China's banking sector: an uneven playing field

Keith Pogson, partner, Global Financial Services, Ernst & Young, discusses the challenges faced by China''s joint stock company banking sector.

As the Chinese banking sector continues its drive to meet the demands of the WTO era, the nationwide joint stock company banking sector faces handicaps and a distinctly uneven playing field in comparison to the favoured state owned-sector, according to Keith Pogson, partner Global Financial Services, Ernst & Young (pictured).

The central government on the Mainland seems to be effectively operating a policy of one country two banking systems, within the framework of repeated public pronouncements of reform, says Pogson, suggesting that more parity will assist the speed of reform in the run up to fundraising on the capital markets.

KeithPogsonAlthough Pogson concedes that the direct impact of  WTO on the banking sector in China will not be as pronounced as in other sectors, the demands of market forces will themselves necessitate further changes. A level playing field will facilitate a faster adjustment to meet these demands, he argues.

Dominating the China banking sector with some 70% of the asset base are the four large state-run banks, namely The Bank of China, The Industrial and Commercial Bank of China, The Agriculture Bank of China and The China Construction Bank. These four leviathans all rank in the top 10 largest banks in Asia in terms of assets.

Several major immediate problems face the Chinese banking sector as it gears up to the challenges from leaner foreign competition. “With the onset of the WTO there is no level playing field in the local banking market. There are two big issues facing banking in China today, that of capital adequacy ratios [CARs] and that of bad debt. With regard to the former, 8% is the norm for banks on the international stage, while in the PRC it can be noticeably less than this. The other key issue of bad debts relates to the poor lending policies of the past and how to rectify the position,” Pogson says.

Both lending criteria and CARs need bringing up to international standards if the PRC financial sector is to adequately service China in the WTO. A central issue is that of bad debts, the treatment of which is hanging over the banking sector in the PRC and delaying progress, says Pogson. In the past there has been no viable process by which loans have effectively been vetted, so they don’t conform to truly commercial loans in the international sense.

“Now there is a process of determining commercial sense to the loans and treatment of non-performing loans, but the nationwide joint stock banks are saddled with dealing with these debts themselves, while the state sector can more easily offload them and start afresh,” he says.

A common problem to both the state and private sector is the encumbrance of handling bad debt. “Management is frequently heavily involved in the problems of trying to work out solutions to these debts which is a real distraction to the real business of running a bank and a barrier to building the asset base,’’ says Pogson.

To release the state banks from this burden, the central government has created four Asset Management Corporations (AMCs) - one to partner each state-run bank. Bad and doubtful debts are stripped out of the bank’s portfolio and packaged off to be re-managed by the AMC. Recent figures suggest that as much as $150 billion has been offloaded to the AMCs.

“This creates the illusion of a ‘good bank’, streamlined and up and running as a more efficient commercial bank without the baggage of the bad debts,’’ says Pogson. However, to pass muster in the international arena, further reform is needed. While this process works for the state sector, it is inherently prejudicial to the interests of the banking sector as a whole, he says. By international banking standards this is a thorny problem as the AMCs issue bonds to finance the purchase of the assets - bonds which were initially believed to be guaranteed by the Ministry of Finance. So, this is not a truly commercial solution to the debt problems, but more of a reshuffling of the issue to a specially created vehicle, with specialist skills and purpose.

In stark contrast, the 10 nationwide joint stock banks operate on dissimilar principles which handicap their competitiveness vis-a-vis the state-run sector. They also face the same fundamental problems of debts, non-performing loans and raising capital adequacy ratios.  “ In addition to these concerns, the management of the private sector has to concern itself with readying their banks for market. They are put at a clear disadvantage as they must necessarily clean up their own house but under different terms,” says Pogson.  Effectively they are on their own and must mitigate their own losses at the expense of gaining new business.

Of this non-state sector group of 10 banks, three have already listed, and of the remainder, a further two to three are in the process of preparing to go to market.

“They are in quandary: the government applies pressure to go to market on the one hand, but handicaps them by giving more advantages to the state sector and pushing them forward for a listing where their balance sheets will be exposed to much higher scrutiny and accounting standards,” he says.

The upside to the introduction of international accounting standards is that future listings will be able to offer a much more ‘true and fair’ balance sheet which, when acknowledged as such by the marketplace, may command a higher price when listing and thus raise further capital.

‘‘In future, each of these banks seeking to go to the market will need to enlist the support of one of the big five international auditing firms to proceed.” This will in turn add credibility to the balance sheet and work decidedly for the long-term benefit of the banks. They will have the advantage of access to capital, enhancement of reputation and ability to grow faster as reforms progress.

In their competition with the state banks, the big 10 nationwide joint stock banks face an apparent disadvantage from the public’s apparent belief of the state sectors cast iron ‘guarantee’ on deposits. The public see that deposits will be repaid. Although the nationwide joint stock company banks may accordingly suffer in this regard in the eyes of some depositors, in comparison, market financial discipline will give them a Darwinian edge down the line. “The discerning customer will be looking beyond mere safety of deposit. The transparency of the new regime imposed by the regulator will provide a different yardstick by which to judge the solidity of a bank, “ says Pogson. This will help to add overall credibility to the marketplace.

The banks have to apply the rules of many regulators and bodies, including the Chinese Securities Regulatory Commission (CSRC) and the Ministry of Finance and its Tax Bureau, as well as the People’s Bank of China, the Central Bank and Chinese equivalent of the HKMA.  

This further exacerbates the process, as the tax bureau effectively places a 3% cap on tax allowances for non-performing loans. “The stark reality is that bad debts may be as great as 40% to 50% of loans but we are facing this artificial ceiling. One could make a very strong case for extending the tax break,” says Pogson. This would encourage more frank disclosure of the debt problem.  A welcome side effect of the reform process is that pressuring the banks to go to market will increase transparency and cause the wider marketplace to start asking pertinent questions which in itself should propagate further reforms.

How do the non-state banks survive? According to Pogson, the smaller private banks maintain certain advantages in having strong footholds on the Eastern Seaboard, which has been the springboard for the economic revitalization of China since 1985, and from their wealthier clientele base which seeks a more sophisticated product.

“Their deposit growth over recent years has been strong. In the quality and type of customer, they also have a clear edge, but the state sector is protected by its magic curtain and the implicit sponsorship of its endeavours by the MOF,” continues Pogson.

However, the last laugh may lie with the nationwide joint stock banks which have been forced to transform their operations at a time when the state banks cannot react so quickly. Until a fully level playing field comes about, there will need to be some horse-trading and re-balancing within the sector. But the securities regulator is not without teeth in its drive for reform, with the principle backer upstairs being Zhu Rongji, seen as a modernizing force in supporting its goals.

Further reform will come about, but survival of the fittest may dictate that those institutions not caught within the state-owned sector will see the greatest asset growth and performance in the 21st Century.

Solutions

Pogson suggests the early adoption of International Accounting Standards either by the marketplace or otherwise.

He recommends that processes be considered to help with the removal of non-performing loans for the nationwide joint stock banks should enable management to focus on new business development.  This may be done by allowing all the banks to access the AMCs, either in tandem with the existing state-sponsored ones, or the creation of individual or collective AMCs for the banks.

This could be done with or without direct government support, but its stamp would ensure its success. One could argue that the government had a degree of moral obligation to let all the banks participate in the AMCs because many of the loans were a throwback to the pre Deng Xiao Peng state economy when government largely directed loan policy as an instrument of social policy.

Another alternative would be a market-driven approach to the disposal of the non-performing loans, by securitization, workouts and restructures, and equity exits in the form of IPOs.