China's Big Banks Must Face Some Nasty Truths
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"CHINA'S banks are not real banks," says Andrew Rothman of CLSA, a broker recently acquired by China's CITIC Securities. The country's biggest financial institutions are so closely held by the state that they are, in effect, arms of the treasury. Cosseted by rules that protect them from competition, they deliver huge profits in good times: bank profits as a share of China's economic output equalled nearly 3% last year, whereas the highest ratio achieved in recent decades by American banks was only 1% of GDP (in 2006). In bad times the state is there to clean up, just as it did during a surge in dud loans in 1990s.
But the bargain that has driven China's "Big Four" banks to the top of the global league tables is breaking down. Profitable though they are now, another wave of non-performing loans will soon hit them. As the Chinese economy rebalances, the state is less willing than it was in the past to pour credit into state-owned enterprises (SOEs) at the expense of households and private firms. Mr Rothman's epithet will not hold for ever. China's big banks are slowly becoming real institutions.
That will matter outside China as well as inside it. Its biggest lenders are giants of the banking world. Industrial and Commercial Bank of China (ICBC), which showed a pre-tax profit of nearly $50 billion last year, was named recently by The Banker, a trade publication, as the world's largest bank measured by core capital. In 2000 ICBC's Tier-1 capital was just $22 billion; by the end of last year it had shot up to $161 billion, overtaking JPMorgan Chase and Bank of America. Three other Chinese banks have made it into the top ten: China Construction Bank (CCB), Bank of China (BOC) and Agricultural Bank of China (ABC).
The sheer size of these institutions is breathtaking. ICBC and ABC have over 400,000 employees each, nearly as many as Volkswagen, the world's biggest carmaker. ICBC has over 4m corporate clients. CCB has some 14,000 branches.
The Big Four were carved out of bits of the People's Bank of China (PBOC), the central bank, in the 1980s--though the original BOC dates back to the Qing dynasty. Ostensibly they were to be run like private commercial banks: all four have floated shares on the Hong Kong and Shanghai stock exchanges. But the state has maintained majority stakes in them as well as in the next-biggest bank, the Bank of Communications. The Big Four are led by senior figures in the Communist hierarchy, with bosses shuttling easily between banks and regulatory agencies. Wang Hongzhang, CCB's chairman, was previously a deputy governor at the PBOC and party secretary at its "discipline inspection commission". Xiao Gang, BOC's former chairman, now heads the China Securities Regulatory Commission, which supervises stockmarkets.
Such incestuous ties are a sign of the special role that the Big Four play in Chinese economic policy. Put bluntly, they are the chief instruments of financial repression. Because of the official ceiling on deposit rates, the big banks have a source of cheap funding that they can direct to favoured SOEs and other arms of government. ICBC, CCB and ABC enjoyed the highest net interest income of any banks around the world last year.
But these headline figures hide a multitude of sins. China's use of its biggest banks to implement the 2009 economic stimulus has left a legacy of murky accounting, off-balance-sheet transactions and dodgy lending. Official data on non-performing loans put their level at just 1% of bank assets. No one believes that number. The banks' quarterly results released this week showed profits with little increase in provisions. But Morgan Stanley, an investment bank, reckons a more realistic figure may be 10% for all banks, and 6-8% for the biggest. Things are worse in the many industries saddled with overcapacity: 17% of loans to the manufacturing sector, for example, could become duds if the economy sours, says Morgan Stanley.
The big banks have been here before. In the 1990s an elaborate bail-out was devised to recapitalise the Big Four and transfer dud loans to asset-management companies. It is improbable that a big Chinese bank would be allowed to go under if a similar situation arose again. Nevertheless their market share is rightly under threat.
Three changes in particular are weakening their position. The first is the stagnation of SOEs, which stands in sharp contrast with the dynamism of the "bamboo capitalists" in the private sector. Nicholas Lardy of the Peterson Institute for International Economics, a think-tank, calculates that over the past decade SOEs have destroyed so much value that, in the aggregate, they have produced negative real returns on capital employed. But private industrial firms, which create most jobs and much economic growth, have sharply positive returns.
As the economy slows, China's leaders have decided that resources should not be squandered in this way. Recent official proclamations threaten to cut investment in bloated state-run industries. China's big banks must therefore change how they do business, though they will still be tempted to lend to big firms that they suspect will not be allowed to fail.
Policymakers are also concerned about the rise of the shadow-banking sector. Because savers make little return on their bank deposits, they have sought riskier alternatives, anything from property to shadowy investment instruments known euphemistically as "wealth-management" products--some of them little better than Ponzi schemes. Charlene Chu of Fitch, a ratings agency, argues that shadow banking is pushing financial intermediation from a few big banks to tens of thousands of financing, leasing and guarantee firms and other less regulated, informal outfits. This, she thinks, is making financial data murky and less reliable.
If China's leaders ever did end the cap on deposit rates it would mean a revolution in banking. In the short term "the profits of almost all banks would shrink," says Oliver Rui of the China Europe International Business School. In the long term, though, he thinks the resulting competition would lead the better banks back to healthy margins. It might also gear them up to win back some market share from the shadow-banking sector, reckons Peter Williamson of Cambridge University's Judge Business School. A reported decision to allow banks soon to start issuing tradable certificates of deposit seems like another step towards preparing them for an end to the cap. But it would also expose them more to short-term funding risk.
The third force for change is China's long-awaited shift from an investment-led economy to one fired by domestic consumption. Over the past two years real consumption has contributed more to economic growth than has gross fixed capital formation; services oriented toward the domestic middle classes have grown more strongly than has export-oriented manufacturing. If this trend accelerates it will encourage the banks themselves to make more loans to small and medium-size enterprises and middle-class consumers.
The winds of change
That will force a cultural change at banks which in the past paid little attention to customer service or credit quality. Joseph Ngai of McKinsey, a consultancy, argues that "lending will no longer be a seller's market", in which firms ram credit down the throats of SOEs. His firm forecasts that loans to small companies and households, which together made up just 22% of the total in 2006, will soar to 57% of all loans (as measured by value) by 2021.
Put all of these trends together and the future looks less than rosy for the Big Four. Wen Jiabao, China's former prime minister, declared last year that they "make profits far too easily…we have to break up their monopoly." Recent proclamations from the PBOC talk of boosting "private capital" in banking. On August 9th the China Banking Regulatory Commission, the industry's main regulator, unveiled draft rules for banking licences that are designed to encourage the entry of private capital into the industry.
Competition has already begun to dent the Big Four's monopoly. Smaller banks known as joint-stock commercial banks (JSCBs) were formed in the late 1980s and early 1990s by raising money from both the government and the private sector. The ambitious growth of JSCBs like China Minsheng and China Merchants has meant that the Big Four's share of banking assets had already shrunk to below 50% by 2010. As lending demand from small firms and households rises, the years of experience that JSCBs already have in this sector will count for even more.
Competition is also emerging from unexpected quarters. Alibaba and Tencent, two Chinese internet giants, are moving energetically into financial services. Tencent offers online payment services to fund managers, and wealth-management services to users of WeChat (a popular social-media app with more than 300m users). Alipay, Alibaba's online-payment arm, has introduced a service called Yu'E Bao ("remnant treasure") which offers e-commerce customers an easy way to divert leftover cash into high-interest funds. In just a few months it has attracted over $1 billion in investments.
These firms and smaller upstarts have a minuscule market share, but "this threat is all that any bank president here wants to talk about today," says a financial-industry specialist. Caixin, a Chinese financial magazine, reports that "several large banks have formed an 'Ali-bashing group' to fight what they see as Alibaba's invasion of their turf."
They are right to be worried. For one thing, punters actually like the products and services offered by the internet interlopers. What is more, unlike China's aloof bankers, these innovators already have volumes of proprietary data on the online purchasing habits and creditworthiness of consumers. The Big Four may yet be disrupted by Big Data.
With bad loans and competition rising, China's largest banks face tougher times ahead. ChinaScope Financial, a research firm partly owned by Moody's, a ratings agency, has analysed how declining net interest margins will affect China's banks. It estimates that the sector will need an injection of $50 billion-100 billion over the next two years just to keep its capital ratios at today's level. The managements of the Big Four realise this, and have won approval from their boards to raise over $40 billion in fresh capital over the next two years. But Andrew Sheng of the Fung Global Institute, a think-tank, reckons the sector will need to raise even more later: up to $300 billion over the next five years.
If the big banks rise to this challenge, greater transparency and more competition should follow. That would not just be good news for China. The once-parochial big banks are following their customers abroad. Nearly a quarter of BOC's assets are now overseas; ICBC's overseas assets grew by some 30% last year, more than double the rate of growth of the bank overall. They are also starting to invest in foreign banks. China's biggest banks are already world-beaters in terms of size. In time they may become world-class.
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