Incremental banking reform proved best

Editor's Note: For over a decade learning from the West has been a major theme of China's banking reforms, which made enormous effort to introduce strategic overseas investors to gain advanced management experience. Some international peers have now suffered huge losses from the global financial crisis, while Chinese banks are delivering rapid growth - leading some to wonder whether China's banking industry should learn from foreign banks, or vice versa.

Xiao Gang, chairman of Bank of China, says the Chinese banking industry should continue to reform and develop with Chinese characteristics while strengthening partnerships with leading international banks to grow together.

Before his current appointment in 2003, Xiao was from 1996 assistant governor and deputy governor of the People's Bank of China, the country's central bank.

The world is currently reflecting on the various problems in the banking industry and China is no exception. During recent joint-stock reform, the Chinese banking industry made great efforts to introduce international strategic investors to learn the advanced techniques and management experience of overseas banks; however, some strategic investors have reduced their stakes in Chinese banks after the expiration of the lockup period.

Some people are questioning whether the reform mode of China's banking industry is correct. On the other hand, some international peers have suffered huge losses during the global financial crisis, while China's banking industry is delivering rapid growth.

In my opinion, the reform of China's banking industry carried out with Chinese characteristics has proved to be successful. Foreign banks and overseas strategic investors divested their shareholdings of Chinese financial institutions mainly out of their own financial concerns. China's banking industry will keep reforming and developing with Chinese characteristics and strengthen cooperation with leading international banks to develop together in an open and complementary manner.

First, incremental reform is the key to the success of China's banking industry.

The reform of banking varies greatly in different countries and is generally categorized into "shock treatment" and "incremental reform". China's banking industry follows an incremental reform approach through gradual experiment and advancement. The reform is based on national conditions while incorporating the experience of the international banking industry instead of merely following suit:

Introduce competition among banking institutions, steadily push forward the reform of State-owned banks and gradually transform from specialized banks into State-owned commercial banks before financial restructuring, introducing strategic investors and launching initial public offers;

Conduct market reform in a gradual and controllable manner, gradually relax control of such price variables as interest rates and exchange rates that can greatly affect the operation of banking industry and guide banking institutions to adapt to the new market environment;

Gradually transform from a combined supervisory mechanism under the central bank to a separated supervisory structure under the People's Bank of China, China Banking Regulatory Commission, China Securities Regulatory Commission and China Insurance Regulatory Commission while enhancing supervisory coordination and mechanisms to ensure financial stability; and

Moderately open up the market to foreign banks and foreign capital on a gradual basis, bringing in the capital needed for China's economic and financial development and introducing leading experience in corporate governance, financial products and risk management technologies, i.e. "capital introduction, system introduction and talent introduction".

When the financial industry has been basically stable, "incremental reform" has effectively balanced the relationship among reform, development and stability and met the target of gradually enhancing the administrative system of financial institutions, progressively expanding business scale and steadily improving business performance. Each round of reform has started by dealing with easy problems and gradually tackled difficult ones, continuously sought and solved problems and accumulated experience in problem solving, thus avoided the turbulence of a drastic reform; each step of reform has displayed the Pareto effect; and each reform has been carried out to support the development of real economy for economic growth, with the banking industry and economic growth complementing each other.

The banking industry reform with Chinese characteristics proved to be successful. Although the reform is carried out in an "incremental" manner and seems to be "slow", significant changes have taken place in the banking industry if we look back to the past years. For example, total assets of China's banking industry increased from 27.7 trillion yuan in 2002 to 62.4 trillion yuan in 2008, up 17.7 percent on an annualized basis; profit climbed from 60 billion yuan in 2002 to 583.4 billion yuan adjusted for tax in 2008; and the ratio of non-performing loans declined from 23 percent in 2002 to currently below 3 percent. It is worth mentioning that China's banks achieved rapid growth in assets and profits in the global financial crisis in 2008, ranking among the best in the world in terms of profit and market value.

Second, corporate governance mechanism with the State as the controlling shareholder provides guarantee for the steady development of the banking industry.

Some people used to believe that the State-controlled share structure would hinder the development of a sound corporate governance mechanism. Now it has proved to be otherwise. Commercial banks with the State or local government as controlling shareholder account for a dominant proportion in the assets of banking institutions (the big five State-controlled banks accounted for 51.1 percent of the total assets of the banking industry in 2008). The State-controlled banks have maintained and enhanced the corporate governance structure under China's special market economic system, where the Shareholders' Meeting, the Board of Directors and special committees, the Board of Supervisors and the management perform their respective duties according to the Articles of Association and the decision-making bodies, supervisory bodies and the management are clearly separated by their rights and responsibilities with effective checks and balances as well as coordinated operation.

Particularly, the introduction of strategic investors, the joint-stock reform and initial public offering have diversified the ownership structure under the control of state-owned shares and fundamentally transformed corporate governance. The board of directors is no longer a "rubber stamp". Now that all significant decisions shall be reported to the board of directors, the directors shall bear legal responsibilities and each decision shall be subject to voting. This has put an end to the rule by the voice of one man only and will facilitate the banks' rational decision-making process and operation in line with the laws and regulations.

The bank governance structure in China has the following advantages:

It has ensured the balance check of the incentive and disciplinary mechanism of banking institutions, prevented the management from engaging in excessively risky activities for short-term interests and huge profits, and achieved balance between social responsibilities and business interests, between collective interests and individual interests, between shareholder interests and staff interests, thus favorable for the banking institutions to exert scientific control.

It has greatly strengthened the credit standing of financial institutions. State-controlled banks are supported by State credit in an invisible way, which is of immeasurable value to a financial institution, particularly in boosting public confidence amid a financial crisis to maintain the stability of the financial system.

It has fostered a distinctive management culture and a prudent decision-making mechanism. State-owned banks pay attention to the competence of the executives and the management of people. The senior management is of sound political and business qualifications. There is a payment ceiling for the management, which is quite different from the Western-style of "individual heroism". The management shoulders great responsibilities and may be held accountable for any mistake. Stressing collective decision-making may affect the efficiency but it can better balance various interests and ensure a correct direction of operation.

State-controlled bank governance structure has not only ensured the banks' steady development but also brought into full play the institutional advantage of "mobilizing the necessary resources for big undertakings", showing strong vitality in coping with external impact and smoothing the fluctuations of economic cycles. We have witnessed that it was the unique governance structure of China's banking industry that helped to cope with complicated economic situations (including natural disasters and the global financial crisis) in recent years as an important buffer.

The financial system dominated by traditional banks strengthens the capability of handling crisis.

The fact that we are less affected by the international financial crisis since 2008 is closely attributable to the financial system and banking operation mode with Chinese characteristics.

The financial systems of various countries are either dominated by the banks or the market. Over the past thirty years, the banking industry has taken a dominant role in China's financial system, bank deposits and loans account for a dominant proportion in the social capital supply structure while direct financing such as stocks and securities account for a smaller proportion. Even in 2007, that witnessed unprecedented development of the capital market, bank loans accounted for 78.7 percent in the financing sources for non-financial institutions. In 2008, bank loans accounted for 83.1 percent in the financing structure of non-financial institutions; and bank assets were around 5.1 times the market value of stocks and 3.9 times the balance of bonds.

I believe that the financial system dominated by traditional banks is an inevitable result of China's high savings rate. As a distinctive feature of China's financial system, high saving rate is attributable to such complicated reasons including: National tradition and cultural factors, family structure, demographic structure, economic growth and social security. The fact that such factors cannot be changed within a short period of time has made it inevitable that China's financial system will be dominated by banking institutions, banks' operation will be dominated by traditional deposits, loans and settlement and the development of the banking industry will be dependent on serving the real economy and continuously expand with the growth of customers.

It is the financial system dominated by banks that has effectively transformed the high saving rate into high investment rate and sustained China's rapid economic growth. During the period from 1978 to 2008, the outstanding balance of RMB loans in China's banking industry increased from 189.0 billion yuan to 30.3 trillion yuan, up 18.5 percent on an annualized basis; nominal GDP grew from 364.5 billion yuan to 30 trillion yuan, up 15.9 percent on an annualized basis. The growth of real GDP is closely connected with that of loans throughout various periods.

It is the traditional core banking business model that has delivered stable growth in income, maintained sound liquidity of balance sheet, sustained the prudent operation of the banking industry and strengthened the banking system's capability of responding to financial crisis. This is greatly different from the western style of banking operation, which is usually characterized by seeking high risk returns via market financing, expanding business by high leverage, engaging solely in a particular business and excessively participating in complicated innovative activities. Such operation mode has suffered a heavy blow in the financial crisis.

Although the global financial crisis has put a limited impact on China's banking industry, its influence on the Chinese economy is deepening. Meanwhile, after years of sustained high growth, it has become increasingly difficult for China's banking industry to maintain a high growth of profits with intensified competition and the advancement of interest rate regime reform. China's banking industry is confronted with a series of restrictions from achieving further development and the gap between Chinese banks and leading international banks is still there though the gap is becoming narrower. The restrictions include:

Technical support represented by modern technology needs to be improved;

The marketing and service system of customer-orientation and market-segmentation has not been completely set up;

Lean management, particularly risk management and product innovation remains to be enhanced;

Lack of talents with international vision and management competence that is adaptable to international development; and

The financial supervisory system needs to be further optimized so as to adapt to financial globalization and innovative development.

Therefore, we must look at the strengths of China's banking industry and the gap compared to Western banks with an objective and dialectical perspective in the current financial crisis. It is not about who should learn from whom; instead, it is about learning from each other, strengthening cooperation and seeking development together. Chinese banks should continue to push forward reform and opening up and strengthen product innovation and risk management.

Looking ahead, as long as we can stick to prudent reform, provide better services for economic growth and incorporate the achievements of the international banking industry to address our weaknesses, China's banking industry will continue to deliver sustainable value for shareholders, staff and customers and create a better tomorrow for economic and social development.

(China Daily 06/22/2009 page2)