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China's Banking Reformand GovernanceTowards a Robust Financial Structure


Paul H Nitze School of Advanced International Studies The John Hopkins University

China’s Banking Reform and Governance

Towards a Robust Financial Structure

Andrew Sheng
All views expressed are personal to author

April 2007
1

Contents
? Challenges to China’s financial sector reform – China’s growth has reached stage where the challenge is to build a healthy financial sector free from its legacy burdens. – China has window of current high growth and high savings, arising from its demographic endowment of savings from young, productive labour force to build a strong and balanced financial sector. Next Stage is to complete Property Rights Infrastructure (PRI) – International experience shows that a modern market economy must have a PRI that continuously define, fine-tune, protect, and enforce property rights between private and public sector and across generations – China has successfully built “hard infrastructure” of public utilities, like highways, telecommunications, water and schools – China must now build the “soft infrastructure” PRI for efficient operation of financial markets to support stable economic growth – This is knowledge and skills intensive work that will take time due to the scale of China’s banking system
2

?

Structure of Chinese Banking System (end 2005)
Number Type of Institution Total Assets (RMB bn) % of total

4 12 3

State-owned commercial banks Share-holding commercial banks Policy banks

20,033 5,900 2,978
635 2,027 205 3,175 1,379 538 36,870

54.3 16.0 8.1
1.7 5.5 0.6 8.6 3.7 1.5 100.0%
3

221+220 rep offices Foreign banks 112 681 32,854 1 City Commercial banks Urban Credit Cooperatives Rural Credit Cooperatives Postal banking Finance, Leasing & other Companies Total

China’s Six Degrees of Transition
Demography: from young labour force to mature and aging population. Wealth: from poor to middle income economy. Globalization: from closed to open economy. Knowledge: from “hardware” economy to “software” knowledge-based economy with wealth creation through services. Market: from planned economy to socialist market economy [from exports to domestic consumption].

Governance: from owner to regulator of socialist market 4 economy.

China & India’s Growth is Demographic Story

5

Asia is now Net Creditor to US and Europe
(US$ trillion)
Growing Imbalances: Net External Positions
USD trillion 2.00

1.50

1.00

0.50

0.00 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 -0.50

-1.00 United States -1.50 Japan Asia ex-Japan -2.00 Europe Australia and Canada -2.50 OPEC Others -3.00

Source : World Bank Financial Structure Dataset, February 2006

6

Roadmap of Chinese State-owned banks’ reform
China entered WTO agreement, requiring ‘national treatment’ for foreign banks in 2006 BOC and CCB transformed from Stateowed banks to joint stock commercial banks

Establishment of CBRC, CSRC, CIRC

Listing of CCB

1999/2000

2001 Dec

2003

2004

2005 Jan

2005 Oct

2006

Establishment of four AMCs to address NPL issues

The central government injected USD45 billion into BOC and CCB

Chinese authorities allowed foreign banks to offer RMB services in 18 cities

Full opening of China banking business, with removal of geographic restrictions on RMB business

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Deepening Banking Sector Reforms
? Continuing efforts to improve the asset quality of the banking system ? Fresh equity injection of US$60 billion by the Chinese government into three of the four state-owned commercial banks since 2003 ? Requirement for all commercial banks to maintain a minimum CAR of 8% by end-2006 ? Introduction of foreign strategic investment in the financial sector and opening of remaining areas for foreign banks' RMB business

Decreasing NPL Ratio
25% 20% 20% 15% 10% 5% 0% All financial institutions 2002 SCB? 2003 2004 2005 JCB? 15% 13.20% 8.61% 17% 15.57% 10.49% 10% 7% 4.94% 4.22% 22%

Increasing Profitability of SCB2
0.6% 0.5% 0.4% 0.3% 0.2% 0.1% 0.0% 2002 2003 ROA 2004 0.23% 0.35% 0.54%

? ? ? ?

Source: CBRC, Company Financial Statements, China Statistical Yearbook 2004, China Statistical Data Abstract 2005 Note: 1 State-owned commercial banks 2 Joint shareholding commercial banks

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NPLs ARE GOING DOWN IN CHINA, BUT THE ROOT CAUSE OF THE PROBLEM MAY REMAIN
?
?

Nonperforming loans from large state-owned commercial banks Percent of loan balances

31.1
26.5 20.4 15.6

Represents $125 billion, or 6.5% of GDP

10.1

2001
1

2002

2003

2004

20051
9

As of Q3. Source: PBOC; CBRC; Press Search; McKinsey Global Institute analysis

Loan growth was slowest in Japan among all AB300 banks in 2005
0%
Japan China AB300 Average Thailand Taiwan South Korea Singapore Hong Kong ex-Japan Average Malaysia Australia Philippines Indonesia Pakistan Vietnam India

10%

20%

30%

40%

6.30%

9.25%

Source: Asian Banker Research

10

BIS Study on Banking 2006 Average growth rate
1995-99 2000-04

Real aggregate credit1
Share in aggregate credit Commercial banks
1994 1999 2004

Other banks and nonbank financial institutions
1994 1999 2004

Latin America2 China India Hong Kong SAR, Singapore Other Asia3 Central Europe4 Total5 Memo: United States
1

3.6 17.1 6.1 1.4 -0.3 9.6 7.8 10.1

4.5 13.3 14.6 3.4 4.7 8.1 9.6 3.3

78 100

69 100

68 100 97 97

22 0

31 0

32 0 3 3

62 86 23

70 96 88 17

74 83 88 18

38 11 77

30 4 12 83

26 17 12 82

Referring to domestic credit by commercial banks, other banks (excl central banks) and non-financial institutions (questionnaire). In cases where data are not available from the questionnaire, they have been taken from the IMF, IFS; deflated using annual percentage changes of the consumer price index; regional averages calculated using 2000 GDP PPP weights. 2 Argentina, Brazil, Chile, Mexico, Peru and Venezuela. 3 Indonesia, Korea, Malaysia, the Philippines and Thailand (columns 3 to 8 except Indonesia). 4 Czech Republic, Hungary and Poland. 5 Countries shown plus Israel, Russia, Saudi Arabia, South Africa 11 and Turkey (columns 3 to 8 except Indonesia, Israel and Russia). Sources: IMF;national data.

Japan contributed the largest block of profits among AB300 banks in 2005
Indonesia, 1.3% Taiwan, 1.4% New Zealand, 1.4% Thailand, 2.0% Malaysia, 2.1% Singapore, 2.3% India, 4.2% South Korea, 9.3% other countries, 1.0%

Japan, 37.0%

Hong Kong, 9.4%

Australia, 12.4%
Source: Asian Banker Research

China, 16.1%
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China: 24 banks in Asian Banker 300 in 2005. Total assets: $3,358 bn. Total net profits: $17.7bn. ROE:13.0%, ROA: 0.6%
Rank

Commercial Bank
Industrial and Commercial Bank of China

Assets ($m)

Net Profits ($m)

ROE

ROA

CAR

NPL Ratio

AB300 Bank

Strength Rank

1
2 3

800,051 591,416 587,576 568,449 176,449 91,061 75,855 71,094 69,092 58,756

4,177.9 129.4 3,911.9 5,838.0 1,145.8 458.7 369.4 317.1 342.1 304.3

26.7%
1.3% 13.3%

0.53%
0.02% 0.70%

9.9%
-18.0% 10.4%

4.7%
26.2% 4.6%

4
5 6

149
236 72

Agricultural Bank of China Bank of China

4
5 6

China Construction Bank
Bank of Communications China Merchants Banks

19.5%
14.6% 16.6%

1.11%
0.72% 0.56%

13.6%
11.2% 9.1%

3.8%
2.4% 2.6%

8
17 26

52
29 19

7
8 9

China CITIC Bank
Shanghai Pudong Development Bank

19.1%
17.4% 19.6% 22.1%

0.53%
0.50% 0.55% 0.60%

8.1%
8.0% 8.2% 8.1%

4.1%
2.1% 1.4% 2.3%

36
40 41

125
43 34

China Minsheng Banking Corporation

10

Industrial Bank

50
13

56

Source: Asian Banker Research

Chinese Banks Building Up Liquidity
Excess liquidity is building up in the banking system in China
30 25 80%

RMB tr

75%

20 15 10 1Q03 2Q03 3Q03 4Q03 1Q04 2Q04 3Q04 4Q04 1Q05 2Q05 3Q05 4Q05 Deposits Loans Loan-to deposit ratio 70%

65%

Source: Asian Banker Research
14

Chinese banks are improving their interest spreads
7% 6% 5% 4% 3% 2% 1% 0% J F M A M J J A S O N D J F M A M J J A S O N D 2004 Mortgage lending rate(>5 years) Saving deposit rate Consumer price inflation(YoY) 2005 3-month interbank rate One-year benchmark lending rate

Source: Asian Banker Research
15

Growth in Banking Services…
Over the past five years, domestic loans and deposits have been growing at >15%
Loans
Mortgage Loans/GDP (2004)
100% 80% 60% 40% 20% 0% China US Hong Kong 12% 32% 79%

Bank Cards
Credit Cards per capita1 (2004)
2.5 2.0 1.5 1.0 <15% 0.5 0.0 China Germany U.S. China Hong Kong US 0.02 1.7 2.2

% of New Cars Bought on Credit(2004)
100% 80% 60% 40% 20% 0% 70% 85%

Mortgage Loans in China
(US$ bn) 250 200 150 100 50 0 1999 2000 2001 2002 2003 2004 16.8 39.9 66.9 99.8 160.6 192.4 (US$ bn) 25 20 15 10 5 0 1.0

Auto Loans in China
21.7 13.9 4.6 22.1

Bank Cards Issued in China
(in million) 1,200 959 1,000 769 800 613 496 600 383 400 180 227 200 0 1999 2000 2001 2002 2003 2004 2005

2.2

1999 2000 2001 2002 2003 1H2004

Source: China Statistical Yearbook 2005, PBOC, CEIC, China Unionpay, US Federal Reserve Flow of Funds Reports, HKMA, EIU Note 1 Most of the bank cards in China are debit cards

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…And Non-Bank Financial Services…
Growth in insurance and asset management could provide banks with important sources of non-interest revenue
Insurance Premiums in China
(US$ bn) 40 36 35 30 25 20 15 11 10 6 5
5 40 35

Assets Under Management in China
(US$ bn)
45 40.0

39

27
30 25

17
20

21.5

12 7 8 9 10

13
15 10.2 10 6.4 9.8

15.7

0 1999 2000 Life 2001 2002 2003 Property & Casualty 2004
0 1999 2000 2001 2002 2003 2004

Source: China Info Bank, Sigma Swiss Re 2004, CSRC, CIRC

Source: China Securities and Future Statistical Year book 2005

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BIS Study on Banking, 2006

Sources of finance in emerging markets1
Domestic credit Domestic debt securities outstanding2 Stock market Memo:International capitalisation financing3

As a percentage of GDP 1999 2005 1999 2005 1999 2005 1999 2005

Latin America4,5 42 45 31 46 36 49 27 22 China 130 169 22 33 33 39 3 3 India 51 65 23 41 42 68 4 5 4 Hong Kong SAR, Singapore 130 122 33 41 286 344 27 55 4,6 Other Asia 89 80 45 58 68 65 20 17 4,7 Central Europe 40 42 26 46 22 34 14 27 4,8 Total 78 92 27 40 52 62 13 12 Memo: United States 80 92 150 163 150 112 23 45 Euro area 122 154 74 59 Japan 161 150 134 200 104 94 7 9 1 2 End of period; for 2005, latest available data extrapolated, if necessary. Excepting Israel, Saudi Arabia and 3 Venezuela. Non-bank cross-border liabilities to BIS reporting banks and international debt securities 4 5 outstanding. Weighted average of the economies listed based on 2000 GDP and PPP exchange rates. 6 Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. Indonesia, Korea, Malaysia, the Philippines 7 8 and Thailand. The Czech Republic, Hungary and Poland. Countries shown plus Israel, Russia (except for stock market capitalisation), Saudi Arabia, South Africa and Turkey. 18 Sources: IMF; International Finance Corporation; Datastream; BIS statistics.

CBRC’s Policy
1. Improving Asset Quality
? ? ? Implementation of Five-Tier Loan Classification System Stress on risk monitoring, evaluation and transparency Stress on quality and effectiveness of on-site inspection and off-site supervision

2. Capital Requirement
? ? “Regulation Governing Capital Adequacy of Commercial Banks” (Mar. 2004) “Key Indicators for Risk-based Supervision of Commercial Banks (Tentative)” (Jan. 2006) Set up directorate and board of supervisors “Guidelines on Corporate Governance Reforms and Supervision of Bank of China and Construction Bank of China”(Mar. 2004) Improving banking sector’s risk management system

3. Enhance corporate governance & risk management
? ? ?

19

Banking Reform Framework
1. Fulfill Ownership Restructuring of Big Four
? ? ? Broadly achieved by 2006 ABC, CDB and Postal Bank to commercialize in near future Now working on rural finance reforms

2. Encourage Foreign Banks to act as Strategic Investors
?
? ?

End 2006, more than 70 banks from 22 countries have set up 290 branches or subsidiaries, plus another 240 representative offices Foreign banks have strategic stakes in 20 Chinese banks
Regulation on Administration of Foreign Funded Financial Institutions (November 2006) – foreign banks given National Treatment

3. Fully Honor WTO Commitments

4. Reform Commercial Bank Operational Structures
? Rapid change in corporate governance and risk management systems
20

Changing Governance + Risk Management
1. Ownership Restructuring
? ? Qualified joint-stock banks are encouraged to become listed Banking adopting IAS + using international auditors

2. Improving Performance
? ? Compliance and Credit Culture being built – Guidelines on Compliance and IT audits issued end 2006, MIS rapidly being built. CBRC Off-site Surveillance System cutover 1 January 2007 City commercial banks are encouraged to conduct cross-city business cooperation and ownership cooperation Banks are reducing their layers of management hierarchy and adopt centralized line management structures, with key operational hubs.

3. Commercial banks consolidating their operations
? ?

21

Rural Finance Reforms
1. Entry relaxed on Pilot basis for 5 provinces
?
?

Qualified licensed banks allowed to invest in these provinces to establish rural financial institutions Looking at Micro-finance pilots with IFC, CDB and other cases for good models

2. Restructuring of Rural Credit Cooperatives
? ? Concentrating on Equity Management Reform, RCCs will be transformed into:
– – – Provincial Credit Unions Cooperative Banks Commercial banks

Restructuring

and

22

Regulatory and Legal Initiatives
1. Criminal Law – Crimes now include conduct that includes wilful providing false information for loans, as well as making large loans imprudently Bankruptcy Law – just passed in December 2006, which also allows bankruptcy of deposit-taking institutions Property Rights Law – passed in 2007 to recognize private property rights and creditors’ claim on collateral Securities Law and Company Law – changed in October 2005 to strengthen corporate governance, disclosure and accountability Guidelines: on financial innovation, private asset management, IT audits, compliance and risk management

2.

3.

4.

5.

Building the Service Sector to help Define, Exchange and Protect Property Rights
? Credit Reference Agency set up by People’s Bank ? China Banking Association increasingly involved in professional training and industry-wide issues ? China Government Securities Depository Trust & Clearing Company set up infrastructure for a deepening bond market ? Conditions ready for benchmark yield curve ? Capital market has revived with large number of new equity funds ? Financial derivatives exchange to be set up soon ? Credit Rating Agencies increasingly involved in bond ratings 24

Crossing the River by Feeling the Stones – Pragmatic Process of Change
? Crossing the River is not Random! ? Objectives and Principles are Clear – Reform according to objective analysis and rational experimentation, benchmarked increasingly against international standards, codes and rules ? Prioritization according to Bounded Constraints of resources, skills and practical realities [Grab the Big and let loose the small – 抓大,放小] ? Proper Sequencing – Reform State-owned Enterprises, before Banking Reform ? Pick one or two Pilots [e.g. SEZs, allow Bank of China, Hong Kong to list first], assess success and then replicate across broad front
25

Elements of Strong Institutions
1. Strong Values, Beliefs and Ownership 2. Clear Property rights and low transaction costs 3. Ready access to Information, Knowledge, Technology and Wisdom/Experience 4. Defined Standards 5. Codes, Rules and Laws 6. Process and Procedures 7. Structure, architecture or hierarchy 8. Incentives and Governance
26

Efficient Markets Have Robust PRI Institutions
? Central Registry of property right [eg land registry, share registry] ? Trading Engine [eg stock exchange] ? Clearing, settlement and payment infrastructure – clearing house and payment system ? Regulated intermediaries ? Rules of Game – norms, standards, codes, regulations, law ? Enforcement infrastructure – enforcement costs cannot exceed benefits to market ? Independent and transparent judiciary ? Effective judiciary, enforcers [police, regulators, enforcement agencies], accounting, legal and financial intermediaries are all part of PRI 27

Keeping Clear Objectives & Principles
? Creation of a financial system that is efficient, transparent, fair and robust in supporting real sector growth and meeting the needs of the economy ? Raise the knowledge, skills and management/risk capacity of the financial system, particularly consumers, investors, financial intermediaries and regulators ? Delineate, protect and transfer property rights fairly, transparently and with low costs ? Open to entry, innovation, competition and orderly exit of market players ? Meeting standards and rules and regulations according to international standards ? Creation and enforcement of incentives towards lowering transaction costs, strengthening capacity to manage and absorb risks and shocks and fair treatment of customers ? Consistent with values of a harmonious society
28

Social Benefits of PRI Lessons from Latin America
? Six positive property effects
1. Fixing the economic potential of assets

2. Integrating dispersed information into one system
3. Making people accountable 4. Making assets fungible

5. Networking people
6. Protecting transactions

No property rights ? system is not accountable, not fungible, no network, no trading ? no credit culture ? the poor suffers
? Private sector alone cannot build PRI, as benefits are for society as a whole
29

Hernando de Soto in The Mystery of Capital, 2000.

Hong Kong Has Market-tested PRI Model for Mainland China
? Hong Kong common law PRI already has been functioning and well-tested to global standards and markets ? PRI is key component of service sector:
– In 2000, China has one lawyer per 11,000 citizens, compared with one per 300 in the US, one per 700 in the UK, and one per 6,300 in Japan. – China has one accountant per 9,650 persons, compared with 412 in Hong Kong and 166 in US.

? In 2001, China has 28% employment in the service sector, lower than 33% in Thailand, 39% in Indonesia, 45% in Philippines, and much less than above 70% in US, France, UK, Singapore.
30

Conclusions
? China has reached the stage of economic development where the macroeconomic conditions favour the next stage of development – reforming banking and financial sector that protect and grow the savings of the public efficiently and robustly. ? China is no longer short of savings – it needs an efficient banking and capital market to help sustain development. ? The shortage is in experienced people, with the right skills, processes and governance to manage the risks of complex financial systems. ? Openness to FDI and foreign strategic investment in the banking system under WTO will introduce competition, bring in new financial products and service quality and train people, processes and governance models to take Chinese enterprises, financial institutions and skills to global standards.
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