Restoring Confidence in China's Banks

China Banking Regulatory Commission Chairman Shang Fulin, in the clearest preview so far of the task facing the government in restoring public confidence in the country's banking system, earlier this week outlined a far-reaching six-part plan to address the system's many ills.

Among the problems that concern the regulator are intensive competition and duplication, with all banks delivering similar services and products without much strategic market positioning. They are overly tilted towards short-term reward-seeking behavior and there is little segregation between off balance sheet business and regular banking, a major problem exemplified by the massive local government debt financing bubble, which at last count amounted to the equivalent of US$1.8 trillion.

The state-owned Big Four banks --Bank of China, China Construction Bank, Agricultural Bank of China and Industrial and Commercial Bank of China are today the world's biggest financial institutions, with ICBC catering to 393 million individual customers -- the equivalent of the entire banking system of Western Europe.

Ultimately, no one really believes Chinese banks will fail across the board, especially after the massive injection of perhaps US$200 billion into bailing them out in the middle of the last decade when they were virtually all bust. But today the banking system is hit with periodic fears over property loans, local government off-budget lending vehicles and the shadow banking system. Interest-rate liberalization is creating unfamiliar competition between banks. Other financing vehicles such municipal bonds and private placements of bonds for SMEs are also roiling what had been a closed system.

Confidence and outlook are what drives investor valuations, and Shang's mission is to shore them up. Although nonperforming loans do not appear to be alarming, the CBRC is urging them to write off as much as possible now, rather than later. Accordingly, banks have significantly increased their bad loan write-offs in order to keep their NPL ratios low. The largest half-year increases can be observed in non-Big Four banks, potentially indicating lower loan quality in their portfolios. While BOC and CCB have decreased their write-offs in the last six months, loan losses at CITIC and China Merchants bank have surged 370 percent and 279 percent respectively. Shang outlined his goals in a speech to the China Banking Association earlier this week in what appears to be preparation for the upcoming Third Plenary Session of the Chinese Communist Party Central Committee in November in which Premier Li Keqiang's new, much more market oriented economic reform roadmap will come under the global spotlight.

Shang's recommendations are rich in specific steps to address the banking system's shortcomings, seeking to remedy many of them to attempt to restore investor confidence and lift sector valuations despite the potential weight on net interest spreads brought about by deposit rate liberalization.

Shang reminded his attending "comrades" at the association conclave that it is time to make headway towards the State Council's chartered economic targets and move further towards the next round of sector reforms.

The areas for reform, Shang stressed, are corporate governance, brand differentiation, risk segregation, ring-fenced innovation, group-level consolidation and information disclosure. We summarize each area briefly below to give investors a taste of what is to come.

Corporate governance and installing an effective management incentive system are regarded as the top priorities to ensure operational stability. That includes guarding against inequitable shareholder behavior, segregating responsibility between the board and senior management, making independent directors independent in more than just name, and ultimately better aligning senior banking staff interests, including the use of stock options.

The Shanghai Securities Journal noted that this particular point on equity options suggests a major policy shift after a similar incentive scheme was banned by the MOF in July 2008. This and other attempts to correlate administrative-level compensation and longer-term performance of their banks will play a key role in mitigating excess nearsighted profit-seeking decisions that have been blamed for the disorderly growth in non-traditional banking products.

Branding and service differentiation are being eyed as the exit strategy from the system's current price-based competition deadlock. The regulator will push the banks to develop their own brands and niche markets, guiding small and medium banks to serve regional communities while encouraging large players to focus on the banking needs of Chinese corporates increasingly "going abroad."

Such a differentiated approach can certainly be expected to accelerate the nurturing of respective financial product and service leaders and help them to stand on a par with the rising number of fiercely completive foreign banks entering the markets.

Segregation of business risk is designed to ensure that the fashionable "one-stop-shop" bank offerings of asset management, insurance, leasing, trusts, personal credit, and investment banking can remain robust even if volatility hits a specific commercial unit. The CBRC recommends implementing organizational isolation, including the use of parent-subsidiary holding structures and installing separate, independent management teams. Transfer pricing between associates must be transparent and no different from trading with third parties. The ultimate goal of such consideration is to ensure that unexpected losses at one particular unit would not destabilize the overall banking group. No doubt this is aimed at addressing the recent surge in trading errors.

Financial innovation under the ring-fenced principle indicates that the CBRC welcomes aggressive exploration of new financial services and products amongst the four major profit centers of the banking sector -- loans, wealth management, agency and securities investments -- but they must be carried out with a high degree of separation or "ring fencing" applied to each so as to avoid spillover risk.

As pointed out by Chairman Shang, certain innovative off-balance sheet transactions at present are in reality linked to the traditional deposit and loan businesses. This could generate undefined risk scenarios. Under the reform, each of the four business units shall define their sources of income clearly, may they be interest rate differential, management charges, handling fees, or through taking on market risk.

Group-level consolidation is important as banking complexity pushes higher on rising cross-border transactions and operations are integrated with their branching subsidiaries. Undefined off-balance sheet transactions have unknown and potentially contagious risk. Banks should stress better consolidating financial statements for both internal and external dealings, as well as domestic and foreign currencies, to the group parent in order to quantify overall exposures and prevent magnifying them. With an accurate and timely financial reporting, bank managers would be able to further strengthen their control their leverage ratios and overall risk levels.

Information disclosure plays a critical part for customers to clear up doubt and build confidence regarding the banks' futures. A positive outlook is vital to banks that depend on their credibility to expand their businesses. Disclosures have to be accurate, proactive and timely. A strategic way to build a better brand image is to understand the value of accurate disclosure, making it a tool to protect customers and improve public relations.

Management boards are requested to become proactive in their disclosures. Not only should disclosures include detailed explanation for policies and operational flows, they should also be presented in several languages and in a style which is easy to understand. Banks are advised not to allow trivial matters to develop into big problems and should be disclosed in a timely fashion, clearing wrongdoings immediately to maintain credibility.

(Steve Wang is research director and chief China economist for the Hong Kong-based REORIENT Securities Ltd. He is a regular contributor to Asia Sentinel.)