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Chinese state owned banks are facing challenges

Introduction
At past few years, Industrial & Commercial Bank of China was the largest Chinese state owned commercial bank and titled the most profitable bank globally. In factChinas banking sector were flourishing in last several years. With stimulation announced by government and a booming real estate industry, huge amount of loans are lent out and contributed incredible gains. This is the reason why Chinese banking sector grew rapidly. Impressively, the government forced cooling policy seemingly did not restrict these big state owned commercial banks, they actually showed great records on their balance sheet. However, a good record is not sufficient to hide problems. The poor universe economic condition intensified the exposure of hidden issues like dealing with soured property loans in nationalised underground banking, managing bad debts in local government financing vehicle and adopting new capital rules. Therefore, Chinas state owned commercial banks are now facing real challenges.

Chinas banking system

Within decades, Chinas banking sector has been reformed from a centralised state-owned banking system to a more competitive market orient commercial banking system. In this banking sector, the Peoples Bank of China as the central bank, which regularises and implements Chinas monetary policy and maintains banking sectors trading activities. Chinese government also has established four specialised state-owned commercial banks, which have made significant contributions to Chinas economic growth. The Big Four includes Industrial & Commercial Bank of China (ICBC), China Construction Bank (CCB), Bank of China (BOC) and Agriculture Bank of China (ABOC). Recently, all four specialised state-owned commercial banks have reformed and public listed to vary their ownership structure. However, these four state-

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owned commercial banks are still held by Chinese government. Recently, with innovation of Chinese financial system, banking sector was grown significantly. In order to finance local infrastructure project efficiently, local government established several new commercial banks. Similar to big four , these new local commercial banks are also hold by government. According to the Economist (2012), even in the downside of world economy, taking the advantage of Chinese strong economics, the big four banks still recorded a 16% annually growth rate in pre-tax profit at the first quarter of this year. Impressively, these banks also kept the non-performing loan at incredible low level, only about 1% NPLs was reported. However, the balance sheet cannot tell the entire story. The reality is that the poor credit management & scoring platform and a over risky lending strategy started to bother these stated owned commercial banks. Now, the storm is coming and many analysts concerned whether the banks and economic system could remain healthy.

Problems and challenge

Underground banking & souring property
According to the official introduction posted on government website, Wenzhou is one of the most important manufacturing centres in mainland of China, its industries cover electrical machinery, leather products, general equipment, power supply, plastic manufacturing, textile and garment, transport

equipment, chemical products, metal products and metal processing. At 2011, Wenzhou reported 9.9% GDP growth rate and its annual GDP researched 335.087 billion Yuan. Such a wealthy city is facing the most serious financial storm since the opening-up policy. After the new around of economy cooling, stated-owned banks started to tight their pocket to finance median and small sized business in Wenzhou. Based on their credit scoring system, these stated-owned banks commonly believed that small and median sized business are too risky to finance. On the other hand, these small and median sized entities turned to borrow money from underground sector with an incredible high interest rate from 60% to 180% in order to survive. However, the new cooling policy has no effect on the big state owned enterprises, they

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still can easily get financial support from state owned banks with a normal interest rate of 7.2% (Lopez, 2011). The problem is that these big state owned entities established subsidiaries and use funds from banks to participate in underground banking activities. Constantly, banks risk exposure invisibly blowed up. Unfortunately, things are getting more complicated when residents are crazier to chase this incredible high return. Compared with large entities, individuals mortgaged their own property and lending money to small and median sized companies. Public was enjoying the way of making money and dreamed about becoming a million one day. The Economist (2012) reported that 99% families in Wenzhou were engaged into these underground-banking activities. In fact, to state owned banks, the high interest payment is the powderhose of increased credit risk. In reality, it damaged future cash flow of these small and median companies, the financial performance of these entities was getting even worse after borrowing from underground banks. In order to pay in a regular base, companies have to roll loan over and kept borrowing. Impressively, some companies have to pay millions of interest daily. In the end, with economy slowdown, small business owners would not be able to pay these interests and have to escape from their debtors. Lopez (2011) stated that once the business owners hardly to meet their obligations, then everyone in economy system got hurt. It is certainty that majority householders and state owned entities in underground-banking system would lose their investment. Constantly, stated owned commercial banks were bleeding although their balance sheet recorded over 75% loans are collateralised. One the other hand, The Economist (2012) points out that collaterals health is the big concern under this situation due to increased liquidity risk. Unfortunately, government insists its cooling policy in housing sector to push the price back to a more acceptable level. This made the situation become even worse to state-owned banks. According to the Soufun website, residents in the large cities have experienced an average over 12% decline in house value. Based on recent policy, the decline is predicated to continue. Moreover, when default happens, banks have to liquidate collaterals with a huge discount to the market value. Eventually, the banks have to record significant losses on their balance sheet. Moreover, It should be noticed that Wenzhou is not only a special case for Chinese underground 3

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banking system. Instead of borrowing from banks, millions small companies owners choose to ask underground institutions for financial assistance. According to Chinese official records, there was around $400 billion Yuan engaged in their underground banking system. However, the true value was estimated to be much higher than $400 billion. Unlike the most developed country, China has a less developed credit managing & scoring system. According to Ping (2010), China spent decades in consummating lending regulation and put a relative low priority on developing credit risk management and recording system. This is the reason why state owned commercial banks usually assess companys risk based on the size of the firms and its ownership structures. Instead, if banks could lend money directly to small and median sized companies, then these entities would only pay interest at 7.2%. Obviously, with lower interest rate, small and median sized entities could survive from their financial distress. As mentioned before, currently, Underground financial institutions took capital not only from banks, but also from individuals. Some residents are keen on gambling, instead of deposit money in banks; they directly put their free cash into underground banking system. As we know, deposit is a key for banking practice. To banks, losing deposit equals to losing profit. Therefore, these state owned commercial banks are challenged by underground banking system and credit risk management & scoring platform.

Local government financial vehicle

Beside of underground banking and poor credit risk scoring system, state owned banks are now facing non-performing loans issued to local government infrastructure project and abortive large state owned enterprise. During the past few years, a booming local government financing vehicles offer huge financial support to local infrastructure project. According to The Economist (2012), these debts were worth 1.4 trillion Yuan at the end of September in 2012. With private assessment, 20% to 30% of these debts are nonperforming. On the other hand, based on recent Bloomberg news, the nonperforming loans had an increase of 18.2 billion Yuan in second quarter to 456.4 billion. The Economist (2012) points out that government is trying to defuse the bomb by processing several new policies. In order to secure the 4

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state owned commercial banks, government has moved half trillion Yuan LGFVs debts from these commercial banks to china development bank. Besides of moving bad debts to policy bank, government also issued local bonds to replace these loans. Similar to Indian stated owned banks, major stated owned banks in china were trying to help borrowers to roll nonperforming loans over. As bank of Shanghai said early this month, some LGFVs debt have been restructured or given an extended credit, if borrowers have trouble in paying out stable cash (Dong and Yuan, 2012). The fact is that some bad LGFVs debts have been rolled over instead of being classified as bad debts. Banks might happy with these adjustments, because instead of recording losses on banking book, with rollover, there are only decreases in banks present value. This might be the reason why that major banks could report such good non-performing loans ratio in early this year. Dong and Yuan (2012) also questioned banks rollover policy and said that some LGFVs debts have been restructured more than once. Similar to India, banks did not help borrower in a short run, but they actually abused rollover rules. What distinct from India is Chinese government published official guidance to organise banks to roll non-performing loans over. The guidance puts limitations on banks restructures policy. Some state owned commercial banks like ICBC has restructured some LGFVs debts, but only these debts have the collateral valued above loans value. Moreover, such restructures only apply to a 60% or more competed project. However, Dong and Yong (2012) believed that some LGFVs would not be able to service their debts, restructures only delay the massive non-performing loans to become bad debts. The Economist predicates that if 10% of banking sectors credit is unredeemable by next two years, the possible loss could be equal to two years profit plus 39% equities from the whole banking sector. This could lead to a serious banking disaster.

Banking innovation
According to Bloomberg (2012), Chinese banks are under huge pressure right now; central government is trying to help banks raising capital again so that predetermined tightening capital rules will delay to the beginning of next year. One important challenge for Chinese banks is adopting new capital rules. In 5

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terms of capital adequacy, according to CBRC, main Chinese state owned commercial banks maintained an average capital adequacy ratio of 12.7 percentage on March 31, 2012. However, the new Basel document required more capital to cover operational risk and better capital to terminate unqualified supplementary capital (Bloomberg, 2012). However, if new risk weighting is applied, the capital adequacy ratio will drop under the required ratio of 11.5%, then banks have to stop their operations. This new capital adequacy is not only simply setting up a capital requirements for Chinese state owned commercial banks but also restrict their lending behaviours. Moreover, the central bank also extended the interval of benchmark interest rates; this made state owned banks have to face an increasing funding cost. After implemented new rules, banks have to reconsider their massive lending policy. Dong and Yuan (2012) believed that instead of continuing recent massive lending strategy, banks would prefer a more stable quality controlled lending policy. This should be a serious challenge to Chinese credit risk management system and credit scoring platform. However, the reform of lending strategy and adopting new capital rule are predicated to process more than three years (Dong & Yuan, 2012). Central bank and regulators insist that implementing new Basel rule could help Chinese banks to improve risk management by building up sufficient capital to absorb losses. Moreover, central bank also announced that a more commercialised interest rate market would be established soon. Dong and Yuan (2012) claimed that adopting new capital rule and having a more commercialised interest rate market is pushing Chinese banking sector to innovate. However, this innovation could be a positive signal that state owed commercial banks are reforming to a real commercialised enterprise.

Conclusion
To summary up, Chinese state owned commercial banks are facing many challenges. For instance, they suffer huge pressure from Chinese underground banking system and local government financing vehicle due to a 6

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rapid growth in soured and non-preforming loans. With the possibility of turning into bad debts, banks have to carefully liquidity and manage these soured and non-performing loans. In addition, a more integral and reliable credit scoring system is suggested to implemented to deal with credit risk. Chinese state owned banks are also facing challenges from a more commercialised interest rate market and implementation of new capital rule. As mentioned above, banks capacity to raise capital and deal with increased funding cost would be questioned. In order to become efficient and real commercialised banking system, Chinese state owned commercial banks have a long way to go. However, the good thing is that Chinese banking regulators are trying to push state owned commercial banks to become more efficient. In the future, with the new around of self-innovation and support from central government, Chinese state owned commercial banks should be able to walk out of dilemma.

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Reference:
Bloomberg 2012, China soured loans rise for third quarter as economy slows, Bloomberg, 15 August, viewed 10 October 2012, < http://www.bloomberg.com/news/2012-08-15/china-bad-loans-rise-forthird-straight-quarter-as-economy-slows.html>. Dong, Y.F., Yuan, F. 2012, Chinese banks are rolling over local governments debt, Yicai, 30 August, viewed 12 October 2012, < http://www.yicai.com/news/2012/08/2034741.html>.

Lopez, L 2011, 'The Chinese underground banking system: what it is and why it should scare you, Business insider, 5 October, viewed 12 October 2012, <http://www.businessinsider.com/china-underground-bankingsystem-2011-10>. Martin, M.F. 2012, Chinas banking system: Issue for Congress, 20 February, Congressional research service, USA, viewed 10 October 2012, < http://www.fas.org/sgp/crs/row/R42380.pdf>. Ping, L. 2006, The banking system in China and India, in China and India: Learning from Each Other Reforms and Policies for Sustained Growth, eds J. Aziz, S. Dunaway & E. Prasad, International Monetary Fund, pp. 84-90.

Soufang website 2012, Soufang, PRC, viewed 12 October 2012, < http://www.soufun.com/>. The Economist 2012, Chinas bank storing up trouble: health profit is misleading, The Economist, 5 May, viewed 12 October 2012, < http://www.economist.com/node/21554234>.

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The Economist 2012, Indian banks hold your nose: Indias public sector banks are sitting something unpleasant, The Economist, 18 August, viewed 10 October 2012, <http://www.economist.com/node/21560572>.

The government of Zhejiang province 2012, The government of Zhejiang province, PRC, viewed 12 October 2012, <http://www.zj.gov.cn/>. Zhang, D.M. 2012, China delays tighter bank capital rules to 2013, Bloomberg, 7 June, viewed 12 October 2012, <http://www.bloomberg.com/news/2012-06-06/china-delays-tighterbank-capital-rules-to-2013-as-economy-slows.html>.