China's Road to Greater Financial Stability

Chapter 7. Structure of the Banking Sector and Implications for Financial Stability

Udaibir Das, Jonathan Fiechter, and Tao Sun
Published Date:
August 2013
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The turnaround of the Chinese banking system has been impressive. Supported by capital injections and key policy reforms—including improved prudential standards and gradual financial liberalization—the banking system is moving toward better disclosure, gradually improved corporate governance, and increased reliance on market mechanisms.

To analyze China’s potential financial stability risks, it is pivotal to distill the key structural factors and distortions that define the Chinese banking system. Structurally, there are several features that, taken together, set China apart from financial systems in other countries: (1) the preeminence of large domestic commercial banks in domestic financial intermediation; (2) sizable structural liquidity in view of high domestic savings due to limited investment alternatives; (3) low remuneration of deposits associated with remaining interest rate controls; (4) the dominant role of the state both in terms of bank ownership and its influence on the credit allocation process, reflected in the importance of quantitative lending targets for monetary policy; (5) regulatory emphasis on maintaining low nonperforming loan (NPL) ratios; and (6) the nontrivial role of the shadow banking sector.

This chapter outlines these structural traits and discusses their relevance for China’s financial stability. In particular, the chapter argues that it is vital to curb the adverse structural incentives in the system to avert the potentially undesirable accumulation of credit risks and to address internal macroeconomic imbalances. In particular, China needs to address capital allocation distortions to provide for more balanced economic growth. More broadly, policies should seek to reduce moral hazard and improve the credit risk management and corporate governance of banks. For example, emphasis on lending to state-owned enterprises (SOEs) and meeting explicit NPL targets lowers the incentives of banks to adopt better risk management practices and curbs the extension of credit to intrinsically riskier borrowers, such as small and medium-sized enterprises (SMEs). Moreover, to curb the incentive of excessively using the banking system for fiscal policy purposes—such as for funding local infrastructure projects—future reforms at the local level should seek to reduce fiscal revenue-expenditure mismatches faced by local governments. The chapter elaborates on the link between such structural factors and the need for local governments to indirectly secure funding via the domestic banking system, and also establishes a link between structural traits and China’s financial stability. It makes the point that such reforms are a complex undertaking that go beyond the financial sector.

Key Structural Characteristics of the Chinese Banking System

Dominance of Large Banks in Domestic Funding

Banks plays a dominant role in the Chinese financial system. Credit in China is primarily channeled through banks, with domestic equity and bond markets playing a relatively small role in the intermediation of financial capital. The role of bank finance in economic growth is considerably more preeminent than in other G20 countries, with bank loans accounting for 67 percent of domestic funding at end-2011 (Figure 7.1). Banking system assets grew to RMB 114 trillion at end-2011, equivalent to 240 percent of GDP.

Figure 7.1Size of Selected Countries’ Financial Systems, end-2011

(In percent of total)

Sources: Bank for International Settlements; Bloomberg; IMF, International Financial Statistics; and IMF staff calculations.

Banking sector activity is still dominated by large commercial banks (LCBs) and joint-stock commercial banks (JSCBs); however, the degree of concentration has been declining. Collectively, the five LCBs and the 12 JSCBs accounted for 65 percent of the broader banking system assets at end-2011 (Figure 7.2).1 Unlike other types of banks (with the exception of certain city commercial banks), LCBs and JSCBs are permitted to operate on a broader (national) scale, with deposit-taking and lending operations spanning urban and rural areas. Their market power remains considerable, despite a marginal decline in recent years. A measure of market concentration—the Herfindahl-Hirschman index (HHI)2—reveals that banking sector concentration, both on the lending and deposit sides, has declined over time, from 0.15 at end-2005 to 0.11 at end-2011 for lending and from 0.12 to 0.09 for deposits.

Figure 7.2Banking System Assets by Type of Bank, end-2011

(In percent of total)

Sources: China Banking Regulatory Commission; and IMF staff calculations.

Note: CDB = China Development Bank; JSCB = joint-stock commercial banks; LCB = large commercial banks.

High Structural Liquidity and Interest Rate Controls

Bank funding in China relies heavily on deposits due to high domestic saving rates and limited investment alternatives. Deposits account for over 80 percent of system-wide liabilities, and 172 percent of GDP, among the highest levels compared to selected G20 countries (Figure 7.3). The absence of well-developed domestic capital markets results in a high retention of savings in the banking sector. Total deposits in the banking system have been growing rapidly, increasing by an average of 17 percent annually since end-1999. As of end-2011, total deposits stood at RMB 80.9 trillion, of which 49 percent was in the form of household deposits.

Figure 7.3Select Banking Systems’ Aggregate Deposits, end-2011

(In percent)

Sources: CEIC; and IMF staff calculations.

The low remuneration of domestic deposits has been a key by-product of financial repression in the Chinese banking system. Remaining interest rate controls account for periodic swings of real deposit rates in China to negative levels during some periods (Figure 7.4). Structurally, over the long term, real deposit rates have, on average, been lower than in many other countries. The very low and at times negative real rates have deprived savers of a reasonable rate of return on deposits. In conjunction with the very high savings rates in the domestic banking system, the low interest rates paid on domestic deposits have provided an implicit subsidization of domestic corporate funding.

Figure 7.4Real Deposit Rates in Select G20 Countries

(In percent of GDP)

Sources: Bloomberg; IMF, International Financial Statistics; and IMF staff calculations.

The low real interest rates have also accounted for periodic fluctuations in the composition of bank deposits in recent years. The evolution of bank deposits has followed closely the upswings and downswings in the domestic equity markets, reflecting domestic depositors’ search for higher yields. From the viewpoint of households’ portfolio allocation, the high opportunity cost of holding savings and time deposits in a low real interest rate environment induces depositors to shift away from longer-term deposits to more liquid demand deposits, and subsequently invest these into the equity market. For example, the upswing in the equity markets in January 2010 was associated with a sharp acceleration in the reallocation of household savings deposits into demand deposits, with the latter increasing at 45 percent on an annual basis at their peak (Figure 7.5).3 The inverse relationship between the size of savings deposits and equity market returns—shown to be statistically significant in earlier studies—has been linked, at least in part, to the structurally low—and even negative—real savings deposit rates (Figure 7.6).4

Figure 7.5Demand Deposits and Returns on the Shanghai Stock Exchange

(In percent, year-on-year growth)

Sources: Bloomberg; CEIC; and IMF staff calculations.

Figure 7.6Household Real Deposit Rate and Returns on the Shanghai Stock Exchange

(In percent, year-on-year growth)

Sources: Bloomberg; CEIC; and IMF staff calculations.

Low deposit remuneration and limited investment opportunities have also accounted for a high share of household savings allocated to the real estate market. Such transfers draw down household deposits and have a strong distributional effect on the domestic economy, as they amount to a wealth transfer from households to large SOEs and the government. The transfer is effectuated by household savings withdrawals to make down payments on house purchases, a process that ultimately benefits the government and enterprises as the principal players in the real estate market.5 The limited investment opportunities for domestic households—other than deposits and, to an extent, the equity market—increase the attractiveness of real estate investments and augment the scale of such transfers.

Banks’ real estate exposures expanded particularly rapidly during the 2009 government-led stimulus.6 The real estate market turned into an important recipient of domestic credit, accounting for about 19.5 percent of total domestic loans by end-2011. Direct bank exposures to the sector took two principal forms: mortgage loans and loans to real estate developers, with the former accounting for RMB 7.1 trillion, or 13 percent of total domestic loans as of end-2011, and the latter for RMB 3.5 trillion, or slightly more than 6 percent of the total.

In addition, the remaining interest rate controls and limited risk pricing make bank profitability dependent not only on the margin but on lending volumes. The government effectively ensures a minimum interest margin by administratively setting a deposit rate cap and a lending rate floor. Such a guarantee on the margin is meant to ensure the long-term stability of banks’ profit margins. In an environment in which Chinese banks do not rely fully on risk-pricing mechanisms, banks’ margins closely mimic the guaranteed margins. Thus, if either margins or lending volumes contract, the two need to move in opposite directions to avert a negative impact on banks’ profitability. However, given that lending volumes are determined by credit quotas, the government effectively has an impact both on the margin and on loan quantities (Box 7.1). For example, Chinese banks’ sizable stimulus-led credit growth in effect partially offset the compression in the net interest margins. Moreover, the potential negative effect on the profitability of Chinese banks is exacerbated by their strong dependence on interest income and limited earnings diversification.

The Predominant Role of the Government

The government has a strong influence on banks’ credit allocation and lending patterns. The government—primarily via the Central Huijin and the Ministry of Finance—continues to be the largest direct shareholder of the five LCBs and the three policy banks, and has sizable indirect shares in JSCBs via its SOEs (Table 7.1). Although since 2005 the LCBs and a number of JSCBs and smaller banks have had successful initial public offerings (IPOs), as of end-2011 the central government continued to hold a majority stake in the top four LCBs, with private sector and strategic investor ownership still relatively limited.

TABLE 7.1Ownership of Large Commercial Banks, end-2011(In percent of total)
HuijinMinistry of FinanceTotal
Industrial & Commercial Bank of China35.435.370.7
Bank of China67.60.067.6
Agricultural Bank of China40.039.279.2
China Construction Bank57.10.057.1
Bank of Communications0.026.526.5
Sources: Company reports.
Sources: Company reports.

The government also has a bearing on banks’ management decisions. As the principal shareholder of domestic banks, the government has the right to appoint bank directors and senior management.7 While LCB and JSCB listings on exchanges have improved corporate governance and led to an increasing share of independent directors on banks’ boards, there is still a prevalent practice for the government to nominate directors and senior managers and set up remuneration schedules.

The use of window guidance and quantitative lending targets continues to influence the commercial nature of banks’ credit policies. While the 1993 Law on Commercial Banks established LCBs as commercial entities with full responsibility for their own profits and losses, their credit allocation decisions are still influenced by policy intervention (Brehm, 2008). Window guidance—a form of voluntary moral suasion to exert pressure on banks to adhere to official guidelines—is a key component of credit transmission in China and has been used as a tool to limit or expand loans to parts of the system. While the PBC defines and carries out monetary policies, the China Banking Regulatory Commission (CBRC) has been intermittently involved in window guidance policies. For example, the CBRC’s 2009 annual report provides explicit guidance for domestic banks on priority sectors that they are expected to target, and on their broader role in domestic economic development.8 Banks have also been required to set up units specializing in small enterprise lending (CBRC, 2010).

The use of quantitative lending targets—including mandated rapid domestic credit growth to counteract macroeconomic shocks—poses a risk of credit quality deterioration. Rapid credit expansion, ceteris paribus, is linked to a decline in marginal returns. The evolution of NPLs and bank capitalization levels after periods of rapid credit growth points to an inverse relationship between such growth and the quality of banks’ assets. Quantitative lending guidance—which is still used in China—limits the incentives of banks to apply prudent risk management practices, given that they are expected to meet high lending targets.

Box 7.1.The Credit Channel in China

Banks are the key source of credit transmission in the Chinese economy. Their predominant role is defined by their considerable size compared to recently established nonbank institutions.

Quantitative credit targeting in China is closely related to domestic monetary policy. To manage credit transmission, the People’s Bank of China (PBC) relies on quantitative tools, including (1) administrative aggregate credit growth targets (both aggregate and for individual banks); (2) preferential credit to underdeveloped geographical areas or industries; and (3) restrictions on excess credit flows to specific industries (Figure 7.1.1). The PBC also makes use of indirect instruments, such as required reserves, which transmit changes in the monetary base via required reserves to bank deposits, and subsequently to the domestic loan supply. However, the PBC does rely heavily on quantitative mechanisms when it wants to reinforce short-term policy outcomes. The response to the global financial crisis is a good example: while both deposit and interest rates were cut significantly and required reserve ratios declined as well, the PBC relied on the cancellation of the credit quotas to support a considerable expansionary policy.

Figure 7.1.1Credit Channel in China

Source: IMF staff.

Note: Open-market operations are mainly used to withdraw liquidity from the financial system and maintain the stability of the renminbi. Open-market operations affect the credit channel via banks’ purchases of central bank bills. The PBC issues these bills when foreign exchange pressures force it to excessively sterilize. Some banks are subjected to directional issuance. CBRC = China Banking Regulatory Commission; SMEs = small and medium-sized enterprises; SOEs = state-owned enterprises.

Effective transmission of these monetary policy signals hinges on the inability of banks to easily substitute between loans and other types of securities. Such substitution, if possible, would thwart targeting of domestic loan levels and would reduce the overall effectiveness of the credit transmission mechanism. In this sense, a potential expansion of Chinese banks’ domestic capital market activities may reduce the effectiveness of the current credit transmission framework. Lastly, fluctuations in the bank loan supply affect the level of domestic investment, with smaller borrowers such as small and medium-sized enterprises being affected most significantly.

While the importance of the interest rate channel in China is slowly increasing, interest rates remain a limited tool for credit policy transmission. They hold limited informational content, given that the lack of sufficient investment options and the relatively high propensity to save make domestic savers relatively insensitive to interest rate changes.

Regulatory Limit on Leverage and Emphasis on Low Nonperforming Loan Ratios

Policy limits on NPL accumulation have induced banks to curb credit risks by lending to borrowers supported by explicit or implicit government guarantees, or to delay NPL recognition altogether.9 The use of explicit NPL targets distorts banks’ incentive structure, leading to limited risk-taking, and unintentionally holding back the adoption of better risk management practices, including sound underwriting practices and prompt loan workouts. Instead, the targets encourage banks to shift NPLs off balance sheet and resort to debt rollovers. In principle, an improvement of banks’ risk management practices tends to be incompatible with the short-term goal of minimizing NPL accumulation. The development and implementation of risk management procedures, effective internal monitoring systems, and credit officer training are time-consuming and cost-intensive. Moreover, given that profitability measures are estimated on a post-provisioning basis, a potential enhancement of banks’ risk management standards could initially have a negative impact on profits to the extent that weak loans are recategorized as NPLs.

The Role of the Shadow Banking System

The shadow banking system in China has grown considerably in recent years, taking on the role of an alternate funding source for domestic entities. Estimates of the size of the shadow banking system vary considerably, given its highly nontransparent nature and the varied assumptions on the types of activities that it encompasses. The broadest spectrum of these activities entails both formal funding mechanisms and informal funding channels. The formal mechanisms include bank-based, off-balance-sheet lending (mostly via entrusted loans), credit-related and wealth-management-related trust products, lease financing, credit guarantees, microfinance, company-to-company lending, offshore borrowing, private equity funding, and regulated pawnshops.10 The informal funding channels include underground banks, private peer-to-peer lending, and unregulated pawnshops. Estimates at different points of time in 2011 and based on varied coverage assumptions put shadow banking lending in the range of RMB 8.5 trillion to RMB 15 trillion.11 This is equivalent to approximately 16 to 29 percent of bank lending, suggesting that shadow banking is nontrivial for domestic funding. Informal lending—the most nontransparent portion of the shadow banking sector, given its unlicensed nature—is estimated to account for about RMB 3 trillion to RMB 4 trillion.12

The expansion of the shadow banking system in China is driven by idiosyncratic factors. Unlike other countries—including the United States, where activity in the shadow banking sector is driven by market mechanisms (such as securitization)—the growth of shadow banking in China is largely lendingdriven and is defined by certain peculiarities of the country’s financial structure, including (1) the constrained availability of bank funding, particularly for SMEs and higher-risk borrowers, given banks’ limited risk pricing capacity; (2) insufficient remuneration on bank deposits and limited financial investment opportunities, which induce private lending amid a search for higher yields; (3) government “moral suasion” directed to banks responsible for the high share of bank credit to domestic SOEs, which in the absence of viable investment opportunities is onlent in the informal market; and (4) regulatory arbitrage, with banks prompted to use alternative channels to circumvent loan target limits. Key features of the system are high interest rates and relatively short tenures of extended loans.

Shadow bank activities can exert negative pressures on financial stability through their amplifying effects on procyclicality and the transmission of risks to the broader financial system. The shadow banking system affects procyclicality by facilitating higher leverage in the economy at a time when conditions in certain sectors, such as real estate, are buoyant. Countercyclical credit limits meant to constrain the level of lending in the economy effectively propel smaller borrowers—such as SMEs and property developers—that have limited access to bank funding to resort to the informal lending market.13 In addition, banks have an incentive to revert to informal securitizations to improve their capitalization and open up opportunities for further lending. Indeed, in the aftermath of the global financial crisis, banks shifted some credits off balance-sheet and repackaged them as wealth management products, subsequently sold to investors.14 Credit risks in the shadow banking sector are also linked to those in the mainstream banking sector, for example via SOEs relending bank loans in the informal market to arbitrage the interest spread between the two markets.15 Moreover, shadow bank lending has implications for monetary stability, including consumer price index and asset inflation. For example, in the post-crisis environment informal lending supported the uptick in property investments, with funding to the real estate sector accounting for up to 60 percent of total lending by some estimates (Credit Suisse, 2011).

Case Study: The Link between Banks and Local Governments

The exposure of Chinese banks to local governments increased markedly as a result of the economic stimulus initiated after the onset of the global financial crisis. Local government financing platforms (LGFPs)—vehicles set up by local governments to support project financing, particularly in infrastructure—played a key role in the implementation of the stimulus. They provided local governments with a platform for accessing off-budget financing to support local (mostly infrastructure) projects and thus to maintain robust economic growth in their localities. LGFPs grew rapidly after relatively limited activity prior to the crisis. It is estimated that local government debt almost doubled from RMB 5.6 trillion at end-2008 to RMB 10.7 trillion at end-2010, with bank lending via LGFPs accounting for RMB 8.5 trillion, or 80 percent of total local government debt at end-2010 (National Audit Office of the People’s Republic of China, 2011).

The rapid expansion of bank credit to LGFPs was related to structural features of the Chinese banking system. The preeminent role of commercial banks in domestic financial intermediation and the sizable structural liquidity in the banking system could ensure an uninterrupted supply of bank credit and sufficient volume to meet the sizable borrowing requirements of local governments. The use of quantitative lending targets and the temporary easing of these targets at the time of the economic stimulus unleashed the potential for a considerable expansion of credit to local governments. Moreover, the guarantee of banks’ interest margins through interest rate controls made banks depend on expanding lending volumes to boost profitability. Overall, banks have strong incentives to make use of the sizable stimulus-related expansion of LGFP loans to maximize market share and shareholder value.

The considerable growth of LGFP-related lending was also underpinned by peculiarities in the incentive structure of China’s local governments and the government fiscal decentralization process. China’s system of top-down appointments and fast rotations of local government officials fosters an environment in which local officials primarily pursue short-term targets rather than long-term outcomes. Moreover, emphasis on relative performance in the promotion of local officials is conducive to herding behavior, as similarities in decision-making protect officials from underperforming relative to peers. Thus, their incentive to achieve a rapid promotion induces local government officials to take on relatively high risks even at the cost of potential debt overhang problems. This translated into strong incentives for local governments to support massive infrastructure investments at the time of the post-crisis stimulus. The burden of such investments fell largely on local governments due to the decentralization of government expenditures and the centralization of fiscal revenues under the 1994 fiscal reform. The sizable local government fiscal imbalances, coupled with legal restrictions on local government funding via bank borrowing or bond issuance, induced a massive expansion of LGFPs in order to secure bank funding.

Implicit support from local governments was a critical driver for the rapid development of the LGFPs, given the emphasis by banks on low NPL ratios. Typically, the establishment of LGFPs was supported by initial capital injections from local governments, mostly in the form of land use rights (Figure 7.7). Moreover, implicit government support permitted funding at more favorable terms, as local governments’ fiscal revenues and collateral, such as land, acted as an implicit guarantee for the repayment capacity of LGFPs. All in all, LGFPs could leverage on the reputation, fiscal revenues, or guarantees of local governments, with which their incentives are largely aligned. In addition, in some cases—particularly smaller local banks—it is conceivable that local governments may have exerted pressures on banks to expand LGFP lending, given that a good relationship with their local government could permit banks to accrue business benefits.

Figure 7.7Typical Structure of Local Government Financing Platforms

Source: IMF staff.

The overly rapid growth of LGFP borrowing accounted for the accumulation of potentially sizable credit risks and amplified government contingent liabilities. The various potential risks embedded in LGFP-related exposures include the following:

  • Local governments’ conflicting incentives as principal agents for national economic growth targets under tight budgetary constraints are conducive to the potential accumulation of credit risks for the banks, which fund them. Local officials are motivated to fund a maximum number of largescale projects to support sufficient growth in their respective regions. This contributes to a trade-off between the scale of needed funding and the potential for the accumulation of credit risks, given that not all projects could be put to productive use.

  • Risks to LGFP-funded projects are linked to a sharper-than-anticipated downward correction in real estate and land prices. A potential correction in the real estate sector and a spillover to LGFPs could test the resilience of the banking system, as banks may face lower land collateral valuations, and may need to recall loans or halt debt rollovers. Given that many LGFP-funded projects are financed via long-term loans disbursed in phases, earlystage long-term projects may face difficulties reaching completion and repaying outstanding debt.

  • The incentive structure of Chinese banks may exacerbate such risks in view of (1) previous use of implicit and/or explicit local government guarantees, which may have subdued perceived risks by banks at the time of underwriting; (2) deficiencies in banks’ ability to carry out adequate risk pricing and credit underwriting; and (3) limited motivation to recognize potential credit losses in a policy environment that emphasizes maintaining low NPL levels.

Key Policy Issues

Going forward, it is important to ensure that domestic banks set credit policies based on commercial considerations, independent of government objectives. In this respect, it would be useful to establish clear, nonoverlapping mandates between policy and commercial banks, with development functions fully allocated to policy banks. In addition, decoupling the government’s monetary and fiscal objectives from reliance on commercial banks would eliminate undue influence on the decision-making of those banks. In this regard, it would be necessary to increase the use of indirect monetary policy instruments (such as required reserves), curb reliance on quantitative credit targets, and do away with window guidance.

Work toward further liberalization of domestic interest rates should be given a top priority. A shift away from policy-determined interest rates would lead to stronger price competition that would induce banks to price risks more effectively, allowing them to manage funding costs to reflect those risks. Liberalization could lead to the compression of net interest margins on the back of intensified domestic competition. The key to successful liberalization is to ensure that banks are able to absorb higher levels of risks without posing a danger to domestic financial stability. Banks would need to significantly improve their risk management practices to be able to absorb such risks. In fact, the authorities are already moving in this direction, most recently providing banks with some discretion to raise deposit rates above the existing cap.16

Further capital market deepening would expand the range of investment opportunities and contain the channeling of savings to the shadow banking sector. The development of capital markets would also (1) increase the allocational efficiency of the domestic financial system by providing households with alternative investment channels to low-yielding bank deposits; (2) heighten banks’ attention to risk-return trade-offs, given the likely contraction in the availability of domestic deposits; (3) provide a source of noninterest income for domestic banks; and (4) decrease the degree of complacency in banks’ liquidity management that may have developed as a result of the ample liquidity and stability of the domestic deposit base.

While the authorities have already introduced measures to curb LGFP-related risks, policy responses need to be more nuanced and respond to risks in particular market segments and locales. Such responses would require more transparency, and hence better information, about the scale and nature of banks’ exposures. For example, apart from their size, LGFP funding mechanisms and the viability of many of the projects undertaken remain unclear. Moreover, the differences in the nature of the exposures of banks across locales and by type of bank—which may account for divergent vulnerabilities across the banking system—are not reflected in estimates of potential buffers. Also, at the local level, the authorities need to curb structural fiscal revenue-expenditure mismatches and limit incentives for excessive risk-taking to contain potential financial stability risks.

Further reforms should also seek to constrain the structural incentives that induce growth in the unregulated shadow banking sector. Specifically, the lack of sufficient risk-pricing mechanisms in the mainstream banking sector adversely affects the ability of banks to service borrowers with higher risk profiles than large SOEs. The introduction of a broad set of reforms—including a gradual withdrawal of the state from its dominant role in the financial system, further interest rate liberalization, and further enhancement of banks’ risk management systems—could support more robust bank lending to higher-risk borrowers that are currently serviced by unregulated institutions. In addition, the government may want to consider legalizing unregulated financial institutions, while expanding the perimeter of regulation and supervision to such entities to curb potential system-wide risks. The policy initiative of formally registering illegal banks as microlenders—first introduced in the Wenzhou and Zhejiang Provinces and the Chongqing municipality in 2008–09—may be a useful pilot for moving further in the direction of integrating these institutions into the formal system. System-wide monitoring of financial sector risks is pivotal both from a monetary policy and financial stability point of view.

The risk management frameworks of banks need to be improved to enhance risk-taking and improve resilience to potentially adverse economic conditions. Perhaps most importantly, banks need to shift to active risk management that reflects the ongoing concerns of their own bank management or board of directors, rather than merely following regulatory guidance. Risk management practices should be both geared to bank-specific issues and be preventive in character, in that they should be conducted to prevent or at least mitigate potential losses. More rigorous analysis of potential loan performance risks, for example, could indicate reductions in exposures to specific sectors that may not be viable from a bank’s risk-return viewpoint. Such analysis would also capture sector-specific market supply and demand effects, and lead to a natural slowdown in lending when imbalances appear likely. In addition, commercial banks would need to enhance the evaluation of risks under the varied economic and market conditions at loans’ points of origination. Banks should also enhance the quality and scope of the underwriting features of their loan activities; assess and manage collateral associated with loans on an ongoing basis; and improve risk management practices to support their going-concern values. Finally, domestic regulators should consider pooling data on key risk factors and exposures across banks—including geographic and sectoral exposures and corresponding probabilities of default and loss-given-default—in order to support more robust assessments of bank-related risks that account for variability in regional and sectoral economic conditions.


The five LCBs are the Industrial and Commercial Bank of China (ICBC), Bank of China (BOC), Agricultural Bank of China (ABC), China Construction Bank (CCB), and Bank of Communications (BComm). The 12 joint-stock commercial banks are China CITIC Bank, China Everbright Bank, Hua Xia Bank, Guangdong Development Bank, Shenzhen Development Bank, China Merchants Bank, Shanghai Pudong Bank, Industrial Bank, China Minsheng Bank, Evergrowing Bank, Zhe Shang Bank, and Bo Hai Bank.

The HHI ranges between 0 and 1, and is estimated as the sum of the squares of banks’ market shares in the banking system’s total assets.

Savings deposits are open-term deposits that do not incur early withdrawal penalties. Generally, there is no cost for depositors to shift away from savings deposits because, unlike time certificates of deposit (CDs), they do not have predetermined maturities and do not incur penalties for premature withdrawals.

See Burdekin and Redfern (2009) for the relationship between savings deposits and equity market returns in China.

Higher household savings withdrawals translate into higher government and corporate savings via land and housing sales. In China, all land is owned by the state, with a significant portion of local government revenues derived from the sale of land usage rights. Corporates, particularly many large, centrally owned SOEs, include real estate developers with significant power in bidding up the price of land.

The housing sector reform has been a catalyst for the sizable expansion of mortgage lending in recent years. The reform has had a tangible impact on banks’ housing-related lending in two ways. The first impact is through the rapid evolution of the housing market following the monetization of housing allocation set forth by the Notification of the State Council on Further Deepening of the Urban Housing System and Accelerating Housing Construction, introduced in 1998. By explicitly prohibiting employers from direct provision of housing to employees, the Chinese authorities effectively opened up the housing market to private developers and indirectly to bank-based financing. The second impact has been through introduction of a series of rules and regulations on mortgage lending, such as management measures on individual housing loans (1998), which set base lending standards such as loan-to-value ratios and mandatory income verification.

Key personnel appointments are normally carried out by the Organization Department of the Communist Party of China Central Committee.

The annual report states that “[i]n the meantime, the CBRC required banking institutions to actively optimize their credit portfolio and allocation, so as to give bank credit a full play in the transformation and restructuring of the national economy. Specifically, banking institutions were urged to increase agricultural and SME loans, develop green credit, support energy-saving enterprises and projects, provide consumer credit for purchasing first homes, household appliances, automobiles and agricultural equipment, and facilitate key projects in line with national industrial policies. Overall, the banking industry played a pivotal role in underpinning economic recovery and restructuring in 2009” (CBRC, 2010, p. 8).

See CBRC’s Guidance for the Governance and Supervision of State Owned Commercial Banks (GaS-LCB), issued in April 2006, which defines required performance criteria for domestic banks, including a minimum NPL ratio of 5 percent and returns on investment of at least 0.6 percent (Article 6.1).

Entrusted loans are loans extended by a financial institution to a borrower expressly designated by a specific depositor, and subject to depositor-specified terms about the amount, structure, and purpose of the loans. The financial institution thus acts as an agent for the funds entrusted by the depositor. The considerable increase in entrusted loans in China has been related to the strict ban on direct bilateral borrowing and lending between commercial entities under existing regulations.

The RMB 8.5 trillion estimate is by Nomura Securities as of November 2011, while the estimate of RMB 14 trillion to RMB 15 trillion is by Société Générale as of June 2011. UBS puts shadow bank lending at RMB 10 trillion as of October 2011.

Société Générale estimates underground banking to account for RMB 3 trillion to RMB 4 trillion as of June 2011; UBS puts its size at RMB 3 trillion (October 2011); and Credit Suisse estimates it at RMB 4 trillion (September 2011).

The tightening of banks’ credit limits leaves commercial banks largely targeting large SOEs, given the priority put on such loans. This creates a potential for a freeze of credit to certain borrowers, such as SMEs.

Such transfer of credit risks prompted a temporary regulatory hold on further securitizations and a requirement for banks to reincorporate trust loans on their balance sheet by August 2012.

Credit Suisse (2011) estimates that roughly 60 percent of informal lending is funded by mainstream banks through various channels (including SOE relending), 20 percent by private entrepreneurs, and about 20 percent by individuals.

As of June 7, 2012, the PBC permits banks to set deposit rates at up to 110 percent of the benchmark rate, above the prior requirement to match the policy rate.

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