Source: Financial Times

It is easier to make money than sense out of China’s banks. These big four state-owned commercial banks are huge profit centres, but many who see vulnerabilities in China’s economy think that these banks are the problem when they actually reflect symptoms of distortions elsewhere. China’s banks are in fact too secure – and their performance could be improved by strengthening competition and breaking up the “too big to manage” entities.

Many critics cite inflexible interest rates which are deemed too low relative to inflation as the issue. Others point to excessive government interventions fomenting risks such as a property bubble. Still others remind us that the state-owned banking behemoths are sitting on a mountain of household deposits which feed into temptations to misuse captive funds given lax governance safeguards.

But China’s interest rates are already relatively high in real terms compared with other major economies in a global monetary system flooded with liquidity. Its capital markets lack the depth for interest rates to be shaped by market forces and the dominance of the big four banks reduces the benefits of having more flexible rates. The emergence of a property bubble has more to do with capital controls which discourage investors from moving their savings abroad and thus encourage speculation in the domestic property market. And these huge deposits are a natural consequence of the massive savings in an economy with limited investment options.

More recently red flags are being waved at the emergence of new wealth management products and shadow banking that allow for higher returns to savers but at the cost of introducing riskier and unregulated instruments in an otherwise stultified system. These initiatives are broadly to be welcomed rather than discouraged. They provide more diversified options for savers and are shaking up a system that has relied too long on just channelling funds to state entities, leaving unmet the needs of potentially more dynamic private enterprises.

Some or many of the borrowers may not meet the criteria that one would wish for and there will be defaults and probably a mini-crisis or two. But these are part of the costs of learning in an otherwise regimented system. Greater transparency along with an appropriate regulatory framework will need to emerge but trying to regulate such activities prematurely could actually do more harm than good by stifling the learning process.

One is hard pressed to come up with indicators that would reveal an imminent banking crisis in China. After all, the big four commercial banks pay a steady stream of high dividends, their non-performing loan ratios are low (even if flawed conceptually), their control over an immense volume of household deposits would be the envy of any other banking system, their lending for mortgages is not highly leveraged, taking a US-style meltdown off the table, and since so much of their activity is geared to state entities or carry explicit or implicit state guarantees, the risks are ultimately less about the quality of the banks but the creditworthiness of the state which remains relatively strong compared with other major economies.

Then what is the problem with China’s banks?

Governance is the issue in a state-dominated activity that provides the glue for much of China’s economy. The incentives for prudent risk taking and adherence to commercial objectives are weak for these banks given their near monopoly position and government interventions. In this environment, admonitions for improved management can only go so far.

The challenge is to introduce more competition in a system which politically will continue to be dominated by the state and where vested interests are exceptionally strong. Given this reality, there are nevertheless actions that could help improve performance. One would be liberalising entry of foreign banks whose presence in China is miniscule at present. This would spur competition and innovation and, contrary to what is believed in China, strengthen rather than weaken the performance of state-owned banks.

A more radical action would be to confront China’s own version of the west’s problem of their banks being “too big to fail”. The counterpart for China is that the big four state-owned banks are “too big to manage”. Breaking them up into three regional banks each would be a powerful means to foster competition and improve governance. This has been a process that has worked well before when China split its national airline into numerous regional entities which then subjected to market pressures resulted in a manageable number of more efficient but still state-owned companies.

These split-up banks would be headquartered in various provinces rather than in Beijing and thus less influenced by politically driven mandates but more by the real needs in their localities. They would not be restricted to operating only in their originating regions but could expand elsewhere and eventually develop a national presence. But they would need to become more commercially oriented and efficient to survive. In this process, some of them would be motivated to seek external partners, as has happened with the airlines, and this would help open the door for increased foreign participation and provide support for further liberalisation.

This piece was originally published by the Financial Times.