China's banks are too big to manage

FT.com

It is easier to make money than sense out of China's banks. The four big state-owned commercial lenders make huge profits, but many who see vulnerabilities in China's economy think these banks are the problem when they reflect distortions elsewhere. China's banks are in fact too secure – and their performance could be improved by breaking up the 'too big to manage' entities.

Many critics cite inflexible interest rates, that are deemed too low relative to inflation, as the issue. Others point to government interventions encouraging risks such as a property bubble. Still others remind us the banks are sitting on a mountain of deposits that feed into temptations to misuse captive funds given lax governance safeguards.

But China's interest rates are high in real terms compared with other major economies. Its capital markets lack the depth for interest rates to be shaped by market forces and the dominance of the big four banks reduces the benefits of having more flexible rates. The emergence of a property bubble has more to do with capital controls that discourage investors from moving their savings abroad, thus encouraging speculation in domestic property. And these huge deposits are a consequence of an economy with limited investment options.

Further concern has been caused by the emergence of wealth management products and shadow banking facilities that allow for higher returns but at the cost of introducing riskier financial instruments. In fact, these initiatives are to be welcomed. They provide more diversified options for savers and are shaking up a system that has relied on just channelling funds to state entities, leaving unmet the needs of private enterprises.

Some borrowers may not meet the right lending criteria and there will be defaults, and probably a mini-crisis or two. But these are the costs of learning in a regimented system. Greater transparency, along with an appropriate regulatory, framework will need to emerge but trying to regulate such activities prematurely could stifle the learning process.

One is hard pressed to come up with indicators that would reveal an imminent banking crisis in China. After all, the big four banks pay high dividends; their non-performing loan ratios are low (even if flawed); their control over an immense volume of deposits would be the envy of other banking systems; their lending for mortgages is not highly leveraged; and, since so much of their activity is geared to state entities, the risks are ultimately about the creditworthiness of the state.

So what, then, is the problem with China's banks?

Governance is the issue in a state-dominated activity that provides the glue for much of China's economy. The incentives for prudent risk-taking and adherence to commercial objectives are weak.

The challenge is to introduce more competition in a system that will continue to be dominated by the state and where vested interests are strong. Given this reality, there are nevertheless actions that could help to improve performance. One would be liberalising entry of foreign banks. This would spur competition and innovation and, contrary to what is believed in China, strengthen the performance of state-owned banks.

A more radical action would be to break up the big four into three regional banks each as a powerful means to foster competition and improve governance. This has been a process that has worked well before when China split its national airline into numerous regional entities, which then resulted in a manageable number of more efficient companies.

These split-up banks would be headquartered in various provinces rather than in Beijing and thus less influenced by politically driven mandates. They would not be restricted to operating only in their originating regions but could expand elsewhere. They would, however, need to become more commercially oriented to survive. In this process, some would be motivated to seek external partners and this would provide support for further, much-needed liberalisation.

Yukon Huang is senior associate at the Carnegie Endowment and a former World Bank country director for China.

Copyright the Financial Times 2012.