• Reforms over the past 28 years have built a solid foundation from which commercial banks in mainland China can further develop. However, this foundation should be further strengthened by a regulatory environment that fosters greater competition, corporate governance and risk management in the banking sector.

China's National Financial Working Conference held in January this year laid out a medium-term policy direction for banking and financial reform in mainland China. There have been three such working conferences in the past 10 years. Each of them has paved the way for a new phase of important financial reform.

The conference in January identified five key areas of future reform:

1. deepening the reform of state-owned banks and steadily restructuring Agricultural Bank of China;
2. further developing the capital and insurance markets;
3. starting the process of reforming policy banks and allowing China Development Bank to operate commercially;
4. expanding investment channels for foreign exchange reserves; and
5. improving the rural banking system.

Three of these five areas are related to banking reform on the Mainland. While a lot has been done to sustain the growth of the increasingly market-oriented Mainland economy, improving the efficient allocation of funds in the banking system is still a priority.

Banking Reform: A Brief History

With the onset of market-based economic reform in 1978, the Mainland 'mono-bank' system, with the People's Bank of China (PBoC) acting both as the central bank and the only commercial bank assisting the government with fulfilling the state production plan, was deemed no longer adequate. Between 1979 and 1984, the banking system was re-organised into four state-owned commercial banks - Bank of China (BOC), Agricultural Bank of China (ABC), Industrial and Commercial Bank of China (ICBC) and China Construction Bank (CCB) (collectively, the Big Four) - and one central bank. With the Big Four specialising in commercial banking businesses, the PBoC has since been progressively focusing on central bank functions.

Beginning in the mid-1980s, new smaller-scale banks were also established in the form of joint-stock and city commercial banks as the PBoC encouraged new players to compete with the Big Four. Running smaller but more efficient branch networks and without the obligations of extending policy loans, this group of 123 commercial banks has greater flexibility in conducting their business. At present, they have a 22% share of total banking assets. The Big Four continue to dominate the market, although their share of assets has fallen from over 90% in the mid-1980s to the present 51%.

In the mid-1990s, the emphasis gradually shifted to financial stability and systemic risks of the banking sector. The first National Financial Working Conference took place against this backdrop in 1997. In 1998, the Big Four received capital injections totalling RMB270 billion from the government, boosting their equity from 2.45% to 6.15% of their combined assets in one stroke. Four asset management companies were set up, which purchased a total of RMB1,400 billion in non-performing loans (NPLs) from the Big Four, equivalent to about 18% of their total loan portfolio.

The second working conference in 2002 went a step further. Reforms began to turn the Big Four into modern financial enterprises with adequate capital and better internal control. Shareholding reforms were executed through a pilot programme that saw BOC and CCB receive a total capital injection of US$45 billion on 30 December 2003. In 2005, the programme was extended to ICBC, which benefited from a US$15 billion capital injection.

Significant Improvements in Asset Quality

With the latest round of recapitalisation, NPL levels at three of the Big Four have been significantly reduced. By the end of June 2006, NPLs of BOC, CCB and ICBC had fallen to 4.2%, 3.5% and 4.1% of total loans respectively. However, this favourable development needs to be seen in the context of rapid loan growth. In fact, apart from the government capital injections, the improvement in asset quality can be explained by increases in bank loans. In the three years up to 2005, loans at the Big Four had expanded by 31%.

In contrast, there has been little progress in reforming ABC. At the end of 2005, its NPL ratio still stood at 26.2%. It operates 18% of the Mainland's bank branches, mostly in villages in the inland and western provinces. Following the third working conference, restructuring ABC is now top of the agenda. Details of the restructuring programme, including the size of the recapitalisation, are expected to be revealed soon.

Reform Should Spread to Policy Banks

As far as restructuring is concerned, the same progress has not been made with the policy banks. In 1994, in order to strip off the Big Four's policy-oriented loans business and push forward with overall financial reform to achieve specially designated policy targets, the Chinese government established three policy-oriented banks: China Development Bank (CDB), Export-Import Bank of China (EIBC) and Agricultural Development Bank of China (ADBC).

These banks concentrate on lower interest rate loans and long-term policy-oriented loans to designated clients and business targets. They have played an important role in promoting key construction projects as well as foreign trade and rural development. However, in the past 12 years, they have been confronted with similar governance problems to the Big Four. Further reform has been placed on the agenda, the central element of which will be the instituting of special laws and regulations that clearly define their role and functions and drive them towards greater commercialisation.

More Competition Needed

Although banking reform has come a long way, the Big Four are still predominantly owned by the government. Shareholding in the other commercial banks also largely rests with state, provincial or municipal governments and enterprises. There has been growing interest among foreign banks in taking ownership stakes in these banks. However, strategic holdings are still small and, as such, do not necessarily encourage foreign financial institutions to actively transfer skills and knowledge to their Mainland partners. Ownership regulations limit the share of a single foreign owner to 20% of capital, and most deals give foreign investors about a 10% ownership stake. The Mainland authorities are trying to maintain a balance between developing and strengthening the management systems of domestic banks and surrendering more control of these banks to foreign investors. However, under this combination of arrangements, local and foreign partners tend to focus on creating value in narrow areas of collaboration.

The current ceiling on deposit rates that can be offered to customers limits competition on the deposits front. Full liberalisation of these rates should increase competition and help promote efficiency. Moreover, as the Mainland is required by the World Trade Organization to further open its banking sector early this year, competition among banks is expected to grow over time.

Efficiency, Governance and Risk Management

Corporatisation - the separation of ownership and management through public listing - is the keystone in achieving greater corporate governance and risk management. Creating the incentives for banks to base their decisions on commercial principles and improving infrastructure for banking operations are very important if the reform effort is to bear sustainable results.

There is also a need for the banks to ensure that guidelines for good corporate governance are being closely followed. Becoming a listed company is already a major step towards greater transparency, with requirements such as more regular financial disclosure and the establishment of a board of external supervisors that includes at least two independent members. Good governance, by implementing an appropriate structure of checks-and-balances, is an important element of the next-stage reform.

Banks should allocate more resources to strengthening risk-pricing mechanisms, establishing sound risk management policies and collecting adequate data. If banks can fully utilise the interest leverage and accurately price the risks of customers, their net spread will enlarge and their profitability will also improve. Banks now operate in increasingly volatile market conditions. Losses brought about by movements in exchange and interest rates, for example, are potentially greater. Comprehensive identification processes and internal controls are essential for mitigating credit, market and liquidity risks.

Equally important is to build a good financial infrastructure, which includes a smooth and efficient inter-bank market. The Mainland's inter-bank market has been in operation since 1996 and controls on its interest rates have been liberalised. However, the market has so far remained relatively thin, with its monthly turnover amounting to only around 0.7% of total bank assets, compared with over 74% in Hong Kong. Over the long term, an active and efficient inter-bank market is essential for providing benchmarks for other market interest rates and for reducing the PBoC's role in adjusting the liquidity of commercial banks.

Conclusion

The Mainland's commercial banks have come a long way from being the executive arms of the State Treasury and are now independent financial intermediaries that operate according to commercial principles. Reforms instituted over the past 28 years have built a solid foundation in separating the functions of the central bank and the commercial banks, and have paved the way for enhancing corporate governance and risk management of the banks.

However, progress with improving the financial infrastructure and enhancing the efficiency and transparency of the policy banks has lagged behind. Reforms during the next stage need to be extended by a regulatory environment that fosters competition and the establishment of incentives for bank managers to perform well. These advancements are critical to the development of a sound and robust banking system that will facilitate the efficient allocation of funds.

MAJOR ECONOMIC INDICATORS