Chinese Banks at Risk (Part II)

 |  Includes: CHIX, CICHY
by: Patrick Chovanec

<<Read Part 1

Two quick follow-ups pulled from the news, which reinforce the points I made yesterday, before moving on to the topic of structural reform in Chinese banks:

  • Chinese Business Press reports that the head of Shanghai’s China Banking Regulatory Commission (CBRC) says they’re seeing rising default risks on loans to real estate developers. Banks have had to roll over loans for some developers that are running low on cash due to the slowdown in sales caused by government cooling efforts. Which goes to show what I wrote yesterday, that at-risk loans are by no means limited to Local Government Financial Vehicles (LGFV).
  • Shanghai Security News cites an unnamed CBRC official responding to the flurry of concern over the latest LGFV figures, arguing that “incompliant” loans do not necessarily equal nonperforming loans (NPL), because the collateral may be big enough to cover the risk. To me, this argument only highlights the worrying exposure of China’s banks to its overheated property sector, due to their over-reliance on collateral-based lending. If banks are planning to be repaid, not in productive returns on investment, but in relatively illiquid plots of land, valued at ridiculously record-setting prices, they’re heading for trouble. Collateral is a backstop, but it’s no replacement for cash repayment. “Don’t worry, it’s all backed by (rising) collateral,” is exactly what people said to rationalize foolish investments in both the Japanese and U.S. housing bubbles.

The challenge I want to focus on today, however, isn’t the banks’ balance sheets. It’s their corporate culture. Over a year ago, when I first called attention to China’s bank lending binge in The Wall Street Journal, I wrote that:

the real damage to [bank shareholders'] interests can’t be quantified in terms of bad debt ratios … Global investors bought into China’s bank IPOs in the belief that those banks, which once functioned merely as conduits for state subsidies, could remake themselves into profit-making enterprises.

The IPO of AgBank — the last of the “Big Four” state banks to list its shares on the stock market – was supposed to be the capstone of this decade-long reform campaign. But to get some idea just how far China’s banks still have to go, it’s worth reading this recent article in Knowledge @Wharton, published by my MBA alma mater. I was interviewed for the article, and it includes several of my quotes on the financial challenges facing Chinese banks, but for those reading this and related posts, none of that will be anything new. What’s more interesting are the comments by other experts on how China’s banks are managed.

The picture that emerges is one in which Chinese banks, despite a decade of reforms, remain more political than business entities. Chinese banks have invested heavily in risk management systems and training staff in credit analysis, and have engaged in joint ventures with foreign banks intended to boost their technical skills and product offerings. But Gary Liu, deputy director of Shanghai-based CEIBS Lujiazui International Finance Research Center, reports that “[Chinese bank] executives are not really managers, but government officials.”

Strategic investors with a seat on the board have some voice, says Wendy Dobson, an economics professor and director of the Institute for International Business at the University of Toronto’s Rotman School of Management, “but the boards are still stacked with people from the party.” “The regulatory environment,” she explains, “is one where the government still sets interest rates and all the banks have access to low risk spread income so they have very little incentive to manage risk.” The result is a situation where bankers are trained to act one way, but conditioned to behave in another. Wharton professor Marshall Meyer recalls a recent trip to China where one bank manager lamented that he had to choose between “being a responsible banker and keeping my job.”

I’ll offer a concrete example of what they’re talking about, based on my personal conversations with banking executives here in China. Many Chinese banks, as part of their reforms, have adopted the practice of conducting annual employee reviews. The idea, of course, is to reward top performers with promotion, and identify and try to correct situations where people are falling short. But the way it works in practice, I’m told, is everyone rotates. This year I’ll get a top performance rating, and you’ll get a mediocre one; next year we’ll switch. Every once in a while, we’ll each have to bite the bullet and take a bad rating for the team. In the end, it’ll all even out. Everyone wins and nobody loses. If you insist on bucking the system, and push for promotion based on merit, you’ll be seen as disruptive and greedy and it certainly won’t help your career. In short, the hardware (the evaluation system) is in place, but the software (the willingness and incentive to actually evaluate employees) is not. The effect on business may leave a lot to be desired, but it’s the government’s money anyway, and there’s plenty of it, so better to share the benefits peaceably.

Given the outcry in the West over the salaries and bonuses paid to bankers, the low salaries received by top Chinese banking executives are a point of pride in China. The article notes that ”despite driving their banks to enviable levels of profitability in 2008, the heads of ICBC and China Construction Bank earned $263,000 and $230,000, respectively, before a government-mandated pay cut of 10% for all the most-senior executives of the country’s biggest financial institutions.” But Huining (Henry) Cao, a finance professor at Cheung Kong Graduate School of Business in Beijing, believes that low executive pay, far from being a plus, is actually a problem. He contends that “by adjusting the pay scales to reflect the ability of individual bank executives to create value could reduce corruption and make working at these companies more attractive.”

The decision to use China’s commercial banks as the main conduit for stimulus spending, rather than responsible lending, undermined the progress that was being made towards building a new kind of banking culture. The problem isn’t that Chinese banks have problems — the world these days is full of banking problems — but that they have been lulled by magically declining NPL ratios and high profits (based on the regulated spread in interest rates) into thinking that, in China alone, skies are blue and they don’t have any problems worth correcting. The fact that banks appear to be doing well makes people all the less willing to rock the boat:

… Liu maintains that despite all the noise about reform, “in terms of corporate governance, I’m afraid the bank haven’t made much progress.” The problem is that there’s little incentive to change, he says. “Reform is not easy because [the banks] are profitable; they don’t have the pressure like they had during the first round of reforms when they had no choice because they were about to go bankrupt,” he says. Riding on the country’s economic boom, “they are very strong now and have strong relationships with local governments and large SOEs.” They also face very little external competition — he points out that the market share of all foreign banks in China at the end of last year was less than 3%. “The banks are getting better but not because of corporate governance but because of the golden opportunity in China’s markets,” he asserts.

I know I often must come across as a “bear” on China, but my purpose here isn’t to run down Chinese banks (one episode of The Office is enough to demonstrate that warped corporate culture is hardly unique to China). China’s banking system has made huge strides over the past 30 years, and has a vital part to play in creating the conditions for China’s future prosperity. A banking system that can allocate capital more efficiently, and earn a sound return on investment, is a goal worth pursuing even in the face of setbacks. But the first step is recognizing those setbacks as setbacks and facing up to the fact that there’s still a long way to go.