As China's National People's Congress puts the final touches on important new banking legislation to be adopted by the end of the year, its members would serve their nation's lumbering financial sector best by focusing on, and learning from, the success of China's booming second-tier banks.
The financial sector is clearly one of the weakest links in China's current economic success story. The banking system is burdened with nonperforming loans (NPLs) that by some estimates top 40 percent of GDP.
The NPLs are largely the result of decades of central planning and of lending to state-owned enterprises based on political rather than financial decisions. These massive bad loans now pose serious macroeconomic problems and undermine the proper functioning of banks.
NPLs must be tackled quickly. But clearing the system of this cancer will not, in itself, bring better banking to China. The root problem facing China's banks is poor corporate governance.
The banking system is dominated by four mammoth state-owned commercial banks: ICBC, Bank of China, Construction Bank and the Agriculture Bank of China. Together, the big four employ over 1 million people and account for almost 70 percent of total bank lending.
These banks are caught between government and social pressures to prop up ailing state firms and the logic of the market to take hardheaded commercial decisions.
Foreign banks have the ability to help strengthen Chinese banking by bringing in independence, managerial and technical expertise and international best practices. They could make a major contribution by entering the retail side of the business rather than limiting their activities to wholesale banking.
But most foreign banks will not go into retail banking. Even if their penetration was to increase from their tiny share of less than two percent, this cannot be the only solution for a market as large as China's.
China's banking problems will have to be solved at home.
The new breed of second-tier banks may point the way forward. In the past decade, these banks have put increasing pressure on the big four.
The newcomers include emerging groups like the Bank of Communications, China International Trust and Investment Corporation, China Merchants Bank, China Everbright Bank and China Minsheng Banking Corporation, as well as several city commercial banks, especially those in Beijing and Shanghai.
This new breed now controls 15 percent of the market and their performance is far superior to that of large state banks. In 2001, these second-tier banks posted returns of 0.46 percent on assets and 10.18 percent on equity, compared with 0.16 percent and 3.13 percent, respectively, for the big four.
This yawning gap is only partly explained by the new banks' focus on more affluent urban areas. Importantly, it is also a result of better corporate governance.
Unlike the big four, which are fully owned by the state, the fast-growing banks have multiple shareholders or a diversified ownership that often includes public and private sector bodies.
The key is multiple versus single ownership. Banks with diversified owners must respond to varied interests, which makes it easier to resist state interference.
Further growth of banks with diversified ownership is needed to help the government evolve from its role of owner and player in a centrally planned economy to that of rule-setter and regulator in a market economy.
Increasing competition from the second-tier banks will also provide a stimulus to reform the big four banks.
Good corporate governance in the second-tier banks hinges on the diversity of shareholder interests, and to ensure that its benefits are realized, minority interests must be protected.
It will still be some time before minority interests can be adequately defended in China's courts. That makes indispensable the strengthening of external independent regulators and agencies, together with the discipline of competition.
To achieve this, an antitrust or competition law should be enacted and corresponding institutions established. Among other things, these institutions should be given the power to address banking and finance issues. The power of the China Securities and Regulatory Commission to protect minority shareholders should be increased.
Also, the power of the China Banking Regulatory Commission should be expanded and the salaries of supervisors increased to reduce the risk of graft. Finally, to facilitate effective competition in the banking sector, other elements of the financial markets need to be developed.
In China, better banking has to be found at home.As the National People's Congress scrutinizes the proposed Central Bank Law, Bank Supervision Law and Commercial Bank Law - -- all of which are expected to be adopted by the end of the year -- - it should not underestimate the potential role of diversified shareholding in improving corporate governance in the banking sector.
Giovanni Ferri is a professor of economics at Bari University in Bari, Italy, and a visiting scholar at the Asian Development Bank Institute in Tokyo. John Weiss is Director of Research at the ADB Institute.
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