was not very explicit, central government continued to intervene, even until now, the allocation of funding in the four main banks to those loss-making SOEs.

The role of private financial institution was very restrained. Furthermore, there, as mentioned before, were interferences of the local governments on the branches of state-owned banks. The corruption in lending activities was, at least to some extent, controlled by the rule that headquarters of SOEs had the exclusive right to appoint bank managers of provincial branches. It was no longer the case that the selection process required the agreement to both local governments and those headquarters. The influence of local government on commercial loans, consequently, was refined (Sayuri Shirai 2001). It was noted that there were share-type commercial banks which started very different to the prevailing banking system. These banks possessed not only the policy-oriented nature as they required to follow government policies, but also conformed to market principles of a well-defined equity structure.

The banks, established by local governments for supplied capital resources for the Special Economic Zones (SEZs), were aimed at breaking the monopolist position of the four state-owned banks. The banks with new structure enjoyed a close relationship with local government, at the same time, were independent in the sense that they were able to conduct business according to proper legal procedures and coping with the needs of economic development. Examples included Guangdong Development Bank, Shanghai Pudong Development Bank and Shenzhen Development Bank. On the other hand, it was acknowledged that in 1986, the PBC authorized the establishment of the Huitong Cooperative Bank of Chengdu, which was the first private banking institution. In 1996 first public traded private bank, the China Minshen Banking Corporation was created. But it was the fact that the presence of private bank in China was very negligible (S).

Interest rate deregulation

Interest rates were always closely related to the banking system. To privatize the banking system implied that it was necessary to liberalize interest rate markets. Banks in the late 1980s were permitted to change lending rates within a certain margin below and above the administrated rate. Next, the central bank launched a set of lending rate ceilings and fools: a ceiling at 20% of the basic rate, and a floor at 10% on commercial banks; a ceiling at 30%, and a floor at 10% on urban credit cooperatives; a ceiling at 60%, and a floor at 10% on rural credit cooperatives. Although PBC lessened this flexibility in 1996, the liberalization process went on - the ceiling was set at 20% for loans to small and medium enterprises, and at 50% for UCCs in 1998, and the ceiling for lending to state-owned enterprises was further increased to 30% (S). Afterwards, the rates of lending and saving were allowed to adjust within a range of the benchmark rate provided by the government. In January 2004, PBC broadened the floating range of financial institutions' lending rates (the People's Bank of China 2004). The upper limit of commercial banks and urban credit cooperatives' lending rates increased to 1.7 times the benchmark lending rate, with that of rural credit cooperatives' was raised to 2 times the benchmark rate.

The lower limit of financial institutions' lending rates was kept unchanged to 0.9 times the benchmark rate. And it was noted that this flexibility in lending rates applies to all types of financial institution, regardless of their ownerships or sizes. Another major reform was the liberalization of interest rates on foreign currency loans and on the foreign currency deposits of $3 million or more. The rates on deposits of less than $3 million were set by the China Association of Banks. Besides, the interbank markets were emerged into a computer-based national market in January 1996, (Sayuri Shirai 2001), for which PBC fixed a reference rate. Six months later, the market became more elastic as the ceiling on interbank rates was eliminated. In 1997, an interbank market which, for the most part, handled repo arrangements was instituted. This secondary bond markets, as a tool of open market operation, helped the government implement monetary policies. Notwithstanding the fact that interest rates in China became more flexible, the rates were served as monetary tools and on the whole, determined by the People's Bank of China.

Management of non-performing loans

The Chinese leaders began to address the issue of bad loan in 1994 by constructing the three policy banks. Nevertheless, it was not sufficient that this problem continued to grow, a series of reforms emphasizing recapitalization and management of NPLs were adopted. In 1998, the government, by issuing of bonds, injected RMB 270 billion into the 4 state-owned banks (Mo 1999). In 1999, International Finance Corporation (IFC) completed an equity investment in the Bank of Shanghai, as well as contributed US$ 27 billion in the Nanjing City Commercial Bank in 2001. In addition, the IFC assisted those small and medium-sized non-state banks that conducted business in the western part of China. Apart from recapitalization, PBC also arranged a debt-equity swap of RMB 5 billion for saving the nearly bankrupt Everbright Trust and Investment Company (ETIC), which could not repay its maturity debt. At the same time, this swap protected the company's largest creditors including a state oil firm and 2 SOBs. Another way of Chinese government used for reconstructing the Chinese banks was the declaring closure and bankruptcy insolvent financial institutions.

During the period of 1997-1998, PBC closed the very financial problematic Hainan Development Bank, as well as 3 trust and investment companies. Also, the Guangdong International Trust and Investment Company applied to the court for bankruptcy in 1999. The financial restructuring covered the merging of 2000 urban credit cooperatives into 88 city commercial banks from 1995 to 1998. This

schedule consisted of re-evaluation of assets and capitals, write-off of a proportion of bad debts and introduction of new shareholders. The transformation of troublesome UCCs to regional banks indicated that local governments intended to lessen, or at least conseal the issue of bad loans in the cooperatives and transferred some of responsibility to the central government. In the year of 1995 and 1997, Hainan Development Bank acquired a number of trust and investment companies and UCCs, while in 2001, PBC approved the merger of 1658 rural credit cooperatives into 81 joint stock rural commercial banks in Zhangjiagang, Changshu, Jiangyin, and Jiangsu Provinces (Sayuri Shirai 2001).

The very critical reform in NPL management was the establishment of the four asset management companies (AMCs) in 1999, each of which received RMB 10 billion by the Ministry of Finance to recover the four state-owned banks' bad loans: Cinda worked with China Construction Bank; Great Wall worked with Agricultural Bank of China; Oriental worked with the Bank of China; Huarong worked with the Industrial and Commercial Bank of China. The AMCs were independent corporate persons owned by the state and were under the supervision of PBC. The job of these temporary financial institutions was to purchase, manage and dispose of NPLs during 10-year life span. In addition to restructuring, they also had to be deal with the reconstruction of state-owned enterprises. Financing by issuing bonds of RMB 850 billion and by borrowing RMB 550 billion from PBC, the four companies, by 2000, had picked up NPLs of RMB 1.4 trillion, which accounted for almost 20% of combined outstanding loans (Lin 2000).

It was noted that although these companies were permitted to apply various methods financial channels to dispose assets like conversion, transfer and sale, debt repackaging, corporate re-organization and securitization, majority of the non-performing assets were re-organized using conversion of debt to equity (Wu 2000). By 2000, the total valued of recovered asset was only RMB 101.3 billion, where the recovery rate was only 33.6%. The total cash recovered was RMB 63.15 billion with a recovery rate 22.9%. It seemed that the AMCs were not very effective in managing those bad loans, which largely related to prevailing banking structure of China with poor accounting system. As a result, the quality of asset was in doubt. On the other hand, moral hazard problem existed because many SOEs refused to repay debts and just waited for debt-to-equity conversion (Huang 2000).

Strengthening of accounting, regulation and supervision

After 1990, a considerable number of non-bank institution entered to the banking market in China because regulations controlling the firm's scope of business were not clear. For the reason of better administration, the government introduced the China Security Regulatory Commission (CSRS) and the China Insurance Regulatory Commission (CIRC) in 1998. The former functioned to supervise the security market; the latter functioned to supervise the insurance market. The people's bank of China no longer took their responsibility. For the purpose to extend the independence of PBC, the supervisory capacity of its provincial branches was transferred to 9 trans-provincial branches in 1998, while a financial supervisory system of responsibility was created to define the responsibilities of head offices and branches in 1999. Furthermore, China implemented an international accepted five-tier classification of loans in 1998, as well as the Administrative Rules for Financial Statistics in 2002 as so to enhance the accounting system (Hong 2001). Aiming at tackling the problem of money laundering and corruption, Rules for Anti-money Laundering by Financial Institutions were exercised in 2003. It was acknowledged that those rules were not got into practice even though there were leas governing. On the other hand, there was vital structural modification-the China Banking Regulatory Commission was instituted, which took over the responsibility of the PBC to supervise the banking system. Followed the formation of the CBRC, a series of regulations were executed for strengthening the soundness of the banking sector in China.

The Structure of China's Banking Industry

State CouncilFigure 3.1.1 Structure of the Chinese Banking Industry China Banking Regulatory Commission (CBRC) People's Bank of China (PBOC) (Central Bank) Over 27 000 credit unions 144 commercial banks 3 state policy banks Over 180 Foreign banks 127 city commercial banks 12 nationwide or regional shareholding commercial banks 5 state commercial banks Over 250 branches Over 200 representative offices About 190 000 branches Source: Structure of the Chinese Banking Industry in Multinational Banking in China Theory and Practice (Meng, 2009).

3.2 The Overall Picture of Banking Risk Management in China

In this sector, I will first briefly introduce the history and transition of the Chinese banking system, together with problems associated to different stages like lending bias. Then I will discuss the studies in the recent Chinese banking reforms, which aimed at limiting the size of non-performing loans. After that I will go to a research studying the banking system with China's accession to the WTO. Over the last 20 years, China's banking system, in parallel to the economy, has underwent a series of reforms that aimed at reconstructing the centrally-planned mono-bank system to an open and private one. But most of state-owned banks (SOBs) suffered from the legacy of policy lending, and burdened by a large stock of non-performing loans (NPLs). Zhou and Zhu (1987) researched the Chinese banking structure at the early stage of banking reform and pointed out some observations: 1) The lack of comprehensive macroeconomic regulations caused the loan agent improbable to implement a sound loan or investment structure. 2) The local governments frequently intervened the business of local branches of the People's Bank of China (PBC), branches of investment banks and those of commercial banks. 

The central government was often involved in the monetary policies of PBC. 4) The inflexible interest regime could not reflect the real cost of capital. From the above findings, it was shown that the problems has existed for a long period of time and were rooted in the long-standing structure of the banking system. The study of Wei and Wang (1997) also confirmed that there was a lending bias of state-ow

ned banks. According to data from 370 cities in 1986, 1989, 1990 and 1991, their empirical results showed that systematic lending bias in favour of state-owned enterprises existed in the Chinese SOBs, revealing that the cities with a higher SOE share of output more likely came up with a faster loan growth. Because of this bias, the effectiveness of restructuring the SOEs and that of developing the private sector diminished. The implication in policy was that the reform of banking sector should be undertaken in conjunction with the reform of state-owned enterprises.

As the restricting of banking sector continued, Lardy (1998), using the economic and banking data of China from 1978-1998, indicated that the performance of the Chinese financial sector during this period was very unsatisfactory: both of the capital adequacy and profitability were very low in Chinese banks, while the growing non-performing loans deteriorated the asset quality. He argued that the recapitalization program of the domestic banks carried out by the Chinese government in August 1998 were far short of the actual amount of money needed to solve the trouble of bad loans. Given that recapitalizing the large financial institutions was necessary but not sufficient, he suggested that a sizeable increase in the competition among banks was required to push up the working efficiency. For rising competition, the People's Bank had to allow the stronger domestic financial institution to setup, and allow foreign banks to expend their domestic currency business. The regulations on the geographic and other constraints on those banks could be related. Another method of intensify competition was to create genuinely private banks which were subject to an appropriate minimum capital standard.

On the other hand, Lardy argued that reconfiguration of the SOBs that slammed up offices networks and staffing, and improvement in the tax system were essential to make the banking system more effective. From above, it was argued that one of the complications of banks in China related to their sizes. Wei and Wang (2000), on top of that, looked into how the scale of the Chinese banks affected the operating efficiency. They collected simple data from 12 local banks, which included the 4 main SOBs and new commercial banks. Applying the Data Envelopment Analysis (DEA), they carried out an investigation on technical efficiency, pure technical efficiency, scale efficiency and returns to scale. The result indicated that only 5 banks possessed technical efficiency; the Industrial and Commercial Bank of China was the only one of the big four state-owned banks could be regard as technical efficient. The other four banks, the Bank of Communication, CITIC Industrial Bank, China Everbright Bank and China Minsheng Bank, were all new commercial banks.

The study also pointed out that the technical inefficiency of Chinese Banks probably linked with pure technical inefficiency, especially for the four SOBs. Among the new commercial banks, technical inefficiency was more likely related to scale inefficiency. Apart from this, they found that, besides the Industrial and Commercial Bank of China, the returns to scale dropped quickly in three of the state-owned banks. So it was suggested that, for each level of technology, those banks suffered from the scale of production as they were too large. For the new commercial banks that were regarded as technically inefficient, return to scale was raised rapidly. It showed that, given the level of technology in use, they benefited from the scale of production. As a result, this study revealed that it was crucial for the 4 SOBs to resize and new commercial banks had the advantage in efficiency. To uncover a suitable structure of banks, Wang (2000) worked out research on the deposit expense rate, loan expense rate, asset expense rate and return on assets of local banks in 1995. He classified the banks with deposits over RMB 200 billion as large-scaled, those with deposits between RMB 10-200 billion as medium-scaled, and those with deposits under RMB 10 billion as small-scaled and noted that the return on assets of those commercial banks experienced a U-shaped trend.

Return on assets of medium-scaled banks was nearly 3 times of that of large-scaled, where the result was similar compared to that of small-scaled banks. The efficiency of scale was the highest among the banks with medium scale. Apart from that, it was argued that the operating cost rate, which measured cost efficiency, dropped quickly when the size of deposit increased. The loan expense rate of bank with medium scale was 0.36% less than that of small-scaled banks; the loan expense of banks with large scale was 0.523% less than of medium-scaled banks. The loan expense rate of large-scaled banks was 67.14% of that of small-scaled banks. By comparing the above ratios, it was suggested that those with medium scale were the most efficient. Sayuri Shirai (2001) examined the reforms and the performance of banks in China. The research, which based on the panel data from 1994 to 2000 of Chinese money banks complied by the Fitch Bankscope, regressed profitability, income proportional to asset and cost of production against a number of characteristics of domestic banks like types of banks, reserve requirement and investment in government bonds, size of bank deposit, scope of business and location.

The empirical results were: 1) the banking sector was dominated by the disproportionately large state-owned banks. 2) Commercial banks were more profitable, cost-efficient, capitalized and less leveraged than SOBs, which implied that commercial banks were sound in structure. 3) The performance of commercial banks deteriorated, though some of them performed better than those of SOBs. It probably related the spillover effect of their entry on the business of state-own banks. 4) The decrease in profitability of commercial banks was likely due to the increment in their liquidity holdings beyond the legally required reserves. 5) Broadening the scope of business of banking was vital, particularly to news banks which would benefit from higher earning. 6) The performance of policy-lending banks was as unsatisfactory as that of SOBs. On the other hand, Park and Sehrt (2001) argued that the financial sector reforms during the 1990s did not enhance the competitiveness of the Chinese banks. Using Chinese provincial data from 1991 to 1997, they tested whether financial reforms in the mid-1990s increased efficient intermediation by different financial institutions, and found that those banks, in which savings could not be correctly distributed to profit-making investors, were inefficient as financial intermediate.

Policy lending by state banks did not drop; lending by financial institutions did not respond to economic fundamentals. Dealing with the troublesome bad loans of Banks in China, Bonina and Huang (2001) compared the experiences of the Resolution Trust Corporation in the United States and bank restructuring in the Central European transition economies to the four asset management companies (AMCs) introduced by the Chinese government. They stated that the financial fragility manifested of domestic banks was caused by the high proportions of non-performing loans and low capital-adequacy ratio. The installation of asset management companies would not be prosperous in cutting the existing NPLs, nor in blocking the formation of new bad loans. They proposed that the relationship between the parent banks and AMCs was required to change so that the problematic deposits from state-owned enterprise would transferred along with their non-performing loans from parent banks to AMCs. The government has to develop those asset management companies into financial institutions competing with the four stated-owned banks. In addition, it was suggested that the Chinese capital markets were allowed to open for potential buyers from private corporations and foreign strategic investors.

Lardy (2002) analyzed the impact of China's accession to the WTO on Chinese banking system. From the data of banks up to 2002 and the WTO entry commitments of China, the more competition would hasten the development of domestic banks in terms of efficiency, but the losing market share from local to foreign banks was a concern. However, he argued that there was a restriction that the domestic currency liabilities of foreign banks could not be exceed 50 percent of their foreign currency liability. Even foreign banks could build up the deposit of domestic currency by extending the share of total foreign currency loans, the diminishing in the absolute amount of dollar lending by foreign banks in 2000 implied that the increase in the domestic currency deposit was constrained. In addition, the lower growth rate of foreign currency loans compared to that of RMB in 2000, on top of that, proposed that foreign financial institutions would face the same barrier.

As long as this regulation existed, the foreign banks would not be able to absorb a large amount of RMB deposits in the first few year after China entered the World Trade Organization; the lost of local banks' market share was limited. In long run, the health of Chinese bank system depended on the performance of state-owned enterprises and the restructuring of China's Banks. Domestic banks, particularly the state-owned banks, had to be injured if most of the SOEs, with which foreign exports would directly compete after protections removed, ran into a trouble. Based on the above review, it can be concluded that because of the non-performing loans and the non-profitable state-owned banks, Chinese banking system is problematic. As China became a member of the WTO in 2002, there will be additional challenges such as the lost of market share in the RMB deposits business to foreign financial institutions. There above review mainly concerned with the fact until 2003. Nevertheless, there were crucial structural changes in the Banking system during 2003-2004, such as the establishment of the China Banking Regulatory Commission.

How the banking system performed with respect to this reconstruction? Also, the Peoples' Bank of China implemented the very critical policy of financial macro control in the first half of 2004. Why did this policy executed? Was it related to the banks in China? At the same time, as China entered the World Trade Organization after 2 years, that was, some of the impacts of the WTO accession emerged. Current Supervision Framework and Methods in China Financial supervision in China is conducted according to the laws and regulations in force. With the enactment of the Law on Securities at the end of 1998, the three major supervision authorities, namely, the People's Bank of China (the PBC), the Insurance Regulatory Commission of China and the Securities Regulatory Commission of China, now supervise the three types of financial institutions and their business activities based on the Law of The People's Bank of China, the Law of Commercial Banks, the Law of Insurance and the Law on Securities respectively.

The financial institutions adhere strictly to the principle of segregation of financial business. Banks in China cannot engage in trust, insurance or securities business, nor can they invest in trust or investment companies; while the securities and insurance institutions cannot be involved in banking and trust business. As to the supervision of commercial banks in China, both the supervision system and the framework are designed strictly in line with the requirements of the Basle Accord. In the past, the financial system in China was established in line with the administrative structure, as was the PBC system. Therefore, there was segregation in the supervision of financial institutions, which meant that supervisory bodies supervised the commercial financial institutions at the same administrative level while being ignorant of the overall situation of a commercial bank confronted with risk.

In consideration of the existing financial risk in China, especially the changes in the international financial environment and the lessons from the South-East Asian financial crises, the method of financial supervision in China is now changing towards risk evaluation of the legal person of a commercial bank and the resupervision of the management structure inside every financial institution. Based on the Basel Core Principles, the supervisory measures have been enhanced in some aspects, such as the design of some indicator systems and the monitoring of the risk situation of financial institutions, especially non-performing assets and the risk faced by medium- and small-sized financial institutions. In addition, procedures for the exit of problem financial institutions were introduced in China in 1998. Viewed from the market angle, this is an issue which

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