This thesis aims to investigate the cause and formation of the legacy costs of the corporate governance in Chinese State-Owned banks and the motivation of Chinese Banks adopt western corporate governance mechanisms. The current problems in corporate governance mechanisms raised the problems in risk management system of many state-owned banks of China. However some Chinese banks have successfully integrated their corporate governance mechanisms by seeking to co-operate with western institutions and international listing, such as the Industrial and Commercial Bank of China and Bank of China. For the foreseeable future, the Chinese state-owned banks will continue to make efforts to reform its corporate governance by reducing the government shares of these banks.
Introduction
China is growing as a huge entity in the world's economy and it's developing rapidly because of its supply of cost-effective labors and material production. The financial sector in China is serving as a quintessential role in the enormous scale of economy. The Chinese state-owned banks, include the Bank of China, the Industrial and Commercial Bank of China, the Construction Bank of China and the Agricultural Bank of China being known as the "big four", was mostly established in the era of planned economy, is still in dominance position in asset scale and market share. Despite their large number of branches and scale in China, the capital efficiency is still need improvements since the lending to state-owned enterprises (SOEs) was based on policy principles rather than profitability and managerial competence (Branstetter 2007, Cousin 2007). Until the second season of 2012, the total amount to Non-Performing Loans of the commercial banks (the Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China, Construction Bank of China and Bank of Communication) is 456.4 billion RMB (CBRC 2012). The development stage of China need the financial sector to play a much more important role; but these bad loans is never to be repaid to inefficient enterprises. This is related to corporate governance problems. The inside reason of the formation of current problems in Chinese state-owned banks will be analyzed in comparison with the relatively successful case of the BocHK.
The history of the establishment of the big four state-owned banks would be demonstrated to give a comprehensive understanding of the legacy cost and problems. The government policy-oriented practices sometimes cause the imbalance of economic growth and profitability and efficiency. The reason of the problem will be analyzed using the principal-agent problem paradigm. To elaborate the problem the governance structure of Construction Bank of China will be analyzed, using as annual reports and balance sheets and other publicly available sources.
The pros and cons of government shares of state owned banks would be discussed using organizational structure models exist in American, German and Japanese Banks to make an explicit view of the corporate culture and structure in Asian banks and European Banks. The discussion of intersect holding will be elaborated in this part. The capital structure of the state-owned banks will be demonstrated as well.
The reformative measures of Chinese state-owned banks has been taken such as put forward such as large capital injections, IPO, co-operate with foreign banks, and inclusion of overseas board members in the aims to improve corporate governance (Hu 2005, Cousin 2007). However questions were raised such as whether China should develop corporate governance with its own specialty and considerations or converge towards the market-based models in the west (Nolan 2010). In the article this topic would be talked about since it is becoming a great issue for the reformative measures shall be taken in China. Fears as the hostile taken over by foreign investors was an issue addressed frequently, intersect holding is being widely applied in Chinese banks with the reference of Germany and Japanese banks. The motivation and current situation will be analyzed. Some other problems, such as a shallow talent pool, lack of managerial and technical expertise will also be discussed.
In order to investigate the causes of current problems in corporate governance problems existed in Chinese state-owned banks, qualitative interviews with staffs and senior managers' work in Chinese state-owned banks will be conducted.
To conclude, international listing is a good mechanism to regulate and discipline the state-owned banks by the external force from a developed capital market. The process of preparing enabled the banks to undergo a house cleaning of its operations and facilitates the standardization of the relationship between the political and banking systems (Sun and Tobin, 2005). The laws and regulation keep the bank operation from political interventions. Also the listing provides potential growth of the bank and it diversifies the centralized power of shareholders.
Literature review
Within the 30 years, the Chinese Banking system reached some degree of complexity. According to the 2011 annual report from press release of the China Banking Regulatory Commission (CBRC 2012), total banking assets amounted to RMB 113.3 trillion, which had increased by 18.9% from the previous year. Total liabilities amounted to RMB 106 trillion, increased by 18.6% from the previous year. Owner's equity reached RMB 7.2 trillion by increasing 23.6% from last year. Capital to Risk (Weighted) Asset Ratio (CRAR) of commercial banks reached 12.71%, increased 0.55% from last year. The 390 commercial banks' capital adequacy ratio had all passed 8% by the requirement of Basel Capital Accord. Non-performing loans decreased by RMB 190.4 billion to RMB 1.05 trillion, with an NPL ratio of 1.77%, a 66 bps reduction from last year. In the June 2007 the banking system consisted of over 8877 institutions, with 189,921 outlets and 2,696,760 employees. The composition of institution assessed by asset scale is demonstrated as follows:
The big five state-owned commercial banks with 49.2% of total banking assets such as Bank of China and Industrial and Commercial Bank of China.
The 12 joint-stock commercial banks with 15.6% of total banking assets such as the Bank of Communications, China Everbright Bank and China Minsheng Banking Corporation.
The 8348 rural co-operative financial institutions with 11.3 % of total banking assets.
Urban Credit Cooperatives and urban city banks with 8.2 % of total banking assets.
The policy bank/non-commercial bank with 8.0 % of total assets. These banks are established or collateralized by governments, with missions of regional economic development. Profitability incentives are not the only driving force in these banks. Examples as Agricultural Development Bank of China and the Export-Import Bank of China.
The rest: non-bank financial intermediaries: 2.2%; Postal Savings Bank of China: 3.6% and subsidiaries of foreign capital banks: 1.8 %, examples as the Standard Chartered Banks, Citi Banks and HSBC.
The corporate governance system in China is one in which is 'control' based, rather than market-oriented because China's unique institutional setting means that the regulators and authorities still make extensive use of authoritative measure to control developments in the economy (Liu 2006). The lending practices is largely based on government policy rather than commercial and market principles. As the growing scale is driven by a historical reason of political force, Chinese state-owned banks is undergoing a fundamental shift to transform the financial system, which will be a complicated and difficult process. It requires the techniques in risk management and new management expertise, which would lead to a radical and extremely challenging shift in organizational culture (Cousin 2007; Hamid and Tenev 2008, Stiglitz 1999).
To increase the speculation to the Chinese banks, China Banking Regulatory Commission (CBRC) was created to formulate supervisory rules and regulations governing bank institutions. The establishment of CBRC increased the transparency, legal regulatory environment and market discipline mechanisms. Its main function is to conduct supervision to monitor and mitigate overall risks of the banks and maintain market confidence by protecting the interest of depositors. However the establishment of CBRC didn't radically change the situation that the state is the controlling shareholder and continues to be the greatest one. The Chinese government allocates goals as to increase economic growth and employment to the banks. The social missions may contradict the profit-oriented goals of the banks. The conflict of interest arises between the state and the bank, in terms as the principal and agent. However some analysis pointed out that there is never an effective ultimate principle since, in the definition of state ownership in China the state ownership is the ownership by the Chinese citizen; which is considered too powerless to assume the monitoring role(Clarke 2003). Due to the lack of existing human principle makes the agency cost extremely large such as losses from corruptions.
Introductions of western corporate governance structures will be playing an essential role to reduce the inefficiencies associated with principal-agent relationships and improve internal control and risk management. From the perspective of Chinese banks, the part foreign ownership is particularly helpful in improving internal corporate governance structures such as risk management and performance incentives, and helping with developing new technology and products (Cousin 2007, CBRC 2008). More foreign investors' entrance in Chinese banking sector could be foreseeable however the state-control share would still be the major dominance share in Chinese state owned banks.
Research question:
The development of Chinese Banking establishment originated from the year of 1979 to 1983. Along with Bank of China, Agricultural Bank of China and Construction Bank of China was revived and established to share the market with the Bank of China. The People's Bank of China, which has been serving as a central bank with commercial banking operations and services, announced that the commercial banking functions were split off into four independent but state-owned banks as a part of economic reform. In 1983, the PBC was promulgated as the central bank of China. In 2003 an amendment law for strengthening the role of PBC in the making and implementation of monetary policy for ensuring the overall financial stability and provision of financial services (Wang 2009). The financial sector has been characterized by state owned banks lending to SOEs on the basis of social policy principles rather than profitability and managerial competence (Branstetter 2007, Cousin 2007). In 1995 the law of commercial banking was took into effect to realize the separation of commercial banking operations from the responsibilities of financial stabilities. Due to the financial crisis in Asia in 1998 and large number of bad debts and operation risks exhibited regardless of its great expansion in branch numbers. In 2005 to 2007, the Industrial and Commercial Bank of China, Bank of China, and the Construction Bank of China was listed in the Hong Kong Stock Exchange and the Shanghai Stock Exchange (Wang 2009); which signified the will to be in line with the international standards. The corporate governance and structure of Chinese state-owned banks is challenged.
China has successfully corporatized the state owned banks, but still has a lot of problems. The corporate governance is generally weak which caused by the discretion enjoyed by policy makers to optimize their policy choices. The moral hazard led to opportunistic behaviors of bank managers. The poorly organized lending policy and political lending to unprofitable state-owned enterprises rendered the China's state owned banks in a difficult situation. The official figure of the non-performing loans ratio for the big Four was 25.1 %, which is almost five times the average for banks in developed countries (Sun and Tobin, 2005). Available sources indicate the Construction Bank of China prepared to write off $673 million worth of bad debt. Also the shift from the policy-oriented lending practices to those based on commercial market principles required building expertise in risk management to limit fraud and evolution in organizational culture. The chairman of the Board of Directors is also the firms' secretary of the CCP Party Committee. Therefore the managers' incentives are also driven by party loyalty instead of market-oriented governance mechanisms (Nolan 2010). A number of varied types of central or regional government agencies in control of equity stake of companies may possess different objectives and incentives. These smaller institutions are likely prone to corrupt lending practices and it's difficult to regulate since they are numerous and dispersed geographically (M. Bekier, R. Huang and P. Wilson, 2005).
In contrast to the scandalous situation in Agricultural Bank of China and Construction Bank of China, The Bank of China (Hong Kong) and Industrial and Commercial Bank of China has successfully improved corporate governance and enhanced their performance by using the international listing as an alternative mechanism(Sun and Tobin, 2005). The deep reason of current problems will be discussed. How are ICBC and BocHK making significant progress? What is the effect to the internal control system and organizational structure to the state-owned banks? How the Asian Banking operations structure is differs from the western? Is intersect holding effective in Japanese and German Banks? The organizational structure and efficiency will be analyzed. Is intersect holding applicable in Chinese state-owned banks? What measures should be taken for Chinese state-owned banks to achieve higher efficiency? These are the question need to be answered.
Methodology
Theorizing on the corporate governance in China's Banks is still in its early stage due the rapid changes which occurred in the sector since the end of the WTO transition period in 2006 (Nolan 2010). It is suggested that topics as this are often using qualitative techniques because it is believed that these approaches allow of maximum exploration of the subject matter (Campell 2004, Eisenhardt 1989, Meyer et al. 1987, Strauss and Corbin 2008). In allowance to new concepts, relationships and perceptions, the method adopted in this study is the in-depth semi-structured interview.
Sample Characteristics
The interviewees are regional staff in state-owned banks in Bank of China, Industrial and Commercial Bank of China and Construction Bank of China.
Interview Procedure
The interview access is permitted by personal introductions through direct approach by email and telephone interviews. These interviews were conducted under conditions of anonymity and confidentiality under the request of participant. These interviews took place in Hebei September 2012. They are interviewed about their experiences, work history, and performance in banking in mainland China. The questions contained questions as the i) the performance of the company; ii) perceptions of the regulatory environment in China; iii) point of views about risk management and corporate governance mechanisms; iv) the steps practiced so far in developing corporate governance structures, v) the influence of foreign capital to the corporate governance structure; vi) other insights. All the notes are taken following the interview.
Analysis
An Overview of the Economy and Banking Industry
According to the report issued by PricewaterhouseCoopers' (PwC for short) currently based on their analysis of the top 10 listed banks results for the first half of 2012, China's economy slowed down with the record of GDP of second quarter of 7.6%. This is the first time over the last three years the growth is below 8%. The Customer Price Index was down to 3.3%. Which signified the inflation rate was eased.
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In the analysis addressed by PwC, the downward trend of global economy was largely due to the impact of European debt crisis. Developed countries will continue to experience the declining trend of GDP in the following quarter in 2012. At the same time Japan and US is going through a slow recovery in GDP. The figure from the National Bureau of Statistics showed a growth rate of 8.1% in the first quarter of 2012, 7.6% in the second quarter, the lowest since the first quarter in 2009. The BRIC countries experienced this lower growth rate which made the prospect of recovering of the global economy uncertain. (Source: PwC)
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The reason for the slowdown in China's growth can be majorly attributed to the weak domestic demand. The data from the National Bureau of Statistics demonstrates that investment in fixed assets, industrial production and retail sales had gone through a slow growth in comparison to the same period in 2011. The consequence is the decline in enterprise profits. According to the date from the Ministry of Finance, the total profit of the state owned enterprises decline by 11.6%.
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During 2010 and the first half of 2011 the CPI presents an upward, China was facing a inflation pressure. To stabilize the economy the central government implemented some policies and measures in the first half of 2012. These measures include accelerating the start of infrastructure projects and intensifying structural tax cuts and loosening its monetary policy.
This could be originated from the end of 2011, the PBC had put measures and result in the expansion of credit. The People's Bank of China had cut the deposit required reserve ratio and interest rates in June and July in 2012, which aims to improve liquidity. (PwC)
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The data from the central bank indicated the scale of social financing in the first half of 2012 was 7.78 trillion RMB, which has a slight improve than the first half of last year. Of that 4.86 trillion RMB was due to increase in loans, with an amount of 683.3 billion RMB than the same period of last year.
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The Renminbi deposits increased by 7.38 trillion yuan in the first half of 2012. An increase of 42.5 billion yuan on a year-on-year basis. The demograph presented a monthly fluctuation in incremental deposits in the year 2012. The deposit is lower at the beginning of the quarter and higher in the end of each quarter.
The Root of the Corporate Governance Problem
The economy of mainland China was founded initially based on the system of state ownership and centralized administrative planning. The regime practices this mindset in making policies in all aspects including economy development. However the authoritarian way of developing economy sometimes contradicts to market principles. It is now widely acknowledged that the modern corporate governance system and risk management is based on the idea of check and balance. China's economy development is mainly dependent on the commands of the central government. It could be seemed nice with the pressure in task achieving; the unchallenged power enjoyed by some interest groups result in the abuse of power and the state-owned banks are also regarded as the "child of the country"; as it is playing much more important role in the economy and perceived as "too big to fail". They could be saved as well as the state owned enterprises. The lendings to the enterprises in China is also becoming a big problem since the lending principles is largely based on personal guanxi and commands as economy development rather than overall evaluation of the credibility of lending and profitability of the lending.
Influence of Guanxi culture
Stemmed from the authoritarian management culture, the exchange of favor and obligations is a phenomenon that exists in Chinese society. Different from the concept of "connections" and "relationship" in western culture, guanxi has more elements of emotions or "renqing" in Chinese, means the moral obligation to maintain the relationship. If one denied to practice the obligation, the other loses "mianzi" (literally means face), signifies the social status, property, prestige of the other part is not respected hence the behavior is offensive. In general, Chinese people are prone to respect the "mianzi" reciprocally to maintain the "guanxi" for personal favors in case. This kind of behavior caused by cultural phenomenon gave a legit excuse for the illegal behaviors such as exchange of power and interest. The Chinese corporate governance system is inevitably influenced by this mindset.
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Current Situation of the Lending
According to the reports of NPL issued by Ernst & Young on May 3rd 2006, the total amount of Non-Performing Loan of the "big four" state owned banks was 358 billion US dollars, which was far more bigger figure issued by the official report of the People' Bank of China, which was 133 billion US dollars. And the estimation of China's NPLs would reach 911 billion US Dollars was given by Ernest & Young. The statement was retracted by Ernest & Young for its wrong assumptions. " Throughout the report this amount was identified as a potential future amount that includes NPLs totaling approximately 358 billion dollars for the big four commercial banks, upon further research, Ernst Young Global finds that this number cannot be supported, and believes it to be factually erroneous," the firm said in the statement. "We apologize that this erroneous report was issued. We sincerely regret any misleading views that the report conveyed." (China daily)
"The report not only seriously distorts the actual assets quality of the Chinese banking sector," the People's Bank of China website quoted an unnamed official as saying." Its statements on several financial institutions are also seriously wrong and its conclusions are absurd and incomprehensible." (China daily) This report may have a serious impact on the IPO process overseas for the Chinese state owned banks. And it faced pressure. Jack Rodman, the Managing Director of Ernest & Young Asia Pacific Financial Solutions LLC, admitted that mistakes have been committed in the evaluation of the report. And the 225 billion dollars' difference is based on the estimation of NPLs by UBS during 2002 and 2004 caused by the increase of lending. (Sina)
