How to fix China's banking system

Old bad debt hasn¡¦t been fully resolved. New bad debt is piling up. Yet the problems can be cleared up without a systemic crisis.

China is slowly coming to terms with the enormous stock of bad loans that burden its banking system. Its financial regulators¡Xthe People's Bank of China and the Chinese Banking Regulatory Commission¡Xhave upgraded the country's loan classification system to uncover problem loans more quickly and consistently, established asset-management companies to help banks dispose of their nonperforming loans, and used billions of dollars from China's vast foreign reserves to sustain insolvent banks until the problems can be resolved.

Actively managing the current stock of nonperforming loans¡Xespecially cleaning them up more quickly¡Xis a critical first step in righting China's banking system. The Chinese regulators must, however, go beyond merely fixing the mistakes of the past and confront an additional source of instability: a flow of new bad debt. Our frontline experience tells us that Chinese banks continue to make astounding numbers of questionable loans atop the existing pile. Any failure by regulators to control these bad lending practices may put China's future prosperity at risk.

China's banking system can safely sustain annual loan growth of only 5 to 7 percent, far below the level needed to check unemployment

Since the country's capital markets remain largely underdeveloped, banks serve as the primary source of long-term funds. Bank lending would have to expand by about 15 percent a year for China to meet its target of 7 to 8 percent annual growth in GDP. Yet as a result of the amount of bad debt that must be written off¡Xto say nothing of the banks' low profitability and limited credit skills¡Xwe estimate that China's banking system can safely sustain annual loan growth of only 5 to 7 percent, which is far below the level needed to maintain economic momentum and keep unemployment in check. The higher growth rate can be sustained only if regulators, banks, and investors collaborate to achieve a step change in risk-management skills.

China's regulators must overhaul the banking industry if they are to get a handle on this new generation of bad debt. Our banking experience in China and other developing markets leads us to recommend a specific series of actions. The regulators must introduce better corporate-governance practices to curb the ability of influential organizations and people to meddle in the lending decisions of banks, improve their risk-management practices, and limit fraud. Banks must recognize their new problem loans more rapidly. They and those who work for them must become more accountable for their lending decisions. Finally, they must adapt and manage their loan portfolios by the lights of explicit, world-class credit-risk-management guidelines and strictly enforce compliance.

Accelerate the cleanup of existing nonperforming loans

In recent years, bad loans have soared alarmingly. By the end of 2004, their value, as reported by the Chinese Banking Regulatory Commission, had reached $205 billion¡X13 percent of total banking assets. Even these figures may underestimate the extent of the problem.

Nevertheless, China's banks have proved surprisingly resilient. While their stock of bad debt is high by any measure, it doesn't seem likely to pose an immediate threat to the banking system's stability. Yes, most banks in China are technically insolvent, as their nonperforming loans far exceed their equity. But these institutions are still highly liquid thanks to a large retail deposit base that continues to expand as a result of a robust economy and thrifty consumers whose savings equal 40 percent of China's GDP.

Chinese authorities have also demonstrated a willingness to fend off bank failures by drawing from the country's more than $400 billion in foreign reserves. In 2003, for example, the central bank injected $22.5 billion into both the Bank of China and China Construction Bank (CCB), two giant state-owned institutions weighed down by bulging bad-debt portfolios. Some of these funds helped resolve loans made to state-owned and quasi-state-owned enterprises and to provincial development projects.

If the economy holds up, the bad-debt problem may be manageable, but regulators still can't relax. Despite recent efforts to speed up the recovery of these loans, China's asset-management companies have sold only a small fraction of those transferred to them. Inexperience in this area and the lack of a vibrant vulture-fund industry that specializes in buying distressed assets partly explain the lack of progress.

In addition, banks in China have a disincentive to sell their distressed assets because once they do, they must recognize a loss. Nevertheless, experience elsewhere suggests that the quick disposal of such assets is the right way forward, since the longer a bank waits, the less value it recoups from the sale. Faster recovery of nonperforming loans will also remove a drag on bank earnings by reducing charge-offs and the need to build up reserves. It will also free capital and therefore improve the ability of banks to supply the credit that China's businesses so desperately need.

To increase the amount of bad debt ready for disposal and to have it disposed of more quickly, regulators should give banks and asset-management companies specific targets. Progress¡Xor the lack of it¡Xshould be made public, and the senior managers of these institutions should be held accountable.

Stanch the flow of new nonperforming loans

As banking regulators push to speed up the disposal of nonperforming loans, they must also fix a more serious problem: the flow of new ones into the system. If such loans should continue to increase at the current rate, or if the economy slows dramatically, bank failures may be inevitable.

Smaller institutions¡Xa particular problem¡Xhave relatively little financial capacity to withstand shocks as well as fewer skills and less money to build them than large banks do. They also get less attention from regulators. If they continue to generate nonperforming loans, depositors may lose confidence and withdraw money in favor of stronger institutions or newer investment opportunities such as mutual funds and insurance. Until now, Chinese bank customers have had few alternatives to a small number of underperforming state-owned banks that offer identical bread-and-butter products, such as savings accounts, deposits at regulated rates, and mortgages. But this shortage won't last as the banking market is opened to meet China's commitments to the World Trade Organization, rates are liberalized, and new bank and nonbank competitors (such as mutual-fund providers) emerge.

Resolving current bad debt has been tough, but regulators will probably find that actively managing the continuing flow is even harder¡Xbecause doing so will require nothing less than the creation of a modern banking industry with a strong credit-risk-management culture. Regulators should expect enormous resistance on several fronts: provincial and municipal governments that rely on banks to finance local businesses, banking executives who fear a loss of power because they will no longer be able to make lending decisions relatively free of supervision, and the industry's hundreds of thousands of employees, who worry about job security in a changing world. To build a modern system, regulators must revamp the corporate governance of banks to improve their risk-management practices and diminish the government's influence over lending, increase their financial transparency (especially the reporting of nonperforming loans), and strictly enforce compliance with world-class lending guidelines.

Improve corporate governance and cut state influence in lending

Effective corporate governance¡Xthe first line of defense in managing bank risk¡Xensures that authorized, accountable people make decisions and establishes checks and balances that minimize conflicts of interest, collusion, and fraud. Many Chinese banks lack even the most basic components of good corporate governance. The problem runs deep, extending well beyond the highly publicized examples of governance failures at larger institutions exposed to the scrutiny of capital markets. The prevalence of fraudulent lending in many Chinese banks is stark evidence of the gaps in governance, oversight, and risk management: at one bank, fraud was involved in about a third of new nonperforming mortgages (as opposed to less than 1 percent in most developed countries). Many loans had fictitious addresses, with no property as collateral. Some mortgage holders received money for properties they didn't own. Poor governance, left unaddressed, makes it harder to implement tighter risk-management policies, and such problems erode the investor confidence that Chinese banks rely on to raise funds in global markets.

Many Chinese banks lack even the most fundamental components of good corporate governance

Even so, there has been some progress. The boards of some of the largest banks, such as the CCB and the Bank of Communications, have been restructured to a certain extent: they are smaller now, and foreign bankers have replaced a number of government officials. But these measures have largely failed to address the heart of the problem, which is the state's pervasive hand in often well-intentioned though unprofitable lending decisions. The government not only fully owns the big four banks but also, directly or indirectly, controls 95 percent of the assets of most others through shares held by local municipalities and state-owned enterprises outside the banking sector. There are no private banks, and foreign ownership is still extremely limited, despite a handful of high-profile investments by the likes of Citibank, HSBC, and Standard Chartered.

Nonetheless, the state's influence over lending decisions has become more transparent. A little over a decade ago, banks existed essentially to disburse money for the Communist Party. Doling out loans to finance loss-making state-owned factories in far-off provinces was accepted practice to maintain centrally planned production targets and employment levels. Today, some banks try to understand and monitor their real risk-management skills and performance by tagging bad loans (in their books) to distinguish between those made on commercial grounds and those extended, historically, at the behest of the central authorities or local governments. Although state-directed lending has slowed down significantly, certain banks and their officers still feel pressure from local party officials or local businesses with political connections to make uneconomic lending decisions.

Unfortunately, the measures adopted to improve corporate governance focus on the largest banks scheduled for initial public offerings in the next few years. Exercising tighter control over a handful of large banks is far simpler than transforming corporate governance in the 120 or so smaller regional and local banks and the nearly 30,000 credit cooperatives, which command 40 to 50 percent of total banking assets in China. These smaller institutions are particularly prone to corrupt lending practices but harder to regulate because they are so numerous and geographically dispersed.

Despite these challenges, regulators must address the fundamental issue of state interference by working with the government. Until now, its approach has been to sell small stakes in several banks¡Xa practice that hasn't eliminated its influence over lending¡Xrather than sell banks outright. The government should devise a plan for the orchestrated and rapid sale of its direct or indirect stake in the 120 institutions not slated to go public in the near future. Many should be sold to private investors, including foreign banks and private equity funds.

Permitting foreign ownership would inject fresh capital into the industry and remove moral hazards by taking the state completely out of credit decisions; a private owner can make them without considering government objectives such as the development of certain regions or sectors. Privatization would also give Chinese institutions a chance to see how foreign companies run the banks they acquire: in November 2004, for instance, Newbridge Capital¡Xwhich had recently bought an 18 percent stake in Shenzhen Development Bank, thereby effectively gaining control¡Xreplaced the CEO and other top managers and installed a new executive team. Foreign banks don't necessarily target the most senior positions in the Chinese banks they acquire; rather, they tend to install their own people in critical roles such as risk management. Western banks also rotate people frequently (every five years for branch managers in some markets) to avoid fraud and "capture" by clients.

Removing the state from bank lending will be neither quick nor easy. Even as the Chinese government privatizes other sectors of the economy, it is reluctant to relinquish control over this one, since lending has traditionally been its chief instrument for controlling the economy. True, the government has begun to loosen its grip on interest rates by letting banks adjust them more freely within a widening range. But it has a long way to go before it, like central banks in the West, manages the economy solely through macroeconomic tools. Moreover, the government remains unwilling to let banks fail, because of the impact not only on thousands of employees but also, possibly, on millions of depositors.

The Chinese government should start reducing its stake in the banking system now, even if, given the size of the job and its political and economic ramifications, it might take many years to complete. In the meantime, regulators can improve bank governance by taking immediate action, such as setting explicit standards for the nature and composition of various bank committees (such as those for audits and risk management), the qualifications and mix of executive and outside directors, and the role and rotation of auditors. Regulators should also take an active role in monitoring compliance and make their findings public.

We acknowledge that the privatization of banks presents potential issues, including anxiety on the part of depositors about the absence of state backing and the misuse of depositor funds by the new owners. But we think the long-term risk of inaction outweighs the difficulties associated with privatization. Until the government removes itself from the ownership of banks¡Xand the accompanying direct influence over them¡Xit will never really act to improve their corporate governance and risk management or to create a credit culture that supports rational lending.

Increase transparency around bad debt

Many Chinese banks don't recognize bad loans, because even if they are nonperforming on a cash-flow basis they don't meet certain technical criteria. Case in point: a loan whose interest is being paid by a business that isn't generating the cash needed to repay the principal. In China, some banks often consider such a loan to be performing, though the principal is clearly at risk. If a bank doesn't recognize a loan as nonperforming, it won't take the appropriate charges on its books, and reported profits will mislead regulators, investors, and customers. Actually, the bank should be building up reserves in the expectation that the loan won't be repaid.

Since introducing a consistent loan classification system several years ago, the regulators of China's banks have made some progress getting them to report their nonperforming loans. The system defines different levels of risk classes and establishes when banks must reserve funds and how much: for example, a bank has to build up reserves equal to 100 percent of a loan's book value if the principal isn't paid. This new system represents progress, but much work lies ahead to improve financial transparency in general and the reporting of nonperforming loans in particular.

Drawing on lessons from South Korea, the United States, and other countries, regulators can take several additional steps. First, they can put any bank with bad loans under specific supervisory action requiring the bank to report more frequently on its progress in resolving its asset problems. Second, they can insist that such a bank undergo strategic reviews to explain in detail its plans to resolve its bad assets. Third, they can hold progress meetings with its officers every month rather than every quarter. Finally, the bank can be encouraged or required to set up its own internal workout unit or separate "bad bank" to manage its problem-loan portfolio, just as Mellon Bank did successfully in the United States during the 1980s. This final step allows the bank to go on serving customers while isolating its bad-debt problem.

Enforce compliance with lending guidelines

If China hopes to stem the flow of new bad loans without starving its economy of the capital needed to grow, it will have to face up to the core issue: poor credit-risk-management skills, which are hard to overstate. When a major bank reviewed 60 percent of its lending in one region, for example, it couldn't determine which industry had received a given loan, what collateral was provided for it, or even who had made the lending decision.

Promoting the development of appropriate skills in assessing and pricing credit risk must therefore be at the top of the list for banking regulators. Unlike the disposal of existing bad debt through asset sales and securitization¡Xtasks that can be accomplished at the stroke of a pen¡Ximproving credit risk management is a massive, multiyear effort in any market. In China, the magnitude of the undertaking is all the greater because so many banking assets are fragmented across institutions and geographies.

In the short term, banking regulators ought to cooperate with industry leaders to develop and implement detailed risk-management guidelines. At the very least, the guidelines would require every bank to appoint its own chief risk officer (a position that is increasingly common in the banks of developed markets) and to be capable of reporting, on a weekly basis, the loans it approves and the new risks it adds to its books. In addition, they should set out the minimum level of skills and qualifications required of bank officers involved in lending decisions. Some of the larger and more sophisticated Chinese banks have already made such changes; many others, particularly smaller regional institutions, have not.

Significant IT investments will eventually be required to bring Chinese banks up to best practice. Nevertheless, the recent experience of some of the largest state-owned institutions shows that risk-management systems can be substantially improved, using existing resources, within months. Unlike most Western banks, many Chinese ones have relatively modern core banking systems and simple products. Much of the required improvement involves process changes rather than a rebuilding of the IT infrastructure.

To make banks fall into line, regulators will have to monitor compliance and, after an appropriate transition period, consider the idea of publicly listing those that don't comply. This kind of monitoring can be undertaken fairly quickly and requires relatively limited investments in IT. But Chinese banks that will remain unlisted have no apparent interest in improving their risk-management practices and are likely to resist moves by banking regulators to focus the lens of accountability on their past and current lending decisions. As a result, the regulators must act more forcefully than they have in the past, by exercising their power to demand corrective action, issuing cease-and-desist orders against certain bad practices, and, as a last resort, revoking bank licenses. Until now, regulators have given Chinese banks a free ride regardless of their performance¡Xnot a single license has been revoked.

Moving to a performance- and risk-based supervisory system is another necessary step. China's regulators can learn from Southeast Asia, where many countries require credit processes to be certified and only banks that meet certain standards can have their licenses renewed. But a lack of skills often makes it hard for Chinese banking regulators themselves to distinguish between good and bad credit-risk-management systems. The regulators must upgrade their own capabilities now and move to adopt internationally recognized best practices. Pressure to become more vigilant will grow as banks gradually move into the hands of private investors and the banking market becomes increasingly competitive.

China's banking system is not in immediate danger of collapse but does face serious problems. Letting them fester will increase both the risk of a large systemic financial crisis and the cost of the remedy. In our experience, most governments find it hard to act decisively without a crisis. Still, regulators can take any number of steps to improve the lending decisions of banks and to put the financial sector on a stronger foundation so that it can support sustained economic growth. No plan will work unless the government makes a complete and unwavering commitment to go on accelerating the disposal of existing bad loans, to stop the flow of new ones, and, ultimately, to build a stronger banking system through better governance and risk management.