Banking reform - the drivers
- China's expected entry into the World Trade Organization (WTO);
- The need to increase Chinese banks' access to and ability to raise funds competitively in international capital markets; and
- The pressure on Chinese banks to focus on the new Basel Capital Accord when it comes into force in 2004 and increase capital efficiency.
China's long awaited WTO entry is expected to happen this year. There has been much discussion about the impact of membership of WTO on the Chinese banking sector and admission is not without cost: China has to open up its banking market to foreign competition. To date, restrictions are still imposed on foreign banks carrying out business in renminbi (Rmb) and the opening up of the market would give them unfettered access to such business. Always being viewed as lagging behind their peers in terms of capitalization, global network, efficiency, expertise, modern management system and culture, the impending entry to the WTO creates immediate pressure for Chinese banks to undertake major reforms of these areas.
Ability to raise funds competitively in international capital markets
Currently, Chinese banks lag behind their foreign counter-parts in their ability to raise funds competitively in the international debt and equity markets. Such fund raising is the most effective way to recapitalize China's banking system without relying on internal budgetary fiscal resources. In the past decade the Chinese Government has been actively privatizing some of the large State-owned enterprises (SOEs). Although the privatization of State-owned banks is yet to happen, some are already preparing for a public offering. In order to have a successful listing on an international stock exchange and provide assurance to potential investors, it is important for Chinese banks to improve their efficiency, transparency and controls and increase their competitiveness through restructuring.
Basel compliance and increased capital efficiency
In January 2001 the Basel Committee released a proposed new Capital Accord to replace the 1988 Capital Accord. The new Accord sets out revised requirements for calculating capital charges against the various types of risk and has potentially significant impacts on the capital requirements of banks. One result of the new Accord is that banks with sophisticated risk management systems can reduce their capital requirements relative to other banks. In order to ensure that they are not disadvantaged by these regulatory requirements, Chinese banks need to strengthen their risk management systems so that they can comply with the new Basel requirements.
We have focused in this paper on issues and challenges that banks in China need to deal with in the course of their reforms, covering the following specific areas:
- Corporate governance;
- Risk management; and
These issues are the more critical ones that demand consideration by bank management. Structural issues in banking reforms are inseparably intertwined. Above all, the important role of the regulators and their support for systemic change can also not be underemphasized.
Banking reform - the challenges
Banks, like other organizations, need to have a well-defined strategy that should at least address the following areas based on their determined market positions:
A customer strategy and a product strategy help define the various segments of customers that banks would like to focus on. They do this by putting in various levels of efforts and by aligning the types of products most suitable to each customer segment so that banks can offer the optimal products for their targeted customers while maximizing their profitability and long-term growth. A geographic strategy helps in rationalizing the branch networks and in ensuring maximum efficiency in the delivery of the banks' products and services to their customers.
Most banks in China only have a high-level strategy. Some have only a vague and glossy mission statement. These strategies/mission statements are not necessarily supplemented by an implementation plan. Qualitative and quantitative goals that should be linked to the strategies may not be well defined.
When developing their strategy, the Chinese banks may well bear in mind the following:
- The strategy should be developed under a good understanding of the economic, financial and competitive environment in China;
- The strategy should have a well-defined market position with clearly stated strategies on customers, products and geography;
- The strategy has to be coherent throughout and agreed by management;
- Adequate resources should be available to support the strategy. These include capital, skills, experienced management and staff and information technology;
- The viability of the strategy should be reviewed and evaluated in view of subsequent changes and/or development in economic, social or financial environments. Milestones for achievement should also be set.
A big challenge for Chinese banks in this area is to overcome their overly bureaucratic structure, which creates hurdles for effective communication. No matter how good a strategy, it will not work unless the goals are communicated to all employees of the bank and everyone understands his/her role in achieving these goals. This is an easy task for Chinese banks when they have to ensure effective communication and secure commitments across all levels.
A strategy needs to be supported by an organization structure that sets out clear responsibilities for all levels of employees. In China, a problem for some banks has been unclear organization structures which result in confusion over responsibilities among employees. Too many levels in an organization structure can result in a slow decision process, together with a general reluctance to delegate authority for decision making. The distinction between the front line and back office employees is sometimes not clearly drawn and accountabilities and responsibilities overlap. This may give rise to significant inefficiencies and control issues in the operations of the bank.
To overcome this, Chinese banks should streamline their organization structure and empower people to make decisions. In revamping their organization structure, Chinese banks should always refer to international best practice and make necessary tailoring to suit their current environment. Currently, some of the international best practices include:
- Being strategy driven and extremely focused;
- Establishing quasi-autonomous Strategic Business Units with clear accountability for business development, revenue generation and service delivery;
- Distinguishing between 'customer facing' and 'business support' functions (departments) to allow for effective resource management;
- Differentiating between Front / Middle / Back office for effective risk management and controls;
- Clearly defining the corporate governance roles of the Board of Directors, Audit Committees, Executive Committees and Management Committees; and
- Setting up independent internal audit unit and risk management unit.
Banking products in China
Banks in China do not have a wide range of products to offer to their customers. For example, products such as mortgages and credit cards, which are considered basic banking products elsewhere around the globe, are not common in China. Customers with surplus cash have little choice but to put it in saving deposits as currently there are few investment products available to customers. As the market develops, it is not difficult to envisage that the relaxation of the regulatory restrictions is just a matter of time and banks will likely be allowed to work with other industries in developing cross-selling opportunities. In order to be competitive Chinese banks will have to increase the choice of products to their customers. This is not something far away as we already start to see a proliferation of banking products getting increasingly popular in China, such as mortgages, debit cards, selling of insurance products at branches and funds settlement services.
In order to equip themselves for the launching of new products, Chinese banks have to put the required infrastructure in place. Some important but basic tasks are to "warehouse" customer information and analyze their customer needs and service requirements, enhance the existing information systems (or set up new systems where necessary) to support the new products, formulate a pricing strategy to appropriately price the products, provide adequate training to the employees and ensure that customers are informed of new products through advertising.
For the past five decades, state-owned banks have been operating under government-mandated lending with a credit quota policy in place, which was only abolished in 1999. Historically Chinese banks have little choice or control over their asset allocations: the prices of most banking products are fixed by the State through narrow interest rate bands. Under this culture, performance measurement was of no great relevance to Chinese banks. However, increased emphasis on profitability and efficiency are driving more changes in management's philosophy on measuring performance of the banks.
In general there are four levels of performance measurement for banks:
- Bank as a whole
Performance measurement for the bank as a whole has never been regarded as an issue to State-owned Chinese banks as compared to international commercial banks, due to their ownership by the State. Performance measures used are often not profit-linked. As banks are urged to open up for competition with their foreign counter-parts, increasing focus will be placed on the overall profitability of the banks and appropriate "commercial" performance measurement will become a necessity.
Performance measurement for divisions/units and products requires sophisticated transfer pricing and overhead cost allocation systems. The lack of an effective transfer pricing methodology, which takes into consideration the credit risk incurred, would make proper pricing of products very difficult. This will be a major challenge for Chinese banks because it will call for significant upgrades of their existing systems or even a change to new systems.
Customer profitability is an area a lot of the international banks are currently trying to encompass in their overall performance measurement framework. It calls for even more sophisticated information systems that are able to consolidate transactions by individual customers.
In addition to the various levels of profitability measurement discussed above, loan growth and deposit growth are also some of the most quoted statistics. It is essential that whatever performance measurements are adopted, they should support the overall corporate strategy.
Setting up an all-round performance measurement framework and having it implemented is a long process and is likely to require significant investments in terms of information technology and staff training. This should be a highly prioritised task for Chinese banks because of their increased emphasis on profitability and efficiency.
Having experienced and well-trained employees is fundamental to banking reforms. Chinese banks need to set up an appropriate performance measurement system that can provide motivation to their employees and form a basis for determining remuneration. Retention of experienced employees is an imminent issue when foreign banks, in anticipation of the WTO accession, are prepared to pay more for experienced, well-connected bankers who understand the current market.
Promotion of an equitable and transparent remuneration system is important to properly motivate employees. Criteria have to be clearly set out in a specific and measurable manner and the overall process should be transparent to the employees. The employees should also be made aware of the profitability of their own divisions and the bank as a whole.
In addition, proper training has to be developed to train up the employees with minimal disruption to the business. Aside from the technical aspects, the training has also to address soft skills which could help bank employees to work in teams and communicate effectively.
Information technology (IT) is integral to almost all aspects of the banking reform. As mentioned above, the measurement of profitability by division/unit, product and customer require sophisticated costing information systems. Another example would be the setting up of a reliable management information system for the monitoring of the bank's exposures for risk management purposes. The issue of having inadequate IT systems and skill sets is not exclusive to the Chinese banks but rather one constantly faced by most international banks. However, the IT structure of Chinese banks is typically non-integrated and it is not unusual for branches of the same bank to have different systems, not to mention the fact that a lot of these branches, especially those far from the major cities, only have manual systems. This is exacerbated by the sheer size of the Chinese banks. Some of the banks in China have thousands of branches throughout mainland China. All these have made consolidation an onerous and time-consuming task.
Chinese banks need to formulate an IT strategy as part of their overall business strategy and operational plans. System enhancement or setting up new systems are big investments for Chinese banks. It is important that the execution and monitoring of the IT strategy should be supported by people with specialist skills and any major IT purchases should be based on the agreed IT strategy to ensure consistency with the business goals.
Corporate governance is a key policy issue confronting many developing countries including China. Chinese banks are yet to develop a sophisticated framework for corporate governance. In the past the state banks have been operating under a centrally planned economy and they often regard themselves as government organizations. State-owned commercial banks, with significant volumes of policy lending, were to a large extent essentially acting as cashiers for the State and corporate governance was minimal.
The Basel Committee has recently issued several papers on corporate governance of banks. These papers set out the strategies and techniques that are basic to corporate governance. The following practices should be viewed as critical elements of corporate governance:
- Establishing strategic objectives and a set of corporate values that are communicated throughout the banking organization
- Setting and enforcing clear lines of responsibility and accountability throughout the organization
- Ensuring that board members are qualified for their positions, have a clear understanding of their role in corporate governance and are not subject to undue influence from management or outside concerns
- Ensuring that there is appropriate oversight by senior management
- Effectively utilizing the work conducted by internal and external auditors, in recognition of the important control function they provide
- Ensuring that compensation approaches are consistent with the bank's ethical values, objectives, strategy and control environment
- Conducting corporate governance in a transparent manner
Central to all these is the need for banks to have a sound management board. On March 24 2000, the People's Bank of China (PBOC) issued a circular on the required qualifications of senior management personnel in financial institutions. The circular sets out minimum qualifications, in terms of education background and work experience, of the senior management personnel who will be involved in the making of important operating and risk management decisions for financial institutions.
Although the primary responsibility for good corporate governance rests with the boards of directors and senior management, there are also other ways that corporate governance can be promoted. For example, governments and regulators play a significant role in promoting corporate governance through laws and regulations. Many of the shortcomings in the actual practice of corporate governance in Chinese banks derive from the policy and institutional environments within which the banks operate. Accounting, auditing and disclosure standards should be lifted to the level of transparency and monitoring necessary for good corporate governance. The Chinese authorities are aware of all this and are looking for ways to improve. One example would be the recent requirements by China Securities Regulatory Commission (CSRC) and the Ministry of Finance (MOF) for listed domestic financial institutions to issue financial information in accordance with International Accounting Standards.
A well-established risk management framework should support a bank's business strategy and risk appetite. Setting up an integrated risk management structure is paramount in managing risks. Common features of an integrated risk management structure according to international best practice include an independent risk management committee and an audit committee that report directly to the board of directors and proper segregation of duties between front and back office.
The three significant types of risks that impact the capital of banks under the new Basel Capital Accord are credit risk, market risk and operational risk.
Credit risk exists throughout the activities of a bank, including the banking book and trading book, and both on and off balance sheets. For Chinese banks, loans are the largest and most obvious source of credit risk. As a result of the history of policy lending, the quality of the loan portfolios of Chinese banks has suffered. Bad and non-performing loans are often recapitalized by additional loans to defaulting debtors in order to protect the bank's balance sheet and to maintain the viability of the borrower. This derives fundamentally from the system of state ownership and the highly political process governing "commercial" relationships between state-owned banks and state-owned enterprises (SOEs). Banks are acting as agents of the state who also owns the debtors, that is the SOEs. The debt transacted through the market is essentially a transfer between subsidiaries of a state economic machine.
PBOC issued a circular dated May 18 1998 which stipulates that all the banks in China should follow certain guidelines in classifying their loans. These guidelines include defining the loans into one of five categories and certain criteria the banks need to apply to classify their loans into the various categories.
The Basel Committee has set out some sound practices for managing credit risk which address the following areas:
- Establishing an appropriate credit risk environment
- Operating under a sound credit granting process
- Maintaining an appropriate credit administration, measurement and monitoring process
- Ensuring adequate controls over credit risk
In January 2001 the Basel Committee released a proposal to replace the 1988 Capital Accord. Under the proposed new Accord, two principal options are proposed for the measurement of credit risk: the standardized approach and the internal ratings based (IRB) approach.
Under the standardized approach, a bank should allocate a risk weight to each of its assets and off-balance-sheet positions and produce a sum of risk weighted asset values by reference to a rating provided by an external credit assessment institution that meets strict standards set out by the Basel Committee. Under the IRB approach, banks will be allowed to use their internal estimates of borrower creditworthiness to assess credit risk in their portfolios, subject to strict methodological and disclosure standards.
Although still at the consultation stage, the Basel Committee has essentially set the direction for determining bank capital adequacy on an international level. The Committee expects the new Accord to be implemented in 2004. Driven by China's expected WTO accession, banks in China will be obliged to move fast to international best practice, that is Basel compliance. This is going to be a big challenge to Chinese banks when the new Accord will reward banks with more sophisticated systems that are able to differentiate risks with lower capital charges. Chinese banks should treat this as a matter of urgency because if they pursue an IRB approach, they need significant lead-time to develop the systems and collect the data necessary to qualify for this approach.
Chinese banks are normally not allowed to hold positions in equities and other derivative instruments and therefore the market risk arising from this is rather insignificant.
Managing interest rate risk is not a complex task for Chinese banks as base rates for Rmb deposits and loans are both fixed by the PBOC, although the banks have the flexibility to adjust the rate on loans to commercial customers within a certain range of the official rates. Over the past few years, the PBOC has been gradually opening up the domestic interest rate market by granting banks more autonomy and flexibility in setting interest rates for loans and large deposits. The relaxation of the remaining restrictions is imminent as China is getting closer to having its interest rates determined by market forces. In this regard, Chinese banks need to prepare themselves for a sophisticated pricing system that provides reasonable and commercially sound interest rate quotes to customers and balance its risk exposure against expected profit.
For exchange rate risk, the banks should aim to keep their open positions to a reasonable size. Currently some Chinese banks do have a policy of restricting their domestic branches from conducting any dealings with foreign counterparts on behalf of customers or on their own account. In the longer term more sophisticated market risk monitoring controls and mechanisms such as the adoption of various limits in trading activities and Value at Risk type models should be implemented.
Different techniques are used to control or mitigate operational risk. Controls are the primary means to manage operational risk. The most conventional control mechanisms are segregation of duties, clear management reporting lines, adequate operating procedures and a high quality independent internal audit and compliance function. These types of controls are essential but they will not work properly unless the overall culture of the bank promotes, respects and rewards strong controls and the board of directors and senior management believe in these values. For Chinese banks, this is a cultural issue. Reforms will definitely take time and must be driven from the top of the organization.
Measurement of operational risk has been a challenge to all banks globally. Most global banks are at a very early stage, with only a few having formal measurement systems. The new Basel Capital Accord proposes an explicit capital charge for operational risk. The new Accord expects that the charge would on average represent 20% of the minimum regulatory capital charge. The methodology ranges from the simplistic one of holding capital equal to a fixed percentage of gross income (Basic Indicator Approach) to the more sophisticated one of tracking key risk indicators in predefined business lines. All Chinese banks will face a challenge to have systems in place to avoid the penalty under the most basic of the calculation methods. As Chinese banks have not focused on measuring operational risk in the past, they will find it very difficult to quickly establish systems and procedures necessary to avoid high capital charges for operational risk. It is likely that most Chinese banks will attempt to use the basic model in complying with the new Basel requirements. However, over time they will eventually be able to build sufficient history to migrate to the more sophisticated models.
Transparency is an important component of the infrastructure that allows market mechanisms to function effectively and fairly. It is the public disclosure of reliable and timely information that enables users to make an accurate assessment of a bank's financial condition and performance, business activities, risk profile and risk management practices.
The Basel Committee considers transparency to be a key element of an effectively supervised, safe and sound banking system. In their paper Enhancing Bank Transparency dated September 1998, the Basel Committee has identified the following six broad categories of information, each of which should be addressed in clear terms and appropriate detail to help achieve a satisfactory level of bank transparency:
- Financial performance;
- Financial position (including capital, solvency and liquidity);
- Risk management strategies and practices;
- Risk exposures (including credit risk, market risk, liquidity risk, and operational, legal and other risks);
- Accounting policies; and
- Basic business, management and corporate governance information.
There is evidence that the regulators in China are placing more and more emphasis on raising the standard of transparency in financial disclosure. On May 31 2000, the PBOC issued temporary guidance to the four State-owned banks with regard to the preparation of their consolidated financial statements. The guidance sets out specific requirements for the State-owned banks including the need to prepare consolidated cash flow statements for the financial year ended December 31 2000. There are also guidelines in relation to the basis of preparation and consolidation.
In February 2001, CSRC and MOF jointly issued a circular that requires domestically listed financial institutions (banking, securities and insurance companies) in China to appoint overseas accounting firms to audit their financial information prepared in accordance with International Accounting Standards.
Although the regulators have been pushing for increased transparency in the financial disclosure of Chinese banks, a lot still needs to be done. The following table shows the areas where "gaps" in financial disclosure by the state-owned banks in China are often found. The indicators are benchmarked to the Basel recommendations:
Key income statement items / detailed analysis / breakdown of P&L items in notes
Key figures and ratios
Business and geographical segment information
Additional disclosures on balance sheet items (for example loan, deposits, trading accounts, investment)
Off balance sheet items (for example notional amount, replacement costs)
Commitments and contingent liabilities
Capital (for example capital structure, ownership, restrictions)
Liquidity (for example maturity profile, marketability of investments and cash flow statement)
Risk management strategies & practices
Liquidity risk, for example cash flow
Operation, legal and other risks
Disclosure of major accounting policies
Basic business, management and corporate governance information
Board structure, board members' qualification and corporate governance information
Senior management structure and qualification
Chinese banks need to improve their disclosure in areas including financial performance, financial position and risk management. However these are only viewed as "minimum" disclosure requirements by most banks worldwide. There always remains significant room for improvement with the non-financial aspects of disclosure, which plays an equally important role in enabling the market to assess Chinese banks fairly. Non-financial information disclosure could include strategies of banks, information on customers and markets, people and reputation. Chinese banks should be moving towards more open disclosure of both financial and non-financial information as part of an improved corporate communication process.
Driven by China's impending WTO entry, the need to increase their competitiveness in global capital markets and the desire to be Basel compliant, Chinese banks have little choice but to open up and be more transparent and efficient so that they can compete with their foreign counter-parts and operate on a commercial basis. With respect to reforms in the banking sector, a lot of areas need to be dealt with, encompassing macro-economic issues and internal restructuring of banks.
Apart from the deep-rooted NPL issue that has always been the centre of everyone's attention, Chinese banks should also focus on other core reform areas including:
- The need to formulate an appropriate strategy which is clear and implementable;
- The development of infrastructure that adequately supports and clearly links to the business strategy including the establishment of a well-defined organization structure, performance measurement framework and supportive information technology systems;
- An environment with adequate corporate governance by international best practice;
- A proper risk management framework and structure; and
- Increasing transparency in financial disclosure.
The road of banking reform in China is a long one. Planning for reforms and implementing changes take time but Chinese banks do not have this luxury given the time limits imposed by both China's expected entry into the WTO and the expected implementation of the new Basel Capital Accord in 2004. However these should be viewed as 'opportunities' to speed up the banking reform in China.
¬ 2001 PricewaterhouseCoopers
Simon Tsang, Partner, Assurance & Business Advisory Services, PricewaterhouseCoopers
Email: [email protected]
Sylvia Chan, Partner, Assurance & Business Advisory Services, PricewaterhouseCoopers
Email: [email protected]
Note: This article was first published in a book called "Structuring for Success"