China's Financial System - Howard Chao

8/3/2019 China's Financial System - Howard Chao

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The Financial System in China:

Risks and Opportunities Following the Global Financial Crisis

White Paper

by

Susan Krause Bell, Partner

Promontory Financial Group, LLC

and

Howard Chao, Partner

OMelveny & MyersLLP

April 2010


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2010 Promontory Financial Group, LLC and OMelveny & Myers, LLP. All rights reserved.

Table of Contents

EXECUTIVE SUMMARY................................................................................................ 1

I. Introduction.......................................................................................................... 2

II. The Chinese Financial System............................................................................ 3

The Banking Landscape...................................................................................... 5State Role in the Financial System...................................................................... 7

III. The Global Financial Crisis.................................................................................. 8

Cooling of the Real Estate Bubble and Drop in Exports ...................................... 8The Governments Response.............................................................................. 9

IV. Prudential Regulation in China .......................................................................... 10

Capital ............................................................................................................... 11

Liquidity ............................................................................................................. 12Corporate Governance ...................................................................................... 13Risk Management.............................................................................................. 13Compensation ................................................................................................... 14Accounting......................................................................................................... 15Supervision of Systemically Important Institutions............................................. 15

V. The Case of Hong Kong .................................................................................... 16

Mainland Financial Firms in Hong Kong ............................................................ 16

VI. A System in Transition....................................................................................... 18

Financial Reform and Market Developments..................................................... 18VII. Implication for Chinese Banks ........................................................................... 21

Risk Management.............................................................................................. 21Credit Culture .................................................................................................... 21Liquidity ............................................................................................................. 21The Role of the State......................................................................................... 22Resolving Troubled Institutions.......................................................................... 22

VIII. Implications for the International Financial Community ..................................... 24

Market Penetration by Foreign Financial Institutions ......................................... 24Foreign Minority Investments in Chinese Banks................................................ 25Impact of State Policies on Counterparties of Chinese Financial Institutions .... 26Chinese Financial Institutions in the International Marketplace ......................... 26

IX. Conclusion......................................................................................................... 27

ABOUT THE AUTHORS .............................................................................................. 33

ACKNOWLEDGMENTS............................................................................................... 35

Appendix 1: Regulation of Securities Firms in China

Appendix 2: G20 Proposals for Dealing with Systemically Important Financial Institutions


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The Financial System in China:Risks and Opportunities Following the Global Financial Crisis

Executive Summary

Most of the worlds major financial systems are in a period of retrenchment and reform as

a result of the severe financial disruption of 2008-2009. Governments are strengtheningapproaches to financial regulation, and commercial banks and other financial firms areattempting to internalize lessons from the financial crisis, improve their reputations, and preparefor new restrictions. Meanwhile the large Chinese banks are vital, profitable and growing. Theassets of the Chinese banking system are growing rapidly and have almost eclipsed the assetsof the U.S. banking system. This paper looks at the unique characteristics of the Chinesebanking system and the governments role in both supervising the banks and managingsystemic risk. It compares the supervision of Chinese banks to that of other global banks, andconsiders what the major risks and opportunities are going forward for the rapidly evolvingChinese financial sector.

This paper should have relevance to anyone interested in the future of the Chinese financialsystem. This includes foreign firms operating, or considering operating, in China, potentialinvestors in the Chinese financial system, and counterparties to Chinese financial firms. Itshould also help Chinese policy-makers and financial firms understand some of theperspectives of the international financial community.

China's financial sector was relatively unscathed by the global financial crisis for severalreasons, including the inconvertibility of the RMB, protection from foreign competition withinChina, conservative regulation, and the overall growth of the Chinese economy. The globalfinancial crisis did hit Chinese shores, however, through the world-wide decline in exportdemand. GDP growth dropped in late 2008, but remained positive and rebounded quickly in2009 following a massive government stimulus package. This strong growth notwithstanding,China's economy and its financial system face challenges. In the short term, the surge in banklending as part of the fiscal stimulus program may be creating overcapacity and will likely

generate new non-performing loans and weaken bank balance sheets. Moreover, rapid changein the form of further financial liberalization, internationalization of Chinese banks, and theeventual convertibility of the RMB will bring new risks into the system.

As governments around the world undertake reforms to financial oversight in the wake of thecrisis, China is also working to bring its relatively young banking system up to world standards,both in terms of sound banking practices and in terms of the competitiveness of the system. Wefind that in many respects, China is broadly in sync with the rest of the G20 in its approach tobank supervision, except for one area. The Chinese government has consistently hada significant ownership position in the financial industry and participates in managing the banks.Related to this, the Chinese financial regulators tend to actively pursue macroeconomic policygoals through the regulated institutions, particularly the banks and securities firms. Thesepractices present problems in an era where China otherwise plans on opening up its financialsystem to more international interaction and competition. Chinese banks are not practicing trulycommercial-based decision-making if State officials are present as owners, managers, anddirectors.

China also has an implicit policy of not permitting banks to fail, which in the short run may playa stabilizing role, but in the long run creates moral hazard and may have the effect of deferringsystemic risk and lessening the pressure for Chinese banks to become internationallycompetitive. This will also make it difficult to realize convergence between the international andChinese approaches to bank regulation and to create a level playing field among Chinese andinternational banks.


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The Financial System in China: Risks and Opportunities Following the Global Financial Crisis 22


The Chinese financial sector will have a better chance of weathering current and future risksand becoming more competitive on a global scale if supervisors and firms place more emphasison developing sound, market-based practices and the State moderates its role in controllinginnovation and decision making. Foreign financial firms wanting to establish or expandindependent operations in China must assess the multi-faceted role of the government anddetermine how it will affect their business strategy. At the very least, they face competitive

hurdles stemming from the role of the State, which tends to advantage the domestic firms. Onthe other hand, foreign firms may be more successful than Chinese banks in certain lines ofbusiness where they have more expertise, such as fee-based services. Foreign investors maycontinue to be able participate in the profitability of Chinese financial firms, although they shouldbe aware that there are some signs that the Chinese government appears to be less willing toprotect banks from losses than in the past. In the end, the predictability of the Chinesegovernment may be the most important, yet most elusive, aspect of evaluating the risk of doingbusiness in Chinese financial markets.

I. Introduction

In 2008-2009, most G20 governments were absorbed in managing the financial crisis and itseffects on their domestic economies. Government officials had to begin crafting immediate andlonger-term solutions to the failures of their financial systems, coordinate these effortsinternationally, particularly as they apply to global institutions, all the while dealing with publicquestions and criticism about their own perceived failures. China, on the other hand, has beenon a different path. Its banks are profitable and growing; in 2009 the Chinese banking systemalmost eclipsed the U.S. banking system in size. Chinas economy was significantly affected bya world-wide drop in export demand, but neither Chinas bank regulators nor its central bankcame under criticism, since the problems did not originate in the financial system as it did inother countries. In fact, internally, China quietly went through a transition from being a studentof other, more developed banking and supervision systems (particularly the U.S.) to confidentlymoving forward on its own path of financial reform, continuing to learn from other systems

mistakes as much as from their successes.To begin to grasp the Chinese story it is important to understand the policy backdrop. The keydrivers of Chinese policy are economic growth and social stability. Given Chinas extraordinarilylarge population, and the fact that it is on average still a relatively poor country, its objectivesmust be met through sustained high economic growth. The government considers socialstability to be an important prerequisite to sustainable growth, which in the economic andfinancial sphere means a high level of job creation, controlled inflation, and avoidance offinancial crisis. It also means the government will try to use the power of the market to spurgrowth and allocate resources efficiently, but ultimately retain control over the overall directionof the market so that their key policies can be implemented.

In what follows, we look broadly at the unique features of the Chinese financial system, and

then at how the financial crisis played out in China. Next we discuss the elements of the globalpolicy response to the crisis, and compare it to prudential supervision in China. We considerthe case of Hong Kong, which offers Chinas financial institutions experience in a freer market,and then look ahead at the impact of Chinas efforts to open up its markets to allow moreinbound and outbound capital flows and financial market competition. Taking all these threadsinto consideration, we reflect on what risks lay ahead for Chinas financial system. We considerthe role of the State in the financial system, and conclude that both the governmentspredilection to use the financial institutions as conduits of economic policy, and its unofficial butwell-understood policy of not letting the banks fail, while possibly beneficial in the short term,could over time create misaligned incentives that increase risk and inefficiency in the system. Itcould also undermine the governments goal of international expansion of Chinese banks,


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because governance and risk management practices at the Chinese banks have not been trulymarket-based or market-tested. The States role in the financial system may also affect theassessment of foreign firms as they consider operating in China, in both positive and negativeways, depending on the potential role a foreign firm contemplates taking in mainland China.Finally, we suggest reasons why the Chinese governments approach to avoiding bank failuresmay not be compatible with their desire for more competitive and internationally integrated

financial system.

II. The Chinese Financial System

It is remarkable to think that not long ago in China, in the 1970s, a Soviet-style mono-banksystem still prevailed in which the Peoples Bank of China (PBOC) controlled almost four-fifthsof all bank deposits and provided 93% of all loans.1 Then in a short period of time, as rapideconomic reforms took root, China moved to a system with a multiplicity of competing large,medium-sized and small local banks, though almost all of them were state owned. By the mid-1990s the banks had replaced the PBOC in providing financing to enterprises, but then faceda new challenge: a monumental buildup of non-performing loans (NPLs) as result of large scale

policy loans which the banks were directed by the State to make to various state-ownedenterprises, often for social purposes, regardless of creditworthiness. Many western expertswere concerned that these loan losses would overwhelm the Chinese banking system, or atleast leave the Chinese government with a heavy burden to subsidize banks for years to come.

The Chinese regulators mandated in 1999 that the NPLs be sold at book value to government-owned asset management companies for disposition, effectively recapitalizing the banks. Thegovernments objective was two-fold: to prepare the Chinese market for the onslaught of foreigncompetition that would follow China joining the WTO in 2001, and to further the governmentsambitious initial public offering (IPO) plans for the large banks. To the surprise of many, thisapproach quickly revitalized the Chinese banks and they were able to proceed with their IPOsbeginning in 2005. In the past five years, China has successfully conducted listings in HongKong and Shanghai of most of the large banks and many of the medium sized banks.2 In

addition to raising capital for the banks, the listings were designed to improve bank corporategovernance and subject them to the rigors of international auditing and investor scrutiny,although the government retained significant share ownership following the IPOs. This was partof a policy of separating market oriented banks from the policy banks that had beenestablished in 1994 to conduct policy lending.3

A caveat is in order regarding data availability. For many Chinese institutions, data has greatlyimproved in the last few years. In particular, firms that are now listed on one of the stockexchanges follow exchange rules for auditing and disclosure. The large banks have also beensubject to regulatory directives as part of financial reform that began in 1998 to make significantinternal improvements including their IT systems, which have contributed to enhancedtransparency. In addition, the regulatory bodies and the PBOC publish aggregate statistics.

However, there are still significant reporting gaps in some components of the financial systemand it is difficult for an outsider to reconcile individually reported and aggregate data. In thispaper, we use official data where possible, and any data reported on individual institutionscomes from each firms annual report.

1Lardy, Chinas Unfinished Economic Revolution, 1998, p. 61.

2The only large commercial bank that has not yet been listed is Agricultural Bank of China (ABC). ABC was slower

to list because of issues with asset quality, management and the much larger restructuring it would need to undergoto list, but many believe that ABC may attempt a listing next year.3

The three policy banks are Agricultural Development Bank of China, China Development Bank, and Export ImportBank of China.


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Chinas financial system is notable for several features that set it apart from Western privatemarket-based financial systems, including state ownership, the predominance of banks forcommercial enterprise financing, a relatively closed system, and the rapid economic growthwithin which the system operates. The commercial banking sector is the dominant repositoryfor Chinese savings, and the vast majority of business financing also comes from the banks.Despite significant recent growth in Chinas capital markets, close to 90% of intermediated

Chinese enterprise financing comes from the banks.4 This is in contrast to the situation in theU.S., where the capital markets account for about half of total business financing.5

The most salient aspect of the system is the dominant role of the State. The State ownscontrolling stakes in the five largest commercial banks and 100% of the three policy banks.(See Table 1.) The State also holds significant equity stakes in the remaining shareholdingcommercial banks and all of the postal savings banks, and has a heavy influence on the ruralcooperative banks and credit societies (which are technically not stateowned).

TABLE1:Total Assets*

RMB US$

State

Ownership*

Top Five Banks (in billions)

Industrial and Commercial Bank of China 9,757.2 $ 1,434.9 51%

China Construction Bank 7,555.5 1,111.0 48%

Agricultural Bank of China 7,100.0 1,044.1 100%

Bank of China 6,951.7 1,022.3 70.8%

Bank of Communications 268.3 39.5 26%

Three Policy Banks

China Development Bank 3,821.2 $ 561.9 100%

Agricultural Development Bank of China 1,354.7 199.2 100%

Export-Import Bank of China 566.7 83.3 100%

_______________

*Source: 2008 Annual Reports

In the securities sector a similar although slightly lesser concentration of state ownershipprevails. State ownership of the seven biggest securities companies in China is no less than37%. (See Table 2 below.) These seven securities companies hold approximately 40% of totalsecurities company assets in China.6

4The figure is 88% for the first half of 2008. The Monetary Policy Analysis Group of the Peoples Bank of China, The

Implementation Report of Chinas Monetary Policy for the Second Quarter of 2009(2009), p. 14.5

Direct statistical comparisons are extremely difficult due to data availability and format. However, according to theU.S. Flow of Funds data, the amount of bank loans and mortgages made up 48% of credit market instrumentsoutstanding at year-end 2008 for non-farm, non-financial businesses. The proportion is vastly different for corporatebusinesses (24%) vs. non-corporate (95%). http://www.federalreserve.gov/releases/z1/Current/z1r-5.pdf,Tables B.102 and B.103.6

According to Securities Association of China, the seven largest securities firms as of year end 2008 held assets ofapproximately RMB428 billion, out of total assets of the securities industry of RMB1,060 billion. Information availableat http://www.sac.net.cn/newcn/home.


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TABLE2:

Seven Largest Securities FirmsState

Ownership

Citic Securities Company Ltd. 37.8%

Haitong Securities Company Ltd. 42.5%

Guotaijunan Securities Company Ltd. 60.5%

Yinhe Securities Company Ltd. 99.9%

Guangfa Securities Company Ltd. 60%

Shenyinwanguo Securities Company Ltd. 52%

Guosen Securities Company Ltd. 40%

Similarly, the State owns commanding stakes in four of the top insurance firms, which togetherhold approximately 48% of Chinas insurance assets.7 (See Table 3 below.) However, theinsurance sector is notable for the presence of a large, nearly-private player. Ping An Group,which owns the second largest life insurer, Ping An Life, is essentially controlled by private

management and the State holds roughly only a 7% interest.8

TABLE3:

Five Largest Insurance CompaniesState

Ownership

Peoples Insurance Company (Group) of China Limited (PICC) ~100%

Ping An Group 7%

China Taiping Insurance Group Co. (China Taiping) ~100%

China Pacific Insurance (Group) Co., Ltd. (CPIC) 48.4%

China Life Insurance (Group) Company (China Life) 68.4%

The Banking Landscape

Chinas banking marketplace is as complex as the country itself. The largest five commercialbanks have a substantial market presence with a market share of about half of banking assets.(See Chart 1.) There are numerous additional types of banking institutions, including the threepolicy banks, 14 joint stock banks, 136 city commercial banks, the postal savings bank, varioustypes of urban and rural cooperatives and credit institutions, trust companies (see Box), variousfinance companies, and foreign banks. The CBRC reports 5,634 banking institutions in total,dominated in number by 4,965 rural credit cooperatives, although many of the larger banks

have thousands of branches.

9

7According to their annual reports and total insurance industry asset figures issued by CIRC, they held assets of

RMB1.65 trillion at year end 2008 out of total insurance company assets in China of RMB3.34 trillion.8

Annual report of Ping An Group for 2008.9

CBRC 2008 Annual Report.


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*Other Includes village and township banks, lending companies, mutual credit companies,

finance cooperatives, trust companies, financial leasing companies, auto finance companies,and money brokerage firms.

2%2%

51%

7%

9%

14%

11%

4%Top 5 State-owned Banks

Joint Stock Banks

Policy Banks

City Commercial Banks

Credit Cooperatives and Rural Banks

Postal Savings Bank

Foreign Banks

Other*

CHART1: Market Share of Chinese Banking Institutions by Assets10

The assets of the larger banking institutions have historically been dominated by commercialloans. The reasons for this focus include the underdeveloped capital markets which leavecommercial enterprises with few financing alternatives to banks, and also the fact that the Stateuses the large banks to meet policy goals through bank lending. The reliance of the banksbusiness model on lending is illustrated by the fact that fee income at Chinese banks remains atless than 10%.11

Ensuring adequate lending to small and medium enterprises (SMEs) has been an ongoingchallenge, and government efforts to increase focus on this area have been only somewhatsuccessful. Retail banking is becoming an increasingly important area for banks. First, aswealth in China grows, banks of various kinds are developing wealth management products forhigh net worth individuals. Second, newer products such as credit and debit cards ande-banking are gaining momentum.

Rural finance is inadequate and is an area of policy focus; government efforts have resulted innew institutions devoted to rural financial services.12 The government, however, also aims toincrease the participation of large banks in rural finance.

10China Bank Regulatory Commission (CBRC), 2008 Annual Report.

11According to CBRC 2007and 2008Annual Reports, fee income at banks was 9.74% at end-2008, up from 9.4%

a year previous.12

CBRC 2007 Annual Report.


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State Role in the Financial System

Predictably, the States dominant ownershipposition gives it a strong voice in governance ofstate controlled financial institutions, including theappointment of management. Moreover, although

China is implementing market driven reforms ofthe financial sector, its financial regulators stillmaintain a much more interventionist approach toregulation than what would be seen in mostWestern regulatory systems. The China BankRegulatory Commission (CBRC), for example,considers it within its purview to direct banks tostop disbursing additional loans for the remainderof a particular year if the market is overheated orto direct banks to dramatically increase lending ifthe macroeconomic environment requires it. TheChina Securities Regulatory Commission (CSRC)

appears to feel responsible for ensuring that stockprices are adequately supported and willconstrain the number of IPOs it approves toachieve this purpose.

While in theory policy lending is now left to thepolicy banks, the large commercial banks in factstill engage in significant state-directed lending.The regulators still have macroeconomic policygoals as part of their mandate, and the State stillbacks certain favored projects through its equityinvestments. Banks therefore receive broadpolicy directives from regulators, such as to

increase or reduce the volume of credit, and thebanks display an obvious preference to lend tocentral or provincial government-backed projectson the likely valid assumption that those projectsare more creditworthy.

While China has made some progress towards a market-based financial system, manyregulatory restrictions remain. Interest rates were strictly controlled until 1986, when modestexperimentation with interest rate liberalization began. It was only in 2004 that the ceiling (butnot the floor) on bank lending rates and the floor (but not the ceiling) on bank deposit rates wereremoved. The regulated spread between the maximum deposit rate and the minimum lendingrate has been one of the reasons Chinese banks have enjoyed high profits.

Chinese financial institutions benefit from two primary protections against foreign competition:the inconvertibility of the RMB for capital account transactions and various regulatory limitationson foreign financial institutions in China. The inconvertibility of the RMB (see box) means thatoffshore banks cannot make foreign currency loans to or engage in other transactions with most

13According to CBRC there were 54 trust companies at the end of 2008. According to a recent KPMG report,

Chinas Trust Sector: The Next Chapter, assets under management at end-2008 totaled RMB1.24 trillion($182 billion), and is estimated to be RMB2.68 trillion ($394 billion) at November 2009.14

QDII licenses, which are issued by the CBRC, allow Chinese investors to invest in shares and bonds overseas.15

CBRC allows a foreign investor to own up to 20% of a Chinese trust company.

Trust Companies

Trust companies make up a small portion of theChinese financial system but bear watching.

13

Trust companies burgeoned in the 1990s but raninto trouble with over-leveraging, bad investments

and, in some cases, fraud. After several notablefailures, some triggered by the Asian financialcrisis, the government closed down a largenumber of trust companies. Over time theremaining trust companies were required to be re-licensed, and the CBRC developed a newregulatory regime and as recently as 2007introduced new rules governing trust companies.Though trust companies are now more heavilyregulated than in the past, they still have someflexibility that other financial institutions do not.

Trust company rules allow them to offer assetmanagement services primarily to institutionalinvestors and high net worth individuals, anattractive, growing market. Investments caninclude a wide variety of structures including

bonds, private equity, and structured productswhich can include packaging bank loans. Trustcompanies can therefore offer yield to individualsthat commercial bank deposits do not, althoughbecause the banks have such impressivecustomer distribution channels, many commercialbanks offer customers trust company productseither through their own trust company subsidiaryor in cooperation with a separate trust companyfor a fee. Trust companies can also makeoverseas investments if they obtain a QualifiedDomestic Institutional Investor license.14

The CBRC allows and encourages trustcompanies to obtain foreign strategic investmentsin order to bring in capital and risk managementexpertise.15 There is significant interest amongforeign investors to invest in trust companies asa way to reach the growing high net worthpopulation in China.


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categories of Chinese companies. Because of various regulatory restrictions and other reasonsdiscussed below, foreign financial institutions have relatively little presence in the domesticmarket. Still, foreign financial institutions have had a significant impact on domestic financialpractices due to the fact that many Chinese financial executives have received training abroad,and many Chinese financial institutions have accepted investments from foreign financialinstitutions, which have also provided training and consulting advice as part of the bargain.

A final point that is almost unique to China, particularlyafter the global financial crisis, is the rapid andsustained economic growth experienced in the country.The Chinese financial sector has to a very large extentridden this rapid growth into a position of strength andsize. At the same time, as will be discussed in the nextsection, the banks have been important instruments inhelping the Chinese government attain this growth. TheChinese banking system is now virtually the same sizeas the U.S. commercial banking system. At the end of2009 Chinese commercial bank assets totaled

approximately $11.5 trillion (RMB78.8 trillion), up 26%from just one year ago, and up 80% from three yearsago.16 By comparison, assets of U.S. commercial bankswere $11.7 trillion at year-end 2009.17

III. The Global Financial Crisis

The financial crisis that swept over the world from 2008to 2009 decimating western financial institutions did littledamage to Chinas financial system. Chinese financialinstitutions were essentially still domestic operators withlimited foreign assets, which meant that they had very

few toxic U.S. assets or claims against failed western institutions.

Cooling of the Real Estate Bubble and Drop in Exports

China did, however, begin to experience its own real estate bubble, which the government tookprompt action to deflate. In particular, in September of 2007, the minimum down payment forresidential mortgage loans on second homes (for borrowers with a mortgage on their first home)was increased from 30% to 40%. Bank reserve requirements were increased five times duringthe period from January to June of 2008, from 14.5% to 17.5% of deposits, and interest rateswere also increased.18 These steps were successful in cooling down the real estate market. Inthe early part of 2008, real estate prices began to decline. The Chinese national real estate

prosperity index an indicator of the overall health of the real estate market dropped from106.6 to 98.5 (a 7.6% drop) during the period from November 2007 to November 2008,consistent with a slowing of the real estate market.19

16CBRC, Total Assets and Total Liabilities of the Banking Institutions as of end-2009and CBRC Annual Report 2008.

17Data from the U.S. Federal Reserve, available at http://www.federalreserve.gov/releases/h8/current/default.htm.

18The Monetary Policy Analysis Group of the Peoples Bank of China, The Implementation Report of Chinas

Monetary Policy for the Second Quarter of 2008(2008), p. 12.19

National Statistic Bureau of the Peoples Republic of China, Comprehensive Department, National Real EstateProsperity Index for November 2007, and National Real Estate Prosperity Index for September 2008, available athttp://www.stats.gov.cn/. The national real estate prosperity index is composite of eight real estate economic

Inconvertibility of the RMB forCapital Account Transactions

A variety of Chinese regulations currentlyprohibit, among other things:

Chinese enterprises (other than foreign-invested enterprises* and certain licensedfinancial institutions) from borrowing fundsin foreign currency without prior governmentapproval;

foreign investors from making foreign directinvestments into China (without priorapprovals from the government);

Chinese investors from freely investing inoffshore securities or companies (unless theyalready have access to funds offshore or theyhave obtained approval from the government);and

foreign investors (other than approvedQualified Foreign Institutional Investors andapproved Strategic Investors) from investingon the Chinese domestic stock exchanges.

*Foreign-invested enterprises are generallycompanies with at least 25% foreignownership whose establishment and affairsare regulated by the Ministry of Commerce.


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In the first quarter of 2009, China experienced the full effect of the international financial crisis.For the first time in decades China experienced a significant decline in export revenues, downalmost 20% from the first quarter of 2008, with similar declines in the succeeding quarters. 20The crisis also caused a precipitous drop in foreign investment into China. The number offoreign investment manufacturing projects in 2008 fell almost 40% from 2007. 21 AnnualizedGDPgrowth fell in the fourth quarter of 2008 to 2.5%.22

The Governments Response

The Chinese governments response to the crisis was rapid and forceful. In November of 2008the government announced a fiscal stimulus package of $588 billion (approximately RMB4trillion), consisting of central and local government expenditures and bank loans; this stimuluspackage had an immediate impact on the economy. Outstanding loans at Chinese banks grewby 32% during 2009.23 This lending spike was a direct result of policy directives by the StateCouncil and the PBOC. The PBOC directed banks to provide substantial additional credit to tenkey sectors which were deemed most important in stimulating domestic demand and ensuringeconomic growth, including infrastructure projects, small and medium-sized enterprises,

agriculture-related projects, and post-disaster reconstruction projects. These projects includedwater conservation, environmental protection, public facility management, communication andtransportation, warehousing, postal service, and real estate.24 A significant number of the bankloans were made to central government-endorsed projects on the assumption that thoseprojects would be unlikely to default. Construction on several very large projects, such as thenationwide high speed rail system began almost immediately on an accelerated basis.

As a result of the stimulus program, Chinas GDP recovered quickly. The World Bank estimatedthat Chinas annualized GDP growth for the first three quarters of 2009 was 8%, 17% and10%.25 The real estate sector rebounded rapidly as well, due to the lending stimulus and somepolicy revisions. In addition to easy credit that saved some cash-strapped developers, inOctober 2008 the PBOC reduced the minimum residential down payment for different types ofloans from 30%-40% to 20%. By November 2009, the national real estate prosperity index rose

to 102.8, from 98.5 a year earlier, an increase of 4.4%.26 A large number of Chinese real estatecompanies, many of which had been in financial difficulty earlier in the year, listed on the HongKong Stock Exchange late in 2009.

indicators issued by the National Statistics Bureau reflecting the condition of Chinese real estate developers withrespect to real estate investments made, sources of funds, income from land sales, acreage of land underdevelopment, acreage of construction completed, acreage that is vacant and selling prices of real estate projects.If the real estate industry is prosperous the index should be above 100, and if the industry is in recession the indexshould be below 100.20

Ministry of Commerce of the Peoples Republic of China, Comprehensive Department, A Brief Summary of theImport and Export of the Nation for the First Quarter of 2009, available athttp://zhs.mofcom.gov.cn/aarticle/Nocategory/200904/20090406184592.html.21

National Bureau of Statistics of China, Table Eleven, Statistics on National Economy and Social Development forYear of 2008, available at http://www.stats.gov.cn/tjfx/jdfx/t20090226_402542733.htm.22

World Bank estimate. China Quarterly Update, March 2009.23

The Peoples Bank of China, Financial Statistics, December 2009; www.pbc.gov.cn.24

The Monetary Policy Analysis Group of the Peoples Bank of China, The Implementation Report of ChinasMonetary Policy for the Second Quarter of 2009(2009), p. 5.25

World Bank estimate. China Quarterly Update, November 2009.26

National Bureau of Statistics of China, The Operation of National Real Estate from January to November of 2009,available athttp://www.stats.gov.cn/tjfx/jdfx/t20091210_402606539.htm.


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Similarly, the domestic stock market experienced a dramatic decline and then recovery. TheShanghai stock index fell from a high of 6092 in October 2007, to a low of 1844 in January2009, but by December 31, 2009 had rebounded to 3277, up 77% from the low. 27

The rapid increase in Chinese bank lending in 2009 has raised concerns about loan quality anda potential large new accumulation of NPLs in the Chinese banking system. As of this writing,

the Chinese government has taken new measures to cool down credit expansion by raisingcapital requirements and provisioning requirements. Also, out of concern about another realestate bubble and potential inflation, the PBOC increased the deposit reserve requirement by0.5% and raised interest rates modestly in the interbank market in January 2010. It appearsthat the government will not shield the banks from losses as it did in the previous NPL crisis;however, it is possible that the borrowers themselves, many of them large state-ownedenterprises (SOEs) will receive government support which will indirectly benefit the banks.28

It is a matter of pride for Chinese regulators to be able to point out how well the Chinese systemhas withstood the crisis. Liu Mingkang, the Chairman of CBRC, attributes this to better riskfirewalls between banking and capital markets within the Chinese system; he has stated One ofthe effective ways to prevent risk contagion is to set up firewalls between banking and capitalmarkets. Only qualified commercial banks are allowed to participate in non-banking activities,and have strict firewalls separating them.29 Others in China note that China simply does notpermit the levels of leverage and risk-taking that have prevailed in the West. In any case, thefinancial crisis shows how well China is insulated from the impact of international systemic risk.However, as we will elaborate later in this paper, the many changes underway in China and inits relationships with the outside world will mean that China financial institutions will likely beless insulated from risk in the future.

IV. Prudential Regulation in China

Probably the single public policy issue that has received the most global attention in the wake ofthe financial crisis is the regulation and supervision of banks, and specifically what changes

need to be implemented in order to prevent similar future crises. Understanding the impact ofthe financial crisis and the international response to the crisis on China therefore requireslooking at how China regulates its financial system, and how that regulation compares to othermajor financial systems, both now and going forward. Because of the predominance of banks inChinas financial markets, we will focus on the banking system, and include some more limitedobservations on the securities industry. Appendix 1 provides some detail on the supervision ofthe securities industry.

China has a functional approach to financial regulation and supervision. The CBRC, the ChinaSecurities Regulatory Commission (CSRC) and the China Insurance Regulatory Commission(CIRC) supervise banks, securities firms, and insurance companies, respectively. Thisapproach is relatively new; in 1998, securities and insurance supervision were consolidatedunder the CSRC and CIRC, respectively; in 2003 bank supervisory responsibilities weretransferred from the PBOC to the newly-created CSRC. The PBOC retains the responsibility for

27Database for historical record of Shanghai stock index, available at http://q.stock.sohu.com/zs/000001/lshq.shtml

(Last visited on February 20, 2010).28

In the early 2000s, newly formed government-owned asset management companies purchased large portfolios ofNPLs from the then 100% government-owned banks in exchange for bonds that were essentially guaranteed by theMinistry of Finance, in effect purchasing the NPLs for their full principal amounts and thereby recapitalizing the banks.Today the major commercial banks are publicly listed, and presumably the government will not purchase NPLs formore than they are worth. By raising capital requirements, the government is signaling that it expects the banks toraise capital or make balance sheet adjustments.29

Editorial by Liu Mingkang Financial Times, June 28, 2009.


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overall financial stability, setting of interest rates, including on deposits and loans, andenforcement of anti-money laundering law.

As a general rule, China has taken a cautious and incremental approach to opening up itsfinancial system to cross-border capital flows and foreign participation. The governmentsphilosophy is that innovative financial products are important but should be introduced at a pace

at which appropriate controls can be instituted, supervisors can become educated, and marketscan develop in an orderly way. The government appears to be comfortable in keeping Chinaa pace or two behind the rest of the world so that the country can learn from the experience ofother nations.

The government also has an activist approach to macroeconomic management and looks to thefinancial institutions as key transmitters of policy objectives. It should be noted that the Chineseversion of the incremental approach not only gives the Chinese regulators tremendous powerover the regulated institutions (not unlike the power of regulators elsewhere), but also significantcontrol over the levers of the economy.

Internationally, the Chinese are now members of the Basel Committee on Banking Supervision(BCBS), having joined formally in March 2009. The BCBS is the preeminent forum for

international coordination on bank supervisory issues, most notably capital standards, but alsocross-border cooperation and a host of other prudential issues.30 The BCBS has taken the leadin implementing the G20s policy recommendations for banking institutions. While theagreements reached in Basel are not legally binding, there are serious expectations thatmembers will apply the policies adopted by the BCBS to their internationally-active bankingcompanies in a manner consistent with their own national systems. These expectations havebecome heightened in the wake of the global financial crisis.

Capital

The CBRC implemented the Basel capital framework in 2004, drawing upon the then-current

Basel I framework and incorporating certain elements of the Basel II framework, which was thenunder development31. In essence, the framework adopted by CBRC used the risk weights fromBasel I and the qualitative and disclosure requirements from Basel II. They also incorporateda set of tiered requirements patterned after the prompt corrective action standards in the U.S.The CBRC noted at the time that the Chinese banks internal credit systems were not yet at thepoint where the more sophisticated methods of Basel II would apply, but indicated continuingefforts to achieve that goal.

Indeed, having released guidance drafts over the last few years on various aspects, the mostrecent set in August,32 the CBRC is now in the process of implementing Basel II. The Basel IIframework will apply to all banks with international operations and will be optional for otherbanks. The expectation of the CBRC is that the banks will be able to fully implement the newframework beginning end-2010 and no later than 2013.

30There are committees of securities and insurance supervisors as well: the International Organization of Securities

Commissions (see www.iosco.org) and the International Association of Insurance Supervisors (seewww.iaisweb.org), which have reached agreements on matters particular to their industries.31

The Basel I capital framework, which became effective in 1992, was applicable to internationally active banks andassigned simple risk weights to various on and off-balance sheet assets. The minimum required capital (tier 1 plustier 2) was set at 8% of risk-weighted assets. In 1996 it was amended to include a separate framework for tradingassets. Basel II, first proposed in 2004, introduced quantitatively-derived risk weights (Pillar 1) and addedrequirements for supervisory review of internal capital adequacy assessments (Pillar 2) and disclosure (Pillar 3).32

http://www.cbrc.gov.cn.


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This timetable would put the Chinese banks on a roughly similar track as that of U.S. banks. 33However, while one of the objectives of the Basel capital framework is to harmonize capitalregulation, one cannot assume that adoption of the same high-level rules necessarily reflectsuniformity of approaches. For example, U.S. supervisors have had to delay the Basel IIimplementation date several times due to the enormous remediation effort required by U.S.banks, and the CBRC may find itself in a similar situation. Even more important, several

significant revisions to the Basel II framework have either been recently finalized or proposed,all of which are in the direction of further increasing capital requirements. The BCBS expectsmember national supervisors to enact these revisions through their national processes, and itremains to be seen whether China can keep on pace with these while undergoing thetremendous effort of implementing Basel II.

Nevertheless, the CBRC takes a conservative approach to capital and other prudentialstandards. One of the ongoing driving forces of the Basel capital framework is to keep ahead offinancial innovation innovation which is sometimes driven by the capital rules themselves and ensure that bank capital is commensurate with bank risk. The Chinese have taken a morecautious, proscriptive approach to bank risk-taking; this approach suggests less of a need toadopt the latest versions of the capital framework as quickly as many other countries. As well,

they have shown a willingness to step in and take short-term administrative actions if they seebanks take risks that may not be properly reflected in the banks capital levels at present andgoing forward.34

In recent years, even as CBRC has been raising capital requirements, the banks seem to havehad little problem meeting those requirements. In 2008, ICBC, CCB, and BOC were among theworlds top 15 banks in terms of Tier 1 capital.35 The high earnings in recent years of the largestate-owned banks contributed significantly to rising capital ratios, and many Chinese bankshave also raised capital by issuing shares to private parties as well as government entities.A question is whether it will become more challenging for Chinese banks to meet the rising tideof capital requirements if their earnings weaken and/or their asset quality deteriorates followingthe current wave of lending.

Liquidity

It is widely agreed that weaknesses in liquidity measurement and management had a significantrole in the spread and severity of the global financial crisis. In response, guidance on liquidityrisk management has been issued by many governments as well as the BCBS, anda framework of required liquidity ratios was proposed by the BCBS in December 2009. InChina, the CBRC issued liquidity guidance in late 2009, and will presumably join the otherBCBS member countries in implementing the recently-proposed ratio framework.

While the CBRC, therefore, is on pace with the other G20 supervisors regarding establishingliquidity standards, the problem is a bit simpler in China because the bank balance sheet issimpler. Given the banks high reliance on deposits and the limited use of securitizations particularly exotic structures liabilities tend to be more stable and more amenable to directmeasurement. Liu Mingkang, the chairman of CBRC, has said that in China they insist that themain funding source of banks should always come from deposits36 suggesting that Chinese

33The banks that are required to adopt Basel II in the U.S. must begin the first phase-in period by April 2011, with

final phasing in complete dependent on a bank completing three successful four-quarter transition periods.34

For example, CBRC recently announced requirements for banks to increase capital and loan loss reserves in lightof this years increased lending. See http://www.cbrc.gov.cn.35

CBRC 2008 Annual Report.36

Financial Times, June 28, 2009.


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banks may never become as reliant on wholesale funding as many other global banks havebeen. Still, liquidity risk management may become more challenging in the future if banksparticipate in a wider variety of products, and if they begin to rely somewhat less on depositfunding. The many lessons learned by other major banks and their supervisors from the globalfinancial crisis will no doubt be useful guides for the CBRC and the Chinese banks in dealingwith these challenges.

Corporate Governance

On one level, the Chinese banks are subject to standards of corporate governance equivalent tothose of all major global banks. China adopted a code of corporate governance for listedcompanies in 2001, to which the Chinese banks had to conform in order to become listed. Atthat time, the government allowed and encouraged larger Chinese banks to seek foreignstrategic investors in order to expose them to the discipline of attracting an outside investor, andto bring some fresh perspectives from market-based institutions into the Chinese banks. TheCBRC has issued rules and policy guidance in a number of governance areas, including rolesand responsibilities of the board of directors, remuneration, conflicts of interest, and internal

control. In addition, the CBRC issued special guidance on corporate governance at small andmedium sized commercial banks.

On another level, there is a fundamental conflict between the continued government ownershipof many of the banks and attaining an effective model of corporate governance. In addition tothe government being the controlling shareholder, the Chinese Communist Party (CCP)appoints the board and sets management compensation at most Chinese banks. To some, thiscalls into question the objectivity of the board, independence of management, and the integrityof the audit and risk management processes. Perhaps even more important, the supervisoryprocess itself may lack independence.

The issue is compounded by the fact that many of the large commercial enterprises in China arealso majority government owned, and the main source of external financing for those entities is

bank loans. Best practice credit risk management is based on arms-length transactions, as wellas periodic, ongoing arms-length review following the initial transaction. Interestingly, the CBRCCode of Conduct includes the statement that its staff must NOT interfere in regulated bankscredit decisions, suggesting that CBRC is attempting to refute any real or perceived influence ithas on credit allocation.37

It is acknowledged even within the Chinese government that much more progress needs to bemade in the corporate governance arena. Wang Zhaoxing, Vice Chairman of the CBRC notedthat [C]ompared to modern systems abroad [the Chinese banking industry] still lags behind incorporate governance, strategic positioning, financial innovations and risk management inparticular.38 If China wishes to more fully open its banking industry to inbound and outboundinvestments, there will be increasing scrutiny on how well Chinese banks have transitioned froma state-directed corporate culture to a market-based corporate culture. China will need to movebeyond being lauded for the significant progress it has made to date, to a place where corporategovernance of Chinese banks compares reasonably well to that of other global banks.

37CBRC 2007 Annual Report, p. 5.

38Chinas Banking Industry: Moving Forward in Accord with Reform and Opening, by Wang Zhaoxing, in Chinas

Emerging Financial Markets (2009), Zhu, Cai, and Avery, eds., p. 85.


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Risk Management

Ensuring that banks effectively manage risk is a challenge facing bank management, boardsand supervisors everywhere, before the financial crisis and even more so after, as supervisorsraise their expectations about bank risk management. The types of risk exposures and theways of measuring and managing those exposures make up a continuously moving target as

markets develop new ways of engineering products and squeezing out more profit margin. InChina, the problem is at once both easier and harder than for other major banking systems. It iseasier in that the Chinese banks risk profiles are more traditional, as the entire commercialsystem is predominately lending-based and the government has been much slower to allowvarious capital markets activities. Achieving effective risk management is more challenging,however, because Chinese banks have a very short history of operating with a culture ofmarket-based decision-making, and maximizing shareholder value is not necessarily a disciplinepracticed even today. Transitioning from a culture based on state decision-making to onebased on market discipline is a complex endeavor, particularly for the large, geographicallydispersed state-owned banks. Moreover, given the continued role of the State as owners anddirectors, and the governments role in encouraging credit decisions discussed earlier, eventoday the banks are not operating fully on a market basis.

Nonetheless, Chinese banks have made a number of risk management advances. For banksthat are listed on the Hong Kong or Shanghai stock exchanges, much progress was made at thetime of their IPOs, when they used major international investment banking and consulting firmsfor assistance in adopting the necessary corporate governance and accounting requirements

The CBRC has actively promoted progress in Chinese banks risk management systems byissuing various rules and policies. For example, in recent years they have issued guidance onasset securitization, credit card lending, the project finance business, management of reputationrisk, operational risk, and liquidity risk, just to name a few. In addition, as part of itsimplementation of Basel II capital requirements, CBRC has proposed detailed rules on creditrisk management, including the detailed loan classification system prescribed in the capitalframework, as well as internal capital adequacy assessment and disclosure. Having these

policies in place is a good step but it is unclear how fully they are implemented in the banks.

The Chinese have also been careful to adopt a slow pace in approving new products, as a wayto ensure that the banks have the risk management capability for a business activity before theyengage in it. For example, over the past couple of years small groups of banks have beenchosen to participate in a pilot program for asset securitization. In this way, the industry as wellas the supervisor can build expertise in the business and the risks. The State Council and theCBRC will allow the activity to expand once they are comfortable that banks understand therisks and are able to proceed with the activity on a safe and sound basis. This incremental,managed approach to innovation may serve financial stability well, as the risks introduced to theeconomy tend to be known; however, as we discuss later in this paper, this result may be at theexpense of a more dynamic and competitive banking industry.

Compensation

One of the biggest issues with which the G20 governments and bank supervisors are wrestlingwith in the wake of the global financial crisis is management compensation. Bankers around theworld, particularly CEOs and those on the capital markets side of the business where high risktransactions can lead to short term gains but longer term losses have in recent years receivedextraordinarily large bonuses; this phenomenon is widely believed to have encouragedimprudent risk-taking. Making this issue even more controversial is the fact that many of these


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institutions received government assistance in the financial crisis in order to avert failure. TheFinancial Stability Board (FSB)39 has issued compensation guidance, and many individualcountries are following suit. At a minimum the guidance requires that compensation policies beestablished that link compensation to a banks long-term risk management objectives.40

It is not clear whether compensation practices in China meet the emerging international

standards. Chinese banks do not have significant capital markets activities enabling individualsto take risky positions that yield short-term gains, which has been the source of much of thebonus controversy elsewhere. Compensation of management is not as excessive as in thecontroversial instances in the west; however, many salaries include valuable perquisites andfinancial industry salaries in China are high relative to other industries. 41 The Financial StabilityBoard standards state that a banks compensation policy should contribute to good riskmanagement by linking an individuals compensation to his or her contribution to the firmsperformance on a risk-adjusted basis, and the CBRC recently issued guidelines oncompensation practices which reflect the FSBs guidance.42 Some might question whether therisk identification and measurement systems at Chinese banks are sufficiently developed toproduce the required information, and perhaps even more significantly, whether managementcompensation at Chinese banks is more closely tied to political objectives than to business

objectives.

Accounting

A key issue in evaluating how one countrys financial supervision compares to another is theaccounting standards used. The Ministry of Finance published new accounting standards in2006, to be adopted by listed companies by 2007, and all other banks by 2009. The standardsare compatible with international standards.

Of particular importance to observers of the Chinese banks NPL problems of ten years ago iswhether the current loan loss provisioning standards are rigorous enough, especiallyconsidering the extraordinary loan growth in 2009. There has been guidance on general

reserves for Chinese banks since 2002, with final implementation in 2005. In the fourth quarterof 2009, the CBRC took further steps to ensure adequate reserve levels by directing banks toraise their ratios of total reserves to NPLs to 150% by the end of 2009. This recommendationwas intended to provide sufficient coverage not only for currently identified problem loans butalso for a potential increase in NPLs owing to the significant loan growth in the first half of 2009.

Supervision of Systemically Important Institutions

Global leaders and supervisors are looking for ways to contain the systemic risk posed by largeinstitutions, those that in the financial crisis were deemed too big to fail, or, more precisely, toobig and interconnected to be allowed to fail. Supervisors are attempting to tackle this issue inseveral ways. The first is for governments to identify which institutions are systemically

important financial institutions, or SIFIs. The second is to impose restrictions or requirementson identified SIFIs to reduce the likelihood of insolvency. The third is to find resolution

39The Financial Stability Board (www.financialstabilityboard.org) is made up of representatives from the financial

bodies of the G20 and several standard-setting organizations. Its mandate is to promote financial stability throughdevelopment of policies and standards.40

www.financialstabilityboard.org/publications/r_0904b.pdf.41It has been reported based on statistics published in the 2009 annual reports that the average salary for executivesof public financial institutions was over three times that of all public companies in China. http://biz.cn.yahoo.com/10-03-/42/w3fh.html.42

Supervisory Guidelines on Compensation Practices of Commercial Banks, February 21, 2010, www.cbrc.gov.cn.


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mechanisms to handle such institutions if they become troubled in a way that is least harmful tothe local and global economy. Finally, it is important that cooperation arrangements are in placeamong national supervisors so that information can be shared expeditiously and supervisorywork can be coordinated. Appendix 2provides more detail on the G20s proposals.

While it is not clear whether the Chinese banks, though large in market capitalization, would be

considered SIFIs by the emerging international standards, it may be a moot point because it iswidely believed that the Chinese government stands behind its large state-owned banks andprobably the smaller commercial banks and will not allow them to fail. While the internationalstandards are still in flux, as a member of the G20, China will have to decide how, and to whichinstitutions, it will apply the final recommendations. Recommendations regarding supervisorycooperation will be relatively easy for China to adopt, as CBRC already has Memoranda ofUnderstanding with supervisors from 33 countries. It is less clear whether and how China willdecide to implement the resolution mechanisms and additional prudential requirements forSIFIs, should the mechanisms and requirements be adopted internationally.

V. The Case of Hong Kong

Hong Kong reverted to Chinese rule in 1997 and is now an essential part of China, but isallowed to keep its own economic system and laws until 2047 at least. Over the years HongKong has served not only as an entrept trading center for Chinas import-export trade, but hasbecome the most important offshore financing center for the mainland. Mainland Chinesebanks are more active in Hong Kong than in any other offshore location. Because of theinconvertibility of the RMB, Chinese firms particularly those that have off shore holdingcompanies have looked to Hong Kong based banks and other firms for foreign currency loansand corporate finance services, and related financial advisory, accounting, and legal services.International banks also use Hong Kong as a base of operations to provide high net-worthmainland individuals with offshore wealth management services.

The Hong Kong financial system comes as close to the pure free market model as any

jurisdiction in the world. There are no controls on capital inflows and outflows, and virtually all ofthe complex financial products in the West are available in Hong Kong. Indeed, Hong Kong hasfor many years been rated the freest economy in the world by the Heritage Foundation. 43 Theirony of course is that Hong Kong is now part of China, where the mainland economy andfinancial system are highly regulated and cross-border activity is closely controlled. Thus, thereare inherent challenges in establishing a seamless and consistent working relationship betweenthe Hong Kong and mainland financial regulatory systems.

Historically, non-mainland owned commercial banks, led by HSBC and Standard CharteredBank, dominated the Hong Kong financial scene, and still account for over 80% of bankingassets in Hong Kong as of December 31, 2008.44 While reliable market share data for thesecurities sector does not appear to be available, it is interesting to note that 691 of the 747licensed securities firms in Hong Kong still appear to be non-mainland owned (most of thesefirms are small).

43See the 2010 Index of Economic Freedomjointly published by the Heritage Foundation and TheWall Street

Journal.44

Figure is based on rough calculations using figures from the dominant mainland banks in Hong Kong and totalbank assets figures published by the Hong Kong Monetary Authority.


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Mainland Financial Firms in Hong Kong

However, mainland-owned financial institutions are playing a larger role in Hong Kong. Manymainland-owned financial institutions have expanded to significant size in Hong Kong and otherlarge Chinese institutions have recently entered the market. The five largest Chinese mainlandcommercial banks have established both banking and securities business presences in Hong

Kong. Of these, Bank of China, with 13% of the aggregate banking assets in Hong Kong as ofDecember 31, 2008,45 is the largest mainland bank in Hong Kong and the second largest bankin Hong Kong after HSBC. In addition, one of Chinas three policy banks, China DevelopmentBank, launched its Hong Kong branch in July 2009. On the securities side, nine Chinesesecurities firms46 have established subsidiaries in Hong Kong, and three more have beenapproved by the CSRC to establish subsidiaries in Hong Kong.47

The rapid growth of mainland owned financial institutions in Hong Kong and the importance ofHong Kong as a financing center for mainland economic activity mean that Hong Kong nowplays a central role in the financial life of many of the largest mainland enterprises. Chinesefinancial institutions often view Hong Kong as a staging ground for their further internationalexpansion. Listings on the Hong Kong Stock market have also become dominated by mainlandcompanies. As of November 30, 2009, the market capitalization of China-related listings onHong Kongs Main Board and the Growth Enterprises Market (GEM)48 constitutedapproximately 49% and 33% of the total market capitalization of these two boards,respectively.49 As of November 30, 2009, there were 91 mainland companies with marketcapitalization of over $1 billion each listed in Hong Kong.50

Not only have mainland financial institutions grown very quickly in Hong Kong, but in manycases they are operating in lines of business which are not open to them in the mainland. Forexample, while Chinese commercial banks are generally still not permitted to enter thesecurities business, all of the top five large mainland-owned commercial banks have securitiessubsidiaries in Hong Kong. Many of the derivatives, credit default swaps and other morecomplex and riskier financial instruments available in Hong Kong and used by mainland-ownedfinancial institutions there are simply not permitted on the mainland yet. While mainland

regulators scrutinize closely the offshore operations (including Hong Kong operations) of allChinese financial institutions, the fact remains that large mainland financial institutions engagein certain lines of business in Hong Kong that are outside of their core experience and riskierthan what they engage in on the mainland.51

Hong Kongs singular importance to the mainland as a free market offshore financial center,together with the growing size of mainland financial institution operations in Hong Kong, could

45Bank of Chinas annual report for year 2008 (p. 35) states that as of December 31, 2008 its total assets in Hong

Kong and Macau were US$183 billion (or RMB1,250,309 million).46

They are China International Capital Corporation Limited (CICC), Guotai Junan Securities Co., Ltd, ChinaMerchants Securities Co., Ltd CITIC Securities Co., Ltd., Guoyuan Securities Co., Ltd, Guang Fa Securities Co., Ltd,Hua Tai Securities Co., Ltd, Shenyin & Wanguo Securities Co., Ltd, and Hai Tong Securities Co., Ltd.47 They are Ping An Securities Co., Ltd, Guo Sen Securities Co., Ltd, and Guo Du Securities Co., Ltd. InDecember 2009, Shanghai based Hai Tong Securities Co., Ltd acquired a 52.86% interest in one of the largest HongKong based public securities firms, Tai Fook Securities Co. Ltd.48

The Hong Kong Stock Exchanges second board.49

Based on the statistics published by the Hong Kong Exchanges and Clearing Limited, available athttp://www.hkex.com.hk/data/chidimen/CD_MC.htm.50

Based on the statistics published by the Hong Kong Exchanges and Clearing Limited, available athttp://www.hkex.com.hk/data/chidimen/CD_HMB.htm; http://www.hkex.com.hk/data/chidimen/CD_RCMB.htm; andhttp://www.hkex.com.hk/data/chidimen/CD_HG.htm.51

For example, the Hong Kong subsidiaries of Bank of China, China Construction Bank, and Bank ofCommunications all engage in the margin lending and short selling business (which were only recently permitted ona pilot basis in the mainland).


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create conditions of unusual risk for the mainland financial system. If a mainland financialinstitution operating in Hong Kong in new and more risky lines of business encountereddifficulties, it seems likely that its parent in China would have to come to the rescue. If for somereason the Hong Kong financial system suffered a crisis, it seems clear that the mainlandgovernment would consider it important to step in to solve the problem. 52 Either scenario couldresult in a significant strain on the mainland financial system.

VI. A System in Transition

Chinese banks today earn good profits and have substantial market share, strong regulatorycontrols, and relatively low levels of leverage. On the surface it appears that the system isstrong and that there is a low likelihood of a domestic financial crisis. There is, however,another view. Some point to the inordinately high level of lending in 2009 as setting the stagefor increased NPLs. Of particular concern is the rapid booking of loans,53 which is commonlya harbinger of weakened controls leading to credit quality deterioration. The concern iscompounded by the lack of transparency around off-balance sheet activity and loans sold.54 Itappears that the government has stepped in and directed banks to increase capital and

reserves to dampen any negative impact, although it is not clear that it will be enough to covernew NPLs, and concerns about transparency may cast doubt on the true adequacy of capital.

Even aside from issues of current loan quality and other risks to capital at its banks, there arerisks ahead for the Chinese financial system. China is one of the fastest changing anddeveloping economies in the world, and despite the relatively conservative disposition of itsfinancial regulators, Chinas financial markets are evolving quickly too.

Financial Reform and Market Developments

Change is coming from many directions. Chinas domestic capital markets are developingrapidly and retail and commercial savers are being offered an increasing number of choices

beyond deposits. While Chinese banks have the dominant distribution network, they arepartnering with other financial services providers by placing customers funds in investmentproducts for fees.

Adding to the mix is the expected liberalization of loan and deposit interest rates, which thegovernment has said is coming but for which the timing has not yet been announced. Themeasure will put pressure on margins and prompt banks to look for efficiencies and seekrevenue through fee income or higher return investments. While searching for additional yield isnot a bad thing per se, it could create higher risk and may require deft risk management to keepin check.

Another expected change is that over time, more complex financial products and services willeventually be permitted by the regulators. Authorities recently approved stock index futures

trading, and a pilot for short selling and margin trading has been initiated. Presumably it is onlya matter of time before other derivative products will be permitted.

52When Hong Kong was under financial stress during the Asian financial crisis in the late 1990s, Prime Minister Zhu

Rongji stated, Whatever Hong Kong asks for we will give in order to help Hong Kong. Available athttp://news.ifeng.com/special/60nianjiaguo/60biaozhirenwu/renwuziliao/200909/0909_7766_1341499.shtml (Lastvisited on January 19, 2010).53

According to Fitch Ratings, the un-weighted average loan growth at the top five Chinese banks in the first half of2009 not annualized was just over 25%. Fitch Ratings, Chinese Banks Annual Review and Outlook,December 17, 2009.54

Fitch Ratings, Chinese Banks Annual Review and Outlook, December 17, 2009.


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As the Chinese authorities take incremental steps to permit the RMB to become convertible,Chinas financial system and institutions will become increasingly subject to the tides of worldcapital flows. Whereas its wall of inconvertibility protected China during the two most recentfinancial crises, this will no longer be the case when capital can flow more freely in and out ofChina. One of the primary compounding factors of the financial crisis in the late 1990s inSoutheast Asia and Korea was the rapid outflow of capital from those countries, with the result

that exchange rates plummeted and numerous financial institutions and other enterprisescollapsed. China observed these events unfold with alarm, and has delayed the fullconvertibility of the RMB until its financial system is strong enough to withstand such significantshocks.

Finally, there appears to be a trend toward an increased number of financial conglomerates.Since 1995, when Chinese commercial banks were prohibited from engaging in the trust andsecurities businesses or investing in non-banking financial institutions or enterprises, China hasmaintained some official separation between its financial sectors.55 However, a few pre-1995large financial conglomerates were grandfathered, and in recent years there has been anincreasing number of approvals for cross-sector ownership. While the number of Chinesefinancial institutions belonging to financial conglomerates is still limited, the number continues to

grow. And yet, the Chinese financial regulatory framework still is largely sector-specific andbecause of the newness of financial conglomerates has not developed much expertise inaddressing cross sector risk. There are few regulations intended to address the overall risklevel of financial conglomerates as a consolidated group.

55See comment by Chairman Liu Mingkang of the CBRC regarding the creation of firewalls between commercial

and investment banking in Section III.


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Does China have its own Glass-Steagall?

Chinas primary restrictions on cross-financial-sector investments derive from the CommercialBanking Law, which in 1995 prohibited Chinese banks from investing in securities and othernon-banking businesses domestically in China.56 However, several Chinese financialconglomerates were formed prior to any restrictions on cross-industry holdings, including theCitic Group, the Everbright Group and the China Merchants Group. The limitations on banksand securities companies investing in other financial institutions have not been interpreted asapplying to offshore investments, which explains why of all the major Chinese banks havesecurities subsidiaries in Hong Kong, as discussed in Section V above.

The State Council has approved several investments by insurance companies in banks since2006. Further, in early 2008, the State Council began to permit banks to make investments ininsurance companies. There are reportedly a series of such transactions being planned,including insurance investments by Bank of Communications and Bank of China. Thus, theoverall trend appears to be greater cross-sector ownership within the financial servicesindustry, and many other Chinese financial institutions appear to have cross-sector ambitions,

including all of the large banks and China Development Bank. Below are some of the largestfinancial conglomerates.

Citic Group. Established in 1979 as an investment holding company at the very beginning ofChinas economic reforms, China International Trust and Investment Corporation (Citic)subsequently entered into the commercial banking (1987), fund management (1993),securities (1995), and insurance (2001) businesses. In 2002, Citic Holdings was approved bythe State Council as the first financial holding company in China.

Everbright Group. Everbright was established in 1983 as an industrial group focusing ontrading by pre-World War II industrialist Wang Guangying. From 1992 to 1996, Everbrightgroup extended its business lines to commercial banking, trusts and securities. In 2002,Everbright established a joint venture insurance company with foreign investor. In August

2007, the State Council approved reorganization of Everbright into a holding companystructure.

China Merchants Group. China Merchants was established in 1872 as a trading and portscompany and became a state-owned enterprise after the revolution. China Merchantsentered the financial sector commercial banking and insurance businesses in the late 1980s.In 1992, it extended its business to fund management, and in 1997 it invested in securitiescompany. In 1999, China Merchants Finance Holdings Co., Ltd. was established asa holding company to control all the China Merchants entities.

Ping An Group. The latest financial conglomerate to arrive on the scene is the Ping AnGroup, unusual in that it is largely private. Ping An started as a highly successful private lifeinsurance company, and now controls 16% of the Chinese life insurance market by revenue.Ping Ans extraordinary cash flows permitted it to grow its business very quickly and expandinto other areas, including securities, banking and asset management. Ping An reorganizedinto a financial holding company in 2003 and was listed in Hong Kong in 2004. Most recentlyPing An Bank signed an agreement to acquire Shenzhen Development Bank. Uponexecution of the agreement, the combined entity will be the tenth largest listed bank in China.

56In 2004 an amendment of the law permitted the state to grant exceptions to this rule.


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VII. Implication for Chinese Banks

All of the foregoing trends mean that the overall level of risk in Chinas financial system is likelyto increase over the coming years. During the process of financial reform Chinas regulatorshave been swift to adapt to Chinas rapidly changing economic environment. The CBRC hasimplemented supervisory standards similar to those of most other major financial system

regulators, with some tailoring to the idiosyncrasies of the Chinese system. However, with thefurther changes that are likely to come, it is important for Chinas regulators to emphasizeadditional standards of best practice in their supervision, and also to consider carefully how theycan bring more efficiency and market discipline into the banking system.

Risk Management

If the Chinese banks continue to expand their offshore operations, executing competent riskmanagement will become even more important. They will have to have the ability to measureand monitor increasingly dispersed risk exposures, many of them in markets that are morecompetitive than their home country. Even now, as discussed earlier, many Chinese bankshave operations in Hong Kong in businesses that they do not conduct on the mainland. Whilethis has no doubt provided good experience with managing offshore business, it is only thebeginning of what may lie ahead with further global expansion. IT systems will have to supportenterprise-wide risk reports, a significant challenge for any global, dynamic financial institution.Similarly, as the Chinese banks come into more direct and regular competition with other globalbanks, at home or abroad, the ability to measure and price risks will be an important competitiveadvantage.

Credit Culture

Credit culture is one key area requiring additional emphasis. The components of a market andinstitutional infrastructure required for commercially-based credit decisions are relatively new in

China. These include a predictable and fair legal framework, historical performance data,widely-used accounting conventions, lending officers with experienced judgment, and internalcontrol processes such as independent loan review and internal audit. The Chinese banks willhave to be encouraged to develop a credit culture that enables them to evaluate credit risk wellenough to compete for loans and be able to measure and manage the risks they undertake.

More importantly, a sound credit culture depends on arms length decision-making, which manywould argue cannot truly exist in China as long as the government retains control of the largebanks as well as commercial enterprises. Although the government is less involved in directingbank credit than in the past, it still invests in select projects of state-owned enterprises, to whichthe banks are naturally more comfortable lending. In addition, in order to help achieve thegovernments economic policy goals, the CBRC will often encourage banks to increase ordecrease lending to particular sectors. While this may help the government reach economicgoals, it may undermine efficient, market-based allocation of credit, as well as development ofa sound credit culture at the banks.

Liquidity

One area where more focus will be needed is liquidity management. The CBRC will need toensure that the banks it regulates understand the changing nature of liquidity risk. As banksfunding sources become more diverse, and new and complex products present less-wellunderstood liquidity risks, banks will have to have more sophisticated liquidity risk management,including stress testing and contingency funding plans. The liquidity guidance that CBRC


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issued in late 2009 included a requirement to conduct quarterly liquidity stress testing, as wellas to develop contingency plans. This is a clear indication that CBRC is seeking to harmonizeits approaches in this area with the G20, and understands the need for improvement in banksliquidity risk management.

The Role of the State

As the Chinese government looks ahead to a more open and competitive financial system, onedifficult issue it faces is the extent to which it will continue its multi-faceted role in the banks.Currently, the government is a significant or the sole shareholder in the top five banks, the nineother joint stock banks, and the policy banks. In addition, the CCP committees in the state-owned banks nominate directors and senior managers and set their remuneration. As wediscussed in Sections II and III above, the government also has a very influential role in lendingdecisions and the overall pace of lending, and it also closely controls the other products andservices the banks can offer.

The governmen

China's Financial System - Howard Chao

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