BRIC Spotlight Report

Chinese Banks have become World Class Institutions

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Fast Facts The Industrial and Commercial Bank of China (ICBC), the country’s largest bank, is also the world’s largest by market capitalization. Its IPO in 2006 still stands as the world’s largest. Based on 2009 Tier 1 capital, ICBC, the China Construction Bank (CCB) and the Bank of China (BOC) rank among the top 15 world banks. China’s five largest commercial banks and its three policy banks hold 60% of the country bank assets, with only 2% owned by foreign banks. Since the 1978 initiation of China’s move toward a market directed economy, its total banking assets have increased 388 fold. Between 2003 and 2008, total deposits of banking institutions jumped 117% and total loans increased almost 89%. Non-performing loans in the Chinese banking sector have declined from 18.0% in 2003 to 1.6% in 2008. The Chinese banking sector employs over 2.7 million people. The undeveloped rural market holds tremendous potential for banking growth due to its 750 million people and a growing number of small businesses. February 2010 Struck down by the financial crisis that was centered in the United States and Europe, the world economy suffered deep declines in late 2008 and early 2009. In China, policy makers were fearful of the possible repercussions of not creating jobs for the ongoing tidal wave of rural youth flowing into its growing urban centers. As such, marching orders were given to China’s major banks to immediately grant a massive increase of new loans at favorable terms. In contrast, bankers in the rest of the world also received monies and encouragement from their central reserve banks. But given greater management choice than in China, they were hesitant to increase lending to businesses under financial duress, fearing a further increase in their growing loan defaults. This sharp difference in management response- lock step obedience in China versus the rest of the world’s hesitant self-interest to prevent loss- explains why the policy effect was so dramatic in China, both in terms of its speed and its scale versus the economy. New Yuan-denominated loans surged to 9.59 trillion ($1.4 trillion) in 2009, more than double the 2008 level. Stimulus in the U.S. also occurred quickly, but only because its capital markets (bonds and stocks) responded rapidly, and these are the primary source of corporate funding in America. The result was that China via its banks, together with the United States, led the world out of what would otherwise have been a long and deep recession. How did the stimulus affect China? Its GDP expanded 7.9% in the second quarter, followed by a resounding 8.9% in the third and 10.7% in the fourth. Full-year GDP growth was 8.7%, exceeding the government’s 2009 target of 8%. There is no doubt that there were potentially dangerous downsides to the Chinese government’s rush in November 2008 to lend a massive $586 billion package. But there is no denying the action was the critical factor ensuring China’s recovery to high single digit growth in 2009. Government policy directed an immediate lending surge in late 2008. Now a 2010 directive has slowed down the lending pace.

Source: People's Bank of China

Will this recent surge in loans cause a return to the huge level of bad loans that saddled the banking system at the beginning of the new millennium? That future answer will depend on the lending disciplines that were followed in making the loans. And it will also depend on whether the loans were made to businesses that were investing in areas where capacity will be needed in China.

Top 10 Banks by Assets Rank Bank Total Assets ($ millions) 1 Industrial & Commercial Bank of China 1,427,610 2 China Construction Bank 1,105,471 3 Agricultural Bank of China 1,026,300 4 Bank of China Limited 1,017,130 5 China Development Bank 558,936 6 Bank of Communications 392,554 7 China Postal Savings Bank 326,362 8 China Merchants Bank 229,976 9 Agricultural Development Bank of China 198,205 10 Shanghai Pudong Development Bank 191,588 Source: BankScope

In the past, loan decisions relied more on politics than economics, with the resultant over-capacity resulting in excessive loan defaults. Ill-advised loans could also, both directly and indirectly, cause soaring real estate prices and stock market bubbles. One of the main challenges for China, as it evolves from a centrally-planned economic model to a market-directed model, is whether it can develop an army of independent bank and capital market professionals who can act as market participants and allocate capital in a way that leads to stable growth, both for the economy and for the individual bank and investment firms.

Market Structure: Dominance of the ‘Big Four’

With over 5,600 banks at the end of 2008, the Chinese banking sector includes a wide variety of institutions. These include policy banks, large and medium-sized commercial banks, and a network of credit cooperatives in both rural and urban areas. The China Banking Regulatory Commission (CBRC) shows the total assets of the banking system rose to 78.8 trillion Yuan ($11.54 trillion) in 2009, an increase of 26.3% year-on-year. Since China launched its economic reforms in 1978, the shift from a centrally planned banking agency to today’s

structure has meant a 388-fold increase in assets, a 21.2% annual growth rate. The banking sector now satisfies 80% of the country’s demand for capital, a ratio that will align with the future development of the modern fixed-income markets and equity-oriented retirement plans in China.

Despite the large number of financial institutions, over half of the assets in Chinese banks are concentrated in four banks whose shares are majority-owned by the central government. By size, these include: 1) the Industrial and Commercial Bank of China (ICBC); 2) the China Construction Bank (CCB); 3) the Agricultural Bank of China (ABC); and 4) the Bank of China (BOC).

China’s “Big Four”

The size of China’s “Big Four” banks has earned them positions on Fortune Magazine’s 2009 list of the top 500 global companies. If one were to use year-end 2009 closing prices of the small percentage of their shares that currently trade as H Shares on the Hong Kong Stock Exchange, the extended valuation of the ICBC and CCB would rank them as the largest two banks in the world.

ICBC directs most of its lending to its original mandate, small and medium enterprises. This sector represents over 55% of China’s GDP and about 68% of its exports. The bank brought a minority of its shares public in October 2006, simultaneously on the Hong Kong and Shanghai Stock Exchanges. The dual IPO raised a record $21.9 billion, making it the world’s largest IPO. With profits projected to rise 15% in 2009, to $16.2 billion, ICBC should retain its position as the world’s most profitable bank.

Source: Annual & Interim Reports of the banks, 2008 & 2009

CCB’s traditional mandate as the second largest bank in China was to make mortgages for residential housing, although it now also emphasizes small enterprise and agriculture-related loans. In a strategic move aimed at rural banking, CCB recently announced plans to join hands with Europe’s largest bank, Banco Satander of Spain, to open banks in rural areas in China.

BOC is the oldest and the most international of the big four banks, holding more overseas loans. It is the fifth largest in the world by year-end 2009 market capitalization. The Bank of China (Hong Kong) was originally a Hong Kong division of BOC, but went public in 2001 as a separate entity. It now manages the Hong Kong branches of seven other banks incorporated in Mainland China.

ABC’s mandate has been to provide loans to the rural areas of China, with well over 50% of it loan book in this sector as of year-end 2008.

Strong Earnings Growth Bank 2008 2009 Q3 ICBC 36.0% 19.0% CCB 34.0% 18.6% BOC 14.4% 18.8% ABC 17.5% 13.0%

While ABC is solely government owned, ICBC and BOC are 30% investor-owned, and CCB is 43% owned by investors. ICBC, CCB and BOC are each dual-listed on the Shanghai Exchange and as H shares on the Hong Kong Stock Exchange.

Recent net income growth of the top four Chinese banks has been particularly strong, especially when compared to other major banks around the world. This level of growth will continue if the bank loan quality does not deteriorate, as can often happen when loans are issued faster than the ability of loan officers to properly assess the risks involved.

The regulatory framework

The People's Bank of China (PBC) started functioning as the country’s central bank of China in 1983. The Central Banking Regulatory Commission (CBRC) was formed in 2003 to assume the supervisory responsibilities of the banking system. The monetary policy instruments used by the PBC are quite traditional, including varying required bank reserve levels on loans outstanding, setting base interest rates and performing open market operations in local government bonds and foreign currency. Unlike the highly independent Federal Reserve of the United States, China’s monetary policy reflects the dictates of the long-ruling Communist Party political organization.

While in the first half of 2008, the PBC followed a tight monetary policy to address overheating concerns, its stance changed in the second half in response to the global financial turmoil. This crisis heavily affected China’s long dominant export sector, and hence, the bank cut reserve requirements and lowered interest rates. The reserve requirement for the larger financial institutions was cut by 2% and smaller institutions by 4%. The PBC also lowered the 12-month saver deposit rates and lowered lending rates to 2.25% and 5.31% respectively, a cumulative reduction of 1.89%. Other global central banks cut interest rates much more aggressively, to calm intra-bank liquidity fears. With next to no out-of-country lending, China’s rate reductions remain moderate.

As of early 2010, overheating and hints of asset price bubbles caused the Bank of China to tighten its monetary policy, increasing the required reserve ratio of loans by 0.5% for the banking industry for the first time since June 2008. This increased the reserve ratio for the larger banks to 16% and smaller banks to 14%.

Loan quality has improved dramatically

Until recently, China’s state-run banking system suffered from a poor lending discipline, so high non-performing loans (NPLs) and defaults were the norm. Plagued by deteriorating assets, China recapitalized its big three banks in the early 2000s, and further fragmented ABC in 2008. A new regulatory framework was introduced and enforced by the CBRC banking regulator and the international loan quality classification was adopted. The CBRC’s goal was to eventually raise the quality of bank management in China to world standards. Since then, the NPL levels of the Chinese banking system have been improving each year.

Limited presence of foreign banks

Foreign bank presence in China remains restricted, currently constituting just over 2% of the total banking assets. In December 2006, reflecting its commitment to the World Trade Organization, China removed all geographic and most business restrictions on foreign banks. But the authorities set regulatory requirements on retail banking, so effectively most global banks in this area are still restricted. As a result, foreign banks have only set up locations in the largest cities, with Shanghai home to 30% of the foreign bank branches.

Regulations restrict foreign ownership in a Chinese bank to a 20% or 25% with multiple foreign investors. American Express, Goldman Sachs and Allianz Investments hold stakes in ICBC. Bank of America is a shareholder in CCB and Singapore’s Temasek Holdings, the Bank of Tokyo Mitsubishi and the Asian Development Bank are investors in BOC.

Unaffected by the global financial crisis

Chinese banks have remained largely insulated from the global financial crisis compared to other international banks. The credit for this goes to the closed structure of the financial sector as well as a strict regulatory framework put in place by the regulators. Not surprisingly, while globally profits of banks were on a sharp declining trend in 2008, net profits of Chinese banks increased 37% in 2008 compared to 2007. Profits in this sector are expected to moderate to 14% in 2009, as the global slowdown severely dented the export-driven economy. Nevertheless, this performance remains creditworthy given the grim global economic scenario.

Rural commercial banks achieved the largest increases in profitability of over 80% in 2008, beating joint stock banks and city commercial banks, which clocked 41% and 30% respectively. With over 60% of its population belonging to the rural hinterland, it goes without saying that rural banking in the economy holds tremendous potential and promise. Rightfully, the economy has a large network of rural credit cooperatives, which can play an instrumental role in fulfilling the unmet credit needs of rural areas. However, they have not tasted much success as of yet. Sadly, most rural credit cooperatives have been plagued with losses, high NPL ratios, and also have had to deal with competition from informal lenders.