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China’s Banking Transformation: The Untold Story

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James Stent
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Library of Congress Cataloging-in-Publication Data Names: Stent, James, author. Title: China’s banking transformation : the untold story / James Stent. Description: New York, NY : Oxford University Press, [2017] Identifiers: LCCN 2016017268 | ISBN 9780190497033 (hardcover) | ISBN 9780190497057 (epub) Subjects: LCSH: Banks and banking—China. | Financial institutions—Government policy—China. | Finance—Government policy—China. Classification: LCC HG3334.S74 2017 | DDC 332.10951—dc23 LC record available at https://lccn.loc.gov/2016017268
9 8 7 6 5 4 3 2 1 Printed by Sheridan Books, Inc., United States of America
2. Culture Matters  25
3. Leninism and Pragmatism of China’s Communist Party  39
4. Transformation: From Bursars to Bankers  64
5. Bankers  100
6. Systems  123
8. Financial Structure: Deep but Narrow  166
9. Coming In and Going Out  189
10. China’s Banks, Sui Generis?  204
11. Collapsing or Adapting?  222
12. Reform Directions  243
In the course of my three years of service as an independent director on the board of  China Minsheng Bank, and ten years at China Everbright Bank— in total thirteen years spanning 2003 through 2016— I watched China’s banks transform from damaged relics of the planned economy into modern commercial banks. Although much further development is needed in the Chinese broader financial system, the change in the qual- ity of Chinese banks that I watched over those thirteen years can only be described as a “night and day” transformation.
Yet most accounts in the media, in financial analysis, and even in much academic work give little recognition to what has been achieved in the Chinese banking sector over recent years. Indeed, much of the literature, popular and specialized, is highly skeptical of the Chinese banking sector. The widespread acceptance of this negative view has led to writing this book in order to provide a different, and more balanced, perspective than is found in the consensus negative view.
My involvement with Chinese banking began on a summer morning in 2003, when I  walked into a reception room of the head office of the China Minsheng Bank for a meeting with the bank’s founder and chairman, Jing Shuping. Since its founding in 1996, Minsheng had maintained its head office in a venerable building on Zhengyi Road, just east of Tiananmen Square in the former Legation Quarter. Unlike much of Beijing, which has been extensively rebuilt, the former Legation Quarter around Zhengyi Road, including the Minsheng Bank head office, had remained architecturally intact. The well- preserved building was constructed in 1910 as the Beijing branch of the Yokohama Specie Bank. Architecturally it
viii Preface
is an Asian transplant of late nineteenth- century brick and stone Dutch architecture in vogue among Japanese at that time.1
China’s ongoing reforms had recently mandated modern corporate governance practice in listed companies such as Minsheng Bank. Under the new requirements, Minsheng’s board should include four independent directors. Jing Shuping had selected three Chinese professionals to be independent directors, but he also wanted to identify a foreigner with both banking experience and Chinese language ability to serve as the fourth independent director. Consultation with, the International Finance Corporation, a World Bank affiliate, which was advising Minsheng at that time, led to the suggestion that I might be a candidate.
An inner door of the ornate century- old reception room opened, through which walked Chairman Jing, dapper in well- tailored suit and tie, but walking slowly at the age of 83. Slight of frame and frail in appearance, he nonetheless exuded warmth, energy, charm, and a piercing intelligence. Born into a Shanghai capitalist family, he had assisted his father prior to 1949 in running the family’s manufacturing busi- ness, and was one of the capitalists who had chosen to stay in China after the civil war ended. The Cultural Revolution years were not kind to him, but he had endured and gone on to become one of the most respected and senior non- communist party figures in China during the ’80s and ’90s, serving as vice chairman of the People’s Consultative Congress and as chairman of the All- China Federation of Industry and Commerce. Through these positions, he developed a broad network of contacts in the emerging Chinese entrepreneurial world. Jing and several other leading entrepre- neurs in the All- China Federation proposed to the then- Deputy Prime Minister Zhu Rongji that a new commercial bank be established, to be owned entirely by private businessmen. Zhu backed the idea, and the Minsheng Bank was established in 1996, with Jing as chairman of the board, and shareholders who ranked among the wealthi- est of China’s new capitalists.
Our conversation ranged for half an hour across a variety of subjects, touching on cul- ture, travel, and of course banking. Chairman Jing indicated that I would be nominated as an independent director at the forthcoming annual general meeting of the bank’s shareholders, and thus began the Chinese portion of my banking career.
The circuitous path that had led me to that interview with Chairman Jing had begun in 1973, when I  joined Citibank of New York as a junior officer in its Asian Division. After brief training in head office, I spent four years in Citibank’s Philippine and Hong Kong branches. In Hong Kong I transferred to Crocker National Bank of San Francisco, which assigned me first to Hong Kong, and then to Thailand, where I lived and worked from 1979 through 2002, and again from 2007 to the present time.
Those eight years during the 1970s working in American banks comprised the first stage of my banking career. It was in those two banks that I absorbed the conservative
1 Li Luke and Hu Jiezhong, eds., Beijing Gujianzhu Ditu (Beijing: Tsinghua University Press, 2009), 204– 205.
Preface ix
tenets of an earlier era of banking practice. Those were the last years of the highly regu- lated era of banking that had been the norm in America since the New Deal reforms of the 1930s. Banking was a stodgy career choice. Yet the American banking system was then relatively stable and the postwar economy was going through a golden era of prosperity.
In those days at Citibank new recruits underwent intensive training in the basics of the profession. We rotated through every department in our training. From the tellers we learned out how to pay out and receive cash and how to balance ledgers at the end of the day, from the foreign department clerks we learned the intricacies of negotiating letters of credit, and so forth. The emphasis was on controlling risk, and on doing things properly. The bank’s thick accounting and procedure manual was our bible. I was imbued with the craft of banking, with the precepts of risk control, and with a strong sense of protecting the interests of the depositors and of the bank. Most of what I know and believe to be important about banking, I learned in those early years of my career.
That was the style of banking that had stood America in good stead during the first three prosperous postwar decades. But change was afoot, the Reagan revolution started in 1981, and the rational markets theories of economics gained broad support, providing the intellectual rationale for sweeping deregulation over the next twenty years. The culture and style of Citibank of today is far different from the Citibank for which I had worked.
At just that time, when the banking world was changing, I left Crocker and American banking to join a small, privately owned Thai bank, the Bank of Asia. I was to spend eigh- teen years with Bank of Asia, during most of which time I was its only foreign employee. The youthful CEO, Yos Euarchukiati, scion of the Sino- Thai family that was the domi- nant shareholder of the bank, realized that the days of old- fashioned overseas Chinese style banking would soon be over in Thailand. The bank would need to professionalize to meet the challenges of the rapidly developing economy of Thailand. First under Yos, and then under his successor Chulakorn Singhakowin, I worked as part of a team of Thai professionals to change Bank of Asia from a traditional into a modern bank.
My stints with the two American banks had provided me with the fundamentals of the craft of banking as it had been practiced in America prior to the deregulation era. The succeeding years with the Thai bank gave me an opportunity to work inside an Asian financial institution in a developing country, tasked to introduce international best prac- tice and bring about organizational change in a local bank. One of the lessons I learned at Bank of Asia was that change must be sequenced, that “big bangs” within an Asian organization were a likely road to failure. Another lesson was the importance of change management— ensuring that all stakeholders in the organization are fully supportive of the change agenda, and that their interests have been given due respect. If all stakeholders were not “with the program,” those left out could all too easily subvert the change agenda. I  learned to be patient with a pace of change that might seem unnecessarily slow, but which in the end would prove a reliable path to reaching our objectives. Those lessons in organizational change at the micro level would provide me with insights into understand- ing how the reform program worked in China at a national level.
x Preface
The years of modernizing and professionalizing the bank paid off. The Bank of Asia survived the systemic meltdown of the Thai economy during the Asian financial crisis of 1997— the bank’s sound management attracting a large capital infusion from ABN AMRO Bank of the Netherlands. From the crisis itself, and from the painful but quick recovery over the next five years, I learned not only about sustainable banking, but also about mac- roeconomic policy pitfalls in developing countries— real estate and stock exchange bub- bles, ill- advised monetary and foreign exchange policies, and the hubris that accompanies rapid economic growth, leaving a country vulnerable to unanticipated shocks.
In 2002 I retired from Bank of Asia, moved to Beijing, and worked on several projects there, including service on the board of Minsheng Bank. I developed the highest respect for Chairman Jing Shuping. Despite his advanced years, and despite having been cut off from the West for thirty years, Jing was keenly aware of international economic and financial currents, was extraordinarily progressive, and immediately grasped new con- cepts presented to him. The strong growth of the bank in those early years owed much to his leadership and vision.
Shortly after completion of my three- year term as an independent director of Minsheng Bank, I accepted an offer to be an independent director of China Everbright Bank. Both Minsheng and Everbright are listed on the Shanghai Securities Exchange, but Minsheng shares are almost entirely in the hands of private shareholders, whereas, following a recap- italization mandated by the State Council in 2007, the state, through several vehicles, is the majority shareholder of Everbright Bank.
I served two terms (the maximum allowed by governance regulations) of three years each as an independent director of Everbright Bank, starting in 2006 and finishing in 2012. During most of that period, I chaired the Board’s Audit Committee, and was also a member of the Risk, Strategy, Nominations, and Compensation Committees. The full board met at least five or six times each year. Committee meetings were held immediately prior to the full board meetings, altogether lasting two or three days. After the completion of my two terms as an independent director, I was elected one of two outside members of the bank’s board of supervisors, where I served until the completion of my term in 2016.
Widespread skepticism about Chinese bank quality prevails among both analysts and the general public. I acknowledge that my view that there has been a “night- and- day” transformation of Chinese banks since the 1990s is contrary to the impression conveyed by most foreign media accounts— which generally describe Chinese banks as fragile and inefficient, perhaps headed for crisis. This view has now become widely accepted outside of China. I find these views ill- informed, misleading, and perhaps imbued with a bias, sometimes conscious but generally unconscious, against a system that is avowedly “social- ist” at a time when adherents of neoliberalism and market capitalism are intolerant of alternative models.
I felt the need for a corrective to the prevailing gloomy and censorious view, so in 2012 I began the research and writing of this book on the banking transformation to which I  had been privileged to be a front- line witness. In the wake of the financial
Preface xi
collapse of 2008, the published academic analyses and popular accounts of the failures of banks in America and the United Kingdom have been of high quality and insightful. Collected together, they would fill several bookshelves. Curiously, although journal- ists and investment analysts have written frequently on day- to- day developments and problems in Chinese banking, only a handful of books, think tank specialist surveys, consultant and rating agency publications, chapters in larger overall studies on China’s economy, and academic articles have dealt with the development and prospects of Chinese banks, and most of these are not easily accessible to the non- specialist. I hope this book fills that gap.
Unlike more academic treatments, or journalistic accounts, I have not written from the vantage point of an outside observer or researcher. This book is an account of banking told by a professional banker, with the benefit of access within banks and of input from many Chinese and foreign banking practitioners. This book is not, however, intended to be an authoritative or scholarly history of the development of Chinese banking over recent decades. Such a book is much needed, and hopefully will be written.
China is the second largest economy in the world. A banking crisis in China would have enormous impact on China’s economy, and that would rapidly turn into a global economic and financial crisis. Moreover, as China moves beyond Deng Xiaoping’s for- eign policy of “hiding its light” and asserts itself internationally, how China manages the stability of its banking system, how its banks expand overseas, how its financial system becomes more open and integrated with global systems, and what China thinks about global financial architecture take on global importance. It is therefore imperative that anyone concerned with China’s political economy should have a deeper understanding of China’s banking system than perusal of the media provides.
Development of the Chinese banking sector, lying at the heart of the nation’s economy, can serve as a case study for understanding what happens in other sectors of China’s econ- omy, even in non- economic areas. It is my hope not only that readers will take away from this book a clearer picture of Chinese banks, but also that an understanding of the bank- ing sector will provide a prism through which to understand how China as a whole works.
The introductory chapter, “China’s Hybrid Banks” sets forth the overall argument of the book that China’s banks are hybrid creatures, operating in most ways like mod- ern Western banks, but designed to serve the real economy under the guidance of the Communist Party in a market socialist political economy. The hybrid character of Chinese banks combines extensive borrowing of Western banking practice and concepts of corporate governance with traditional Chinese beliefs in how society and the political economy should be ordered. The result is a banking system that has effectively contrib- uted to national economic growth, but which has attracted a plethora of foreign criticism because it does not adhere to conventional Anglo- American concepts of how modern banking systems should run.
China’s banking transformation story would not be comprehensible to non- Chinese readers without explanation of how China’s culture and historical development have
xii Preface
influenced contemporary Chinese banking, and how Chinese banks fit into the broader political economy. Too often misunderstanding of Chinese banking practice and poli- cies stems from viewing the Chinese system through the lens of a non- Chinese, and par- ticularly Anglo- American, ideological framework that does not take sufficient account of the very different culture and political economy in which Chinese banking is embedded. Chapters 2, “Culture Matters,” and 3, “Leninism and Pragmatism: China’s Communist Party,” provide essential background on Chinese culture and political economy to make the main narrative of the banking transformation comprehensible in the broader context of how China works today. They explain how the persistence in contemporary China of Confucian views of how society should be ordered provide the rationale for strong party- state control of the banks. They also explain the “why” and “how” of the Party’s role in Chinese banks, particularly through its powerful Organization Department, which controls senior appointments in the banks.
Chapter 4, “Transformation: From Bursars to Bankers,” provides a chronological nar- rative of the development of Chinese banking over the years since Opening and Reform commenced in 1976. It relates the principal phases of development, the search for a model of banking that would suit China’s needs, and the financial turmoil of the 1990s, which led to recognition of the priority that should be given to development of a healthy bank- ing system and thus to Zhu Rongji’s dramatic reform program to transform banking into a modern system.
Having related how the transformation took place, Chapters 5 and 6 describe Chinese banking as it is today. Chapter 5, “Bankers,” discusses how Chinese banks are managed and governed, the quality of human resources, and the role of the Communist Party in banks. Chapter  6, “Systems,” is a more technical chapter discussing the credit qual- ity and risk management, internal controls and auditing, IT capabilities, strategies and nature of competition of Chinese banks. These two chapters are heavily based on my own understanding of how Chinese banks work arising out of my service on the boards of two banks, corroborated by a large number of Chinese and foreigners with sound knowl- edge of Chinese banking from various different perspectives. What I have written in these chapters has been confirmed by other foreigners and Chinese with firsthand knowledge of Chinese banks.
Chapter 7, “Power of the State,” describes how the state exercises control over the bank- ing system indirectly through its coordination of the resources of the “national balance sheet” and directly through ownership of banks and through the financial regulatory authorities.
The achievements of the government in expanding financial access broadly through society and the economy are contrasted with the underdevelopment of “direct finance”— the bond and equity markets— in Chapter  8, “Financial Structure, Deep but Narrow.” Chapter 9, “Coming In and Going Out,” describes the restricted but nonetheless impor- tant role that foreign banks play in the Chinese system, and the challenges that Chinese banks are facing as they expand overseas.
Preface xiii
Is China’s present banking system, as described in this book, entirely a creature of the present communist regime, or has it arisen out of Chinese ways of organizing the political economy that predate communist control of the country? Is the way in which banks oper- ate within the broader political economy unique to China, or does the Chinese experi- ence bear similarities with the experience of other countries? These questions are explored in Chapter 10, “China’s Banks, Sui Generis?,” through a retrospective of Chinese banking from late imperial times up to the end of the Republican era in 1949, and through looking at two of the other Asian developmental states, Japan and South Korea.
The arguments of those who believe China’s banking system remains fragile and head- ing for crisis are examined in Chapter 11, “Collapsing or Adapting?,” followed by a sketch of the principal challenges facing Chinese banks— particularly asset quality issues and the threat from nonbank digitally based competition. The likely course of future banking reform is the subject of Chapter 12, “Reform Directions.”
The concluding chapter discusses the challenges China’s banks face as the economy transitions into a lower- growth, less investment- and export- dependent economy— the New Normal. The success of the banking transformation in terms of providing the coun- try with a banking system that provides broad financial access, allocates capital efficiently, and is a sustainable and stable system is evaluated.
China’s Banking Transformation takes a generally positive view of what has happened in Chinese banking. Some have protested to me that I am ignoring the costs that China has paid in terms of environmental degradation, cultural heritage loss, increased inequal- ity, etc. There is broad agreement among Chinese and foreigners that these are immense problems, but this book is not about those issues. If I  were to write a book on those subjects, it would not be a positive story. This book, however, is about banking, which is a positive story.
Others have warned me that the speed of change occurring in China will make any- thing I write about banking out of date soon after the book is published. There is some truth in that, and no doubt some things in this book will soon be dated. This book, however, is not primarily concerned with the issues faced by banks in 2016 as the book goes to press, but rather seeks to explain the longer- term role that Chinese banks play in the political economy, to explain how Chinese banks work in ways both similar to and different from Western counterparts, and to demonstrate how the nature of Chinese banking arises out of China’s culture and is conditioned by its history. I do not expect that any of these will soon change in China.
This book is based on my accumulated experience and observations over the thirteen years that I have served on the boards of two Chinese banks. To my colleagues on the boards and in the management of the two banks, I owe an immeasurable debt. Through the years they have shared with me their hopes and ideas, frustrations and worries, suc- cesses and failures, permitting me to become a “member of the team.” As the only for- eigner in both banks, I have felt honored and privileged. My position on the boards of these banks has provided me with access that has been available to only a handful of other
xiv Preface
foreigners. I hope that the years of experience I have accumulated over a lifetime of bank- ing and which I have shared with my Chinese colleagues has contributed in some way to the development of these banks.
Despite my privileged access, my personal experience of Chinese banking was lim- ited to what I  learned from my work on the boards of two banks and, despite my best efforts, was invariably colored by my American cognitive framework. I expanded my understanding and checked the validity of my book’s themes through conducting interviews with approximately 150 people, mostly Chinese, but also foreigners, and in a few cases interviewed the same person more than once. People interviewed included banking practitioners, government officials, journalists, academics, economists in multilateral organizations, and businessmen. Interviews were conducted in Chinese and English languages, depending on the preference of my interlocutor. The people interviewed were all knowledgeable and extremely generous in sharing their views and experience with me. They asked only that I be objective in what I write in this book, pointing out both the strengths and weaknesses of the Chinese system. Those who spent time with me in interviews were too numerous to acknowledge individually here, but I want to express my deep appreciation to all of them for the time they took out of busy schedules to share their knowledge and insights with me. Without their assistance this book could not have been written.
I would like to acknowledge my debt to two people in particular. First is Hugh Peyman, who accompanied me on most of my interviews. Hugh has shared with me his great understanding of China’s contemporary economy. His critical challenges to my assump- tions and beliefs sharpened my own thinking. Michael Yang provided invaluable research support, and Michael went beyond research to also caution me when I was misunder- standing some aspect of Chinese culture or society.
I have also benefited greatly from first learning about Chinese history, language, and culture in America and Hong Kong fifty years ago, studying under great teachers who con- veyed not only their knowledge of China but also their passion for the country, its people, its language and its culture— Frederick Mote, Ch’en Ta- Tuan, Joseph Levenson, Frederick Wakeman, James Cahill, Edward Shafer, Liu Ming, and Liu Yamei, among others.
In writing in this book of my experience working within Chinese banks, I have been mindful not to disclose confidential bank and government material to which I had access.
I would like to thank Michael Aldrich, Robert Binyon, Darrell Duffie, Michael Ipson, Frank Rokers, Andy Rothman, Danny Unger, and Wei Anning for taking the time to read a draft of my manuscript in its entirety and provide me with most helpful sugges- tions, criticisms, and corrections. Several others also read and commented on sections of the text in which they had expertise: Joern Helms, Dennis McNamara, Keith Pogson, Ed Wu, Xiao Bing, Xu Jun, and Arthur Zou. Their feedback has greatly improved the final product. I am also grateful to David Shambaugh for the encouragement and guidance he gave me. Ultimately, though, I am solely responsible for everything in this book.
ABC Agricultural Bank of China AMC Asset management company BIS Bank for International Settlements BOC Bank of China CAS Chinese Accounting Standards CBRC China Bank Regulatory Commission CCB China Construction Bank CIC China Investment Corporation CSRC China Securities Regulatory Commission DRC Development Research Council GAAP Generally Accepted Accounting Principles ICBC Industrial and Commercial Bank IFC International Finance Corporation IFRS International Financial Reporting Standards IPO Initial Public Offering IT Information Technology MIS Management information system MOF Ministry of Finance NDRC National Development and Reform Commission NPL Non- performing loan OECD Organization for Economic Co- operation and Development
xvi Abbreviations
P2P People to people PBOC People’s Bank of China PSB Postal Savings Bank SME Small and Medium Enterprises TARP Troubled Asset Recover Program WMP Wealth Management Products WTO World Trade Organization
China’s Banking Transformation
The economic devastation unleashed by failures of Western banks in the financial crisis of 2008 highlighted the central role played by banks in economies and the impor- tance of establishing a proper financial regulatory system. So also did the meltdown of Chinese banking in the 1990s. When they work efficiently, banking systems facilitate eco- nomic growth and stability, a happy state of affairs that prevailed in the United States in the two decades after World War II. American banks in that period did perform their role efficiently as a circulatory system keeping the blood flowing in the economy, as described by Princeton economist Alan Blinder in the quote heading this chapter. Moreover, finan- cial system development preceded and enabled general economic takeoff in what are now the advanced nations— including the Netherlands, Britain, United States, Germany, and Japan.4 The flip side, though, is that irresponsible banking sets off financial crises that bring in their wakes prolonged economic distress.
1 China’s Hybrid Banks
Some people think of the financial markets as a kind of glorified casino, with no relevance to
the real economy— where the jobs, factories and shops are. But that’s wrong. Finance is more
like the circulatory system of the economic body. And if the blood stops flowing … well, you
don’t want to think about it. Alan Blinder, 20131
If we combine a planned economy with a market economy, we shall be in a better position to
liberate the productive forces and speed up economic growth. Deng Xiaoping, 20142
We should make good use of the roles of both the market, the “invisible” hand, and the
government, the “visible” hand. Xi Jinping, 20143
1 Alan S. Blinder, After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead (New York: The Penguin Press, 2013), 5– 6.
2 Xie Pingru, ed. Xiaoping Said: Build Socialism with Chinese Characteristics (Guangzhou: Guangzhou Higher Education Press, 2014), 62.
3 Xi Jinping, The Governance of China (Beijing: Foreign Languages Press, 2014), 128. 4 Charles W. Calomiris and Stephen H. Haber, Fragile by Design: The Political Origins of Banking Crises and
Scarce Credit (Princeton, NJ: Princeton University Press, 2014), 9, 23– 24.
2 China’s Banking Transformation
Everyone knows that the economic rise of China over the past four decades is unprec- edented in world history. Yet in the 1990s, just as this economic rise was accelerating and China was poised to become an economic player on the world stage, China’s banks were mired in bad debt, technically bankrupt, and backward in management and opera- tions. They were not actually commercial banks in the real sense of the word, since they operated as vestiges of the old planned economy model that China was rapidly leav- ing behind. As China dismantled its centrally planned economy and replaced it with a hybrid capitalist economy increasingly driven by market forces, it studied the workings of Western capitalist economies. It recognized that a system to effectively provide financial intermediation to channel the flow of funds from savings into investment was essential to the workings of a modern market economy. China could not achieve its economic growth objectives if its banking system remained dysfunctional.
Replacing banks of the old planned economy with banks that function well in a more market- based economy— in other words, creation of a modern banking system— became a priority national strategic objective. Achievement of that objective in little more than a decade is one of China’s major achievements. Today, the largest Chinese banks are real commercial banks, playing an important role in the nation’s economic development.
Market Socialism or Market Capitalism?
China’s modernized commercial banks are hybrid creatures— in part resembling Western counterparts, in part shaped by China’s political economy framework and by its own cultural heritage. They conform to global best practice in structure, management, and operations. As in Western banking systems, Chinese banks measure efficiency primarily by their creation of shareholder value, as reflected in return on equity (ROE). The pub- lished average ROE of the listed Chinese banks over the past few years has been consis- tently above 15%. In this focus on bottom line profitability, and in the payment of a share of profits to shareholders in the form of dividends, Chinese banks are no different from banks in the market capitalist U.S. and U.K. economies.
This market capitalist banking model is, however, only half the story of Chinese banks. The market capitalist model has been modified to accord with Chinese cultural norms, and it has been adapted to fit China’s political economy, which is directed by the Communist Party. The rationale for banking in China and the role that banks play in China’s political economy differs from what animates banking in the Anglo- American economy and to a lesser degree from most European banking systems. The rationale for Chinese banks is utilitarian— to be effective instruments for the state in fostering eco- nomic development, to serve the real economy. Chinese banks have a dual role to play, giving rise to what I term the hybrid nature of Chinese banks.
This hybrid nature follows the thinking of Deng Xiaoping and Xi Jinping in the quotes at the head of this chapter, in which they spoke of combining the market and the
China’s Hybrid Banks 3
government in the economy, resulting in market socialism (as opposed to market capi- talism). Political scientist Sujian Guo explains that if pure laissez faire market capitalist economies lie at one end of the spectrum and pure planned economies at the other end, then in between lie “mixed economies,” of which “market socialism” is an apt description of the Chinese mixed economy toward which Deng Xiaoping pointed the way when he launched Reform and Opening in 1978. Guo defines “market socialism as a type of economic system that combines the socialist principle of public ownership with the prin- ciple of the market economy, with predominant public ownership in those areas deemed critical to the implementation of socialist principles and social policy.”5 Commercial banking, of course, is one of those “critical” areas.
This hybrid role both arises out of the historical legacy of the communist planned econ- omy and is embedded in traditional Chinese thinking about the proper role of the state in the economy. Chinese banks have enthusiastically adopted and incorporated into their operations international standards of shareholder ownership and governance; systems of risk management, accounting, and internal control; listing on securities exchanges; and focus on value added to shareholders— all designed to promote the efficient manage- ment of the banks and to protect the banks from a repeat of the failures of the 1990s. Chinese bank regulatory authorities have put in place a strict supervision system mod- eled on global best practice. This capitalist packaging should not, however, obscure the reality that Chinese banks are managed not only to create shareholder value but also to play a vital role in promoting Chinese economic development. They must make money for shareholders and contribute to national economic development goals, as defined by the Communist Party. This is the essence of banking in China’s market socialism and is the fundamental difference between banks of market socialism and Anglo- American market capitalism.
In Chapter  10 I  compare the Chinese banking system and the banking systems of nations that practice a form of capitalism, such as Germany, Sweden, Japan, and the Netherlands, whose capitalism is termed “cooperative capitalism” in the social science literature. In those nations, single- minded focus on shareholder value is lessened, as shareholders must cooperate with other stakeholders, including labor, the general public, and the state, thereby situating those systems somewhere between market capitalism and socialist capitalism.
Market socialist hybrid banking as it exists today is the result of the past two decades of financial reform that have brought about a “night and day” transformation in the qual- ity of China’s banks. Although there are valid criticisms that China’s banks still do not efficiently allocate capital, nonetheless it is unlikely that China’s spectacular economic growth over the period of financial transformation could have occurred if Chinese banks
5 Sujian Guo, Chinese Politics and Governance: Power, Ideology, and Organization (London: Routledge, 2013), 252– 253.
4 China’s Banking Transformation
had not played a generally positive role. From shareholders’ perspective, while Western banks have been battered by a combination of bad debt and scandals since 2007, Chinese banks have thrived, growing rapidly in size, profitability, and adequacy of capital and pro- visions. They have also been responsive to national economic policy directions, thereby playing the role that the government expects of them in supporting the real economy and national infrastructure development.
The timing of China’s bank transformation was fortuitous. Bankers know that “It is easy to lend money in the good times; good bankers are the ones who get repaid in the bad times.” China’s economy was booming. Furthermore, to ensure that banks restored profitability and stability after the debacle of the 1990s, China effectively protected and subsidized banks through interest rate repression (government policy keeping interest rates at below market rates, penalizing savers and consumers, and subsidizing borrowers and investors), through implicit guarantees of state- owned enterprise (SOE) debt, and through intervention to prevent troubled industries from defaulting on their bank debt. China’s banks transformed in a short period of years that coincided with the highest sustained economic growth rates of any major economy in world history, and bank assets grew at very high rates by lending into what was a low- risk economic environment. The timing could not have been better, for both the financial sector and the real economy. The real economy could not have taken off so rapidly without a functioning banking system, and the banking system could not have performed so robustly in the absence of a booming economy.
China is now commencing a wrenching transition to what is called the New Normal, which involves structural rebalancing and a deceleration of growth. New growth targets of around 6.5% are still high compared with performance of the rest of the world, but the deceleration from successive years of growth at the rate of 10% and higher, and the accompanying structural rebalancing of the economy, are shocks to the economy, which inevitably will entail considerable adjustment on the part of businesses and perhaps a certain amount of Schumpeterian destruction. Some industries, no longer competitive, will decline, to be replaced by newly emerging industries. Some firms will no longer be profitable and will either go under or reinvent themselves in new, more competitive guise. Moreover, the government, the banks, and business enterprises of China have over the past two decades of hyper growth learned to manage under boom conditions. They lack the experience of managing in an environment of decelerating economic growth. Nonetheless, notwithstanding the complex challenges, if the competence of China’s management of the economy over the past few years is any guide, it is likely that the government will be able to guide the economic transition in ways that mitigate problems while opening new avenues for renewed vigorous economic growth.
How banks fare in this less benign economic environment will tell the tale of how robust the bank management systems put in place over the past two decades really are and how well the banks have calibrated the risk/ reward trade- off on their loan portfolios. Only in the bad times is the quality of banks truly put to the test. Furthermore, many
China’s Hybrid Banks 5
of the supports and protections previously provided by the government to the banks as they developed their management capabilities are now being bit by bit withdrawn. The hybrid nature of China’s banks, with strong state ownership and guidance, will to a cer- tain extent shield banks from the full brunt of the transition. Over the next few years, not only will the quality of banks be tested by adverse economic winds, but also the reforms of the financial system will be ongoing. As China’s venerable economic thinker Li Yining recently wrote, referring to the economy as a whole, and reflecting the pragmatic flexibil- ity of China’s mainstream economists:
Structural adjustment is not bounded by limits. Following the advances of science and technology, following changes in the domestic and international situations, and following the growth in management experience and rise of executives’ mana- gerial quality, today’s structural optimization only represents optimization for the present stage, and cannot represent the future ongoing structural adjustment. From this perspective, structural adjustment is relative, so structural adjustment will continue.6
As China’s economy grows and changes, new challenges will appear, and in response new development objectives will rise to the top of the agenda:  greater efficiency of capital allocation, reduction of income and wealth inequality, cleaning up the natural environment, urbanization, and a host of other reform items. In each of these areas, banks will be expected to play a role. China’s modernization and the strengthening of its banking system is a major achievement, but the development of bank capabilities and evolution of the financial system, of which banks are a part, is an ongoing story. Li Yining said that in the economy “structural adjustment will continue,” so in the banking system evolution will be ongoing to meet new situations and new challenges. A few key aspects of the likely path of evolution can be discerned now with reasonable certainty: ongoing interest rate deregulation; “debanking”— reducing dependence of the economy on indirect finance through banks, increasing the funding role of direct finance through equity and bond markets; cautiously affording a greater role to the private sector in bank ownership; the rise of non- bank “fintechs” such as Alibaba to contest the banks for financial transaction settlement; and greater international expo- sure of banks.
Other aspects of the system’s evolutionary path are less certain. For example, pos- sible privatization or reduction of government shareholding in existing major state commercial banks; fostering the development of universal banking (banks offering financial services such as insurance and brokerage products); giving banks greater scope for developing derivatives business; providing a larger role for foreign banks;
6 Li Yining, Chinese Economy in Dual Transition (Hong Kong: Zhonghua Book Company, 2014), 8.
6 China’s Banking Transformation
and the ultimate disposition of the non- bank financial institutions comprising today’s “shadow banking system.” However the system evolves, one can be certain that, barring major change in the political institutions of China, the government will retain more control over the financial system than in the United States and most European nations. China’s banking is unlikely over the next few years to evolve from the hybrid model of market socialism into a market capitalist form of banking. Xi Jinping has made it clear that even though the “invisible” hand of market forces have now been officially declared by the government to be “decisive,” the “visible” hand of government guidance will not be withdrawn.
As long as the national reform process maintains the dynamism of the past two decades, there are grounds for optimism about the ability of the banking system to make the necessary adjustments needed to cope with new stages of economic growth and development. Given the importance that the Chinese government accords to the financial sector, there is every reason to believe that the evolution, of which economist Li Yining writes, will be ongoing. Nonetheless, the difficulties the banking system will face in adapting to a rapidly changing economic environment, both domestically and internationally, and the challenges posed to banks by accelerating digital technology advances are formidable.
From Cashiers to Modern Banks
The extent of the banking transformation can only be fully appreciated if one recalls what Chinese banking was like from the 1950s through the 1980s. Under Mao Zedong’s leader- ship (1949– 1976), China had no need for banks. Almost all economic activity was owned, directed, and funded by the state. Within two years of the establishment of the People’s Republic of China (PRC) in 1949, all the existing banks remaining from the Republican era had been wound up, leaving only one financial institution in China— the People’s Bank of China (PBOC), which served for the next three decades as the bursar for gov- ernment allocation of funds throughout the country. The PBOC was an accounting and cashier unit that provided the funding needed to carry out the central economic plan. Bank of China continued to exist in the form of overseas branches to handle China’s for- eign trade and foreign exchange requirements in jurisdictions that recognized the PRC government, such as the United Kingdom, Hong Kong, and Singapore, but had no inde- pendent domestic existence.
In 1978 Deng Xiaoping launched “Reform and Opening”— reform of a Soviet- style planned economy that had failed China as a development model and opening to the West in search of capital, technology, ideas, and institutions needed to break out of pov- erty. Deng was a supreme pragmatist, not wedded to any particular ideology, committed only to using whatever policies and programs would provide China with the economic stability and energy to regain national “wealth and power.”
China’s Hybrid Banks 7
At the start of Reform and Opening, China did not know how to build a financial system or how to run banks, so it proceeded cautiously, listening to the advice of main- stream Western economic advisors such as the World Bank, the International Monetary Fund (IMF), foreign consulting firms such as Boston Consulting and A. T. Kearney, for- eign commercial banks setting up training programs in China, and international audit firms such as KPMG and Price Waterhouse, to name just a few. Chinese went on study missions to learn how banking systems in other countries worked. Thousands of young Chinese brought back with them new ideas acquired studying in universities in America, Europe, Japan, and elsewhere. As with other aspects of its national development over the past three decades, so also in the financial arena, much of China’s success can be attributed to the diligence, enthusiasm, and openness with which Chinese have studied global best practice and then applied what they had learned to building a new and stable Chinese banking system.
Step by step, the Mao- era monobanking system was broken up. Out of the PBOC and the Ministry of Finance were created four nationwide state banks:  the Bank of China (BOC— as mentioned above, it had continued to exist overseas), the China Construction Bank (CCB), the Agricultural Bank of China (ABC), and the Industrial and Commercial Bank of China (ICBC). In the 1980s several joint stock banks were set up, mostly owned by one state entity or another, and a host of credit cooperatives and credit trusts were licensed. The big banks, however, still more closely resembled cashiers funding the remains of the planned economy than modern commercial banks. They dis- bursed money not based on credit analysis or efficient capital allocation, but, based on government plan, they loaned to state- owned companies, most of which were inefficient and money- losing. To compound the problem, no proper system of banking regulation yet existed.
In the mid- 1990s, China’s private sector was taking off, but China did not yet have a modern commercial banking system to support entrepreneurs. State banks loaned only to state companies. Moreover, banks did not understand how to manage the risks of lend- ing. The state companies in turn did not understand how to manage their debts. Bad debts piled up on the books of the banks, estimated to reach as much as 40– 50% of bank assets.
At that time, the extraordinary economic growth of China’s real economy was still in its early stages. The accomplishments of the twenty years after 1978 were impressive, but China’s gross domestic product (GDP) in 2000 was still only $1.2 trillion, while the United States in the same year was a $10 trillion economy.7 China was growing rapidly but was overall still a poor country.
A combination of the high level of bad debts on bank books, the collapse of some Chinese financial institutions, and the spectacle of the Asian financial crisis devastating
7 World Data Bank, http:// databank.worldbank.org/ data/ views/ reports/ tableview.aspx, accessed May 10, 2015.
8 China’s Banking Transformation
the banking systems and economies of Thailand, Korea, and Indonesia in 1997– 1998 con- vinced China’s leaders that its banking system had become a bottleneck that would hold back growth of the real economy. Thorough reform of the banking system was required. China’s banks would have to become modern commercial banks.
The question was:  What kind of modern commercial banks? Even among Organisation for Economic Co- operation and Development (OECD countries), which provided the models of successful financial development that China studied, there were several models, reflecting the varieties of capitalism that existed in these economies. The U.S. model was the most powerful and influential at that time, but was structurally not typical of other OECD countries’ banking systems, due to the high priority given to shareholder interests in the United States, the light hand of government regulation, the high degree of independence from government, and the instability of the system over time. The U.K. system was similar to the U.S. system but was oligopolistic and had a different regulatory approach. The Japanese “coordinated capitalist system” and the German “collaborative capitalist system,” which can together be described as “coopera- tive capitalism,” offered models that saw shareholders as one among multiple stakehold- ers, emphasizing instead value for multiple stakeholders and according a strong guiding role to the state.
Creation of a modern banking sector had begun in 1992, when then Deputy Prime Minister Zhu Rongji took on the additional post of Governor of the PBOC, China’s central bank. Zhu began to lay the groundwork for banking transformation. The trans- formation, however, only really picked up speed in 1998, after the twin shocks of the Asian financial crisis and the collapse of two large Chinese credit trusts and hundreds of local credit cooperatives provided the impetus for concerted and thorough overhaul of the sector and made the task urgent. Although Zhu retired from government service in 2003, when the transformation was still in early stages, he is rightly given credit for work- ing out the strategy that was followed over the next several years.
China studied the different banking models of advanced economies, developed plans for creation of a modern Chinese banking system incorporating foreign ele- ments suited to China’s needs, and then proceeded to overhaul its banks, transform- ing bankrupt bank- cashiers into modern commercial banks. The focus was primarily on the four giant state banks: ICBC, CCB, BOC, and ABC. If they could be put on the right track, then the smaller banks would fall into place. Zhu’s transformation strategy had three elements: first, break the planned economy cultures of the banks by converting them into corporate entities, to be managed in accordance with sound corporate governance and banking practice; second, clean up their balance sheets by stripping bad loans off bank books and housing them in asset management compa- nies, paying for the exercise with government- backed bonds; and third, recapitalize the banks and list them on international stock exchanges, forcing them to submit to market discipline.
China’s Hybrid Banks 9
Listing on international securities exchanges was a brilliant move not only because it brought in fresh capital, but because it also effectively “outsourced” part of the job of forcing the bureaucratic state banks to improve efficiency, balance sheet quality, profit- ability, and corporate governance. To obtain approval for listing, the banks had to sat- isfy the listing requirements of the Hong Kong securities exchange, which were more stringent than those of the domestic exchanges. Additionally, foreign shareholders were demanding new stakeholders, registering their approval or disapproval every trading day by their purchases and sales of bank shares. Share prices became a preoccupation of bank boards and managers— a new way of keeping score.
By 2010, in the short space of just over a decade, the transformation, at least for the top tier banks, was basically complete. Assigning a date to the completion of the trans- formation into a modern commercial banking system is a subjective exercise. The year 2010, when the last of the four giant state banks, ABC, was listed on the Hong Kong Securities Exchange, is probably as good a cut- off point to use as any. China’s lead banks had become profitable, well capitalized, well provisioned, competently managed, and technologically advanced. The main elements of modern commercial banking had been put in place in not only the four giant state banks (by then the number had changed to five, including the Bank of Communications), but also in the twelve joint stock banks. Some of the more than 100 city banks were beginning to perform credibly as well.
The building blocks of modern banking were in place, including corporate governance, proper bank accounting, profit oriented management, risk control, internal audit, infor- mation technology (IT), and acceptable retail branch service standards. Moreover, in 2003, the bank regulatory function had been spun off from the PBOC and lodged in the newly established China Bank Regulatory Commission (CBRC), headed in its first decade by the able and visionary Liu Mingkang. By 2010, the CBRC’s capabilities were maturing; it had established its reputation as a competent, hands- on regulator, acknowl- edged by foreigners familiar with its work to be on a par in professional capability with central banks of most major countries. It differed, however, from other top- level central banks in two ways. First, it was not independent. Second, it exerted vast influence on the strategy, tactics, and daily operations of Chinese banks to an extent that would be regarded as intrusive in other banking jurisdictions.8
Since 2010, change has been more evolutionary than transformational. China’s banks were no longer government cashiers; they had become real commercial banks undertak- ing financial intermediation. But, as Li Yining stated, there is no end to the adjustment process. The banking system needs to provide broader access, capital markets need to develop further to provide financial deepening, and the financial markets need to become
8 Private communication from Frank Rokers, formerly seconded by ING to be Chief Risk Officer at Bank of Beijing.
10 China’s Banking Transformation
more market driven and less administratively controlled— topics explored in later chap- ters of this book.
China’s Banking Structure Today
China’s banks today are diverse in size and type. For the purposes of this book, I have grouped the banks into three tiers. First are the seventeen tier 1 banks, which are distin- guished by their size and also by the fact that they operate nationwide networks. The CBRC officially and appropriately classifies the seventeen tier 1 banks as the “major commercial banks,” subdividing them into the five “large commercial banks” and the twelve joint stock banks. The tier 1 banks held 59% of total banking system assets at the end of 2014. Aside from size, the distinguishing feature of the five large commercial banks is that the state directly owns a majority shareholding in each of them: ICBC, CCB, BOC, ABC, and Bank of Communications. These are extremely big institutions. The largest in terms of assets is ICBC, which at the end of 2014 had total assets of $3.31 trillion, making it the largest bank by assets in the world. ICBC had 17,122 branches nationwide in China and 338 offices overseas in 41 countries on six continents. It had over 5 million corporate customers and 465 million individual customers.9
Smaller than the five giants, but still tier 1 major commercial banks, are the twelve joint stock banks, nine of which are majority owned through various mechanisms by the government, and three of which are owned by private shareholders. Of these seventeen tier 1 banks, the big five large commercial banks and eight of the twelve joint stock banks are listed on the Shanghai, Shenzhen, or Hong Kong stock exchanges. Some are listed on more than one exchange.
Tier 2 banks are the 145 city banks, which are mostly owned by provincial and local governments and generally are restricted to operating in their base areas. Only three of these are listed on domestic securities exchanges, and one on the Hong Kong exchange. Although city banks only comprised 10% of total banking system assets at the end of 2014, some of the city banks rival the tier 1 banks in quality. Others are in need of con- siderable improvement in governance, management, and operations. They tend to be more susceptible to influence from local governments than are the national banks, as local governments are often significant shareholders or can influence the banks through local power networks.
Tier 3 banks are localized and special purpose institutions that number in the thou- sands and break down into several different license categories, including rural credit cooperatives, town and village banks, small loan companies, the state- owned Postal Savings Bank, and several others. Many in number, their quality varies greatly, but alto- gether they only account for 19% of total banking system assets. Their significance lies in
9 ICBC 2014 Annual Report, Chinese version, 23– 24, 149, and 152.
China’s Hybrid Banks 11
the creative role that they play in deepening financial access for farmers, small businesses and consumers, especially in remote areas not well served by big bank branches.
There are three large government- owned special purpose policy banks: China Development Bank, China Agricultural Development Bank, and Export- Import Bank of China. They are state- owned, play important roles in the financial system of China, and their assets (comprising 9% of the total banking system assets) are included in official measurements of the total banking system size. They are not listed on securities exchanges and do not take deposits. They rely on bond issues and the government budget for fund- ing. Except to the extent that they play a role in China’s international financial strategy, these three special purpose banks are not covered in the discussion of commercial bank- ing in this book, as each of them represents a special situation quite different from the rest of the commercial banking sector that is the subject of this book. They are not included in this book’s classification of the three tiers of the banking system but are included for purposes of computation of the assets and liabilities of the entire banking system.
Accounting for only 2% of China’s banking assets, the foreign branches nonetheless play an important role in the overall system (described in Chapter 9).
Among major financial systems around the world, some rely for funding of the econ- omy principally on direct financing through the equity and debt markets. The United States is the exemplar of this model. Others such as Germany and Japan rely to a much greater extent on indirect finance— bank credit extension. China, however, is an outlier in its extreme reliance on bank funding, accounting for 67% of total economic funding at the end of 2011. This reflects the underdevelopment of non- bank sectors of China’s financial markets— equity markets, bond markets, venture capital, and insurance are all relatively small portions of total funding compared with other countries. Having acknowledged the underdevelopment and the need for development of direct finance, it is interesting to note that China’s reliance in 2011 on bank funding at 67% is not signifi- cantly higher than that of Germany. As in many aspects of financial system structure, the United States is as much the outlier on one side as China is on the other.10
Fragile and Facing Collapse?
For anyone following the financial press accounts of banking in China today, my assess- ment of Chinese banking as a transformed system may arouse skepticism. The consensus view from most foreign observers in the media and in the investment analysis world is that Chinese banks’ reported numbers conceal a multitude of problems that will lead to a repeat of the banking crisis of the 1990s.
10 Silvia Iorgova and Yinqiu Liu, “Structure of the Banking Sector and Implications for Financial Stability,” in China’s Road to Greater Financial Stability: Some Policy Perspectives, eds. Udaibir S. Das, Jonathan Fletchter, and Tao Sun (Washington, DC: International Monetary Fund, 2013), 124.
12 China’s Banking Transformation
Many well- educated, highly motivated, and generously compensated analysts in pres- tigious Western investment and brokerage firms follow Chinese banking developments in great detail, sitting in their offices in Shanghai, Hong Kong, Singapore, New York, and elsewhere around the globe, poring through financial reports, estimating the poten- tial for bad loans that might arise from sectors of the economy that appear distressed or overleveraged. Some write of Chinese banks as compliant tools of Party bosses, lending as ordered from above, going on credit binges, lacking transparency, sclerotic in corporate culture, and grossly underreporting bad loans.
Analysts regularly forecast the coming collapse of the banking system, bringing down with it the entire economy. The first of the China banking skeptics was Gordon G. Chang, who in 2001, in The Coming Collapse of China, made dire predictions about the financial sector, oblivious to the transformation of the banks that Zhu Rongji was then getting underway. More than a decade later, in May 2012, a Bloomberg correspondent wrote that the capital of China’s big banks was overstated because bad debts had been disguised as receivables from the central government. The correspondent further maintained that not recognizing accumulating bad debts meant that “[b] y the time any big problems show up in the banks’ numbers, the jig will be up.”11
Perhaps the most well known of the banking skeptics has been Charlene Chu, for- merly of Fitch Ratings, who for years has attracted widespread attention for her fore- casts of forthcoming banking distress. In February 2014, in an interview with the United Kingdom’s The Telegraph, she explained that “[t] he banking sector has extended $14 tril- lion to $15 trillion in the span of five years. There’s no way that we are not going to have massive problems in China.”12 Well grounded in the numbers and in quantitative analysis, her warnings represent a plausible point of view. Over the years, subsequent events have not unfolded as she had predicted, although perhaps she would retort that the day of reckoning has simply been put off. Press reports of her carefully qualified forecasts often exaggerate them with lurid headlines predicting imminent collapse of China’s finances, leaving a more negative impression with the casual reader than Chu may have intended.
Widespread skepticism has led to low ratings of Chinese bank shares on the Shanghai and Hong Kong securities exchanges. Based on audited and published financial results, Chinese banks have been among the most profitable, best capitalized, and most well- provisioned banks in the world, but price- earnings and price- book value ratios of Chinese bank shares are among the lowest rated of major bank shares in the world. Analysts and investors do not believe the numbers reported and at different points in time expected
11 Jonathan Weill, “China’s Big Banks Look More Like Paper Tigers,” Bloomberg View, May 10, 2012, https:// www.bloomberg.com/ view/ articles/ 2012- 05- 10/ china- s- big- banks- look- more- like- paper- tigers, accessed 12 June 2016.
12 “The $15 Trillion Shadow over Chinese Banks,” The Telegraph, February 1, 2014, http:// www.telegraph.co.uk/ finance/ newsbysector/ banksandfinance/ 10611931/ The- 15- trillion- shadow- over- Chinese- banks.html, accessed 12 June 2016.
China’s Hybrid Banks 13
the banks to incur major losses from exposure to local government debt, to the housing sector, to the SOEs, to industries with overcapacity, or from whichever sector was the currently fashionable source of investor anxiety.
This consensus narrative is sharply at odds with what I  have experienced working within two Chinese banks and with the viewpoint of many others who have had the opportunity to work closely with Chinese banks in various capacities. In this book I argue that Chinese bank quality is stronger than generally recognized, that a repeat of the banking collapse of the 1990s is unlikely, and that apprehensions concerning bank losses from exposures to various sectors, including high credit- to- GDP ratio, real estate bubbles, and shadow banking collapses, while all clearly dangers to stable and sustainable banking, are nonetheless exaggerated. How, then, could all those analysts be getting their analyses of the banking sector wrong? What are they missing?
The banks themselves must shoulder some of the blame for the skepticism with which they are viewed. Listed Chinese banks do not open themselves up to investor and analyst scrutiny as they do in the West. If not given an opportunity to enter into meaningful dialogue with the banks at board, senior management, and middle management levels, outside analysts are unlikely to trust, or indeed even to be aware of, the quality of bank internal controls, credit risk supervision, corporate governance standards, etc. The appar- ent reluctance of banks to open up to analysts only fuels suspicions of problems being covered up.
The critics, often judging China’s banks from a market capitalist perspective, seem unaware that many of what they decry as shortcomings or distortions in the Chinese banking system have actually been characteristics of some Asian capitalist, as well as a few Western, economies. Banking in the successful “developmental states” of Northeast Asia, the state’s intervention in finance in much of Asia, and even occasionally the U.S. govern- ment’s intervention in the financial system for greater societal good, are ignored by critics of the Chinese system (discussed in Chapter 10).
Outside analysts overlook three factors. First, they overlook the very real transforma- tion of how banks operate and how they are managed that has occurred since the 1990s. Second, they underestimate China’s obsession with controlling banking risk, resulting in a variety of checks and balances that have been put in place to guard against another finan- cial collapse along the lines of what happened at the end of the 1990s. Third, they analyze the banks as though they were part of an Anglo- American market capitalist economy, rather than being embedded in a market socialist economy, which is not only different in economic structure but also enables the state to intervene powerfully to affect outcomes.
Charlene Chu acknowledges the power of the state to intervene in China and there- fore anticipates that the state will be able to find short- term solutions to defaults as they occur, but she believes that over a longer period of time the state will be unable to paper over the growing severity of problems. Her analysis, however, may underestimate the abil- ity of the state in a market socialist economy to not only undertake ad hoc remedial inter- ventions to maintain market order, just as the U.S. Federal Reserve does, but also to adopt
14 China’s Banking Transformation
policies to address the underlying bubbles and also guide economic growth in ways that will mitigate problems such as overcapacity. Grasping this point requires understanding the cultural, political, and economic context in which China’s banks operate.
Cultural, Political, and Economic Context
Both the hybrid features of China’s banks and the power of the state to intervene in the economy to bring about positive economic outcomes arise out of the cultural and politi- cal economy context. In social science literature, definitions of “culture” are legion. I use this definition of the word “culture”: “Culture is the shared knowledge of and schemes created by a set of people for perceiving, interpreting, expressing, and responding to the social realities around them.”13 Simply put, it is how we believe people in a society should relate to each other, both interpersonally and through their governance institutions. Out of a culture arise the structure and norms of social and political institutions, and ulti- mately economic institutions as well.
Since the collapse of the Soviet and East European communist regimes in 1989, think- ing about how to organize economies and how emerging nations should manage national development has been dominated by the view that the main features of Anglo- American market capitalism, generally called neoliberalism or the “Washington Consensus,” can be more or less universally applied around the world. This neoliberal approach is grounded in “rational expectations” theories of economics and other social sciences that have domi- nated academic discourse for the past half century.
The logic of these theoretical approaches is appealing, but for many the Wall Street financial collapse of 2008 called into question neoliberal approaches and rational expec- tations theories. Skepticism has grown as to whether or not rational expectations theory realistically reflects the way people act.
Countries will tailor and fashion economic solutions based on their own national his- torical experience, in line with their own cultural values and norms, and compatible with their own intellectual frameworks for understanding the world. As the late Douglass C. North, economic historian and leading thinker in the field of institutional economics, put it: “Ideas are adopted if and when they share a kind of cohesion that does not take them too far from the norms we possess.”14
13 J. P. Lederacin, Preparing for Peace: Conflict Transformation Across Cultures (Syracuse, NY: Syracuse University Press 1995), 9. Eric L. Jones in Cultures Emerging: A Historical and Economic Critique of Culture (Princeton, NJ: Princeton University Press, 2006), ix, states: “Culture is like class: it has no generally accepted operational definition.” Jones then states that most writers treat culture as the “pattern of beliefs, habits, and expectations, of values, ideals, and preferences, shared by groups of people, large and small.”
14 Douglass C. North, Understanding the Process of Economic Change (Princeton, NJ: Princeton University Press, 2005), 27.
China’s Hybrid Banks 15
This is not to argue for Chinese exceptionalism. All countries in the world regard their own cultures as to a greater or lesser degree exceptional, and indeed they are. Despite this diversity, social sciences do provide insights and tools that are of universal validity. It is in the application to an individual country’s situation at given times and stages of develop- ment that the universal must be adapted to the particular circumstances of each country. Whether one accepts this point of view or not, the fact is that it is deeply believed in China, starting with Deng Xiaoping’s “what we want to build is a socialism suited to conditions in China.”15 Senior Chinese economist and former Chief Economist of the World Bank Lin Yifu writes, “we can never be too careful when it comes to the application of a foreign theory, because with different preconditions, no matter how trivial they seem, the result can be very different”16 (italics in original).
Among market- based economies, no two countries in the world have business or bank- ing systems or practices that are exactly the same. Capitalism takes on unique features in each country, in part due to historical circumstances (what social scientists call path dependence— meaning you cannot ever fully escape your past, or, more elegantly, the choices available at any given point of time are limited by what has gone before) and in part by being adapted to national culture (what social scientists call being culturally embedded— meaning it is difficult to escape the formative cultural influences with which you grow up). Thus, the market economies of the Netherlands, France, and Britain each have uniquely Dutch, French, and British aspects, respectively, even if they are all subject to the bureaucratic homogenizing influences of European Union (EU) regulations and share many common Western European cultural antecedents. Economies reflect national cultures.17 Imposing foreign ideas, techniques, and norms on a country without appropri- ate localization can be countercultural and hence fail.
Moreover, Western approaches to banking are not static; they themselves are mutable and continually evolving, in line with national cultural and political economy norms. The present Anglo- American model is not the only way that such systems have worked in the past, or that they do or should work in today’s world. To further complicate the concept of culturally embedded systems, economic historian Eric Jones reminds us that “there is variation within culture” and that the relationship between culture and political economy flows in both directions— each influences the other in a dynamic way.18
If the differing historical paths and cultures could cause the political and economic sys- tems of northern European nations to differ amongst each other, then how much more so might China’s Asian historical path and culture give rise to a political economy, and banking system, different in many ways from Western models? Gordon Redding and
15 Deng Xiaoping, Selected Works of Deng Xiaoping, vol. 3 (Beijing: Foreign Languages Press, 1994), 256. 16 Justin Yifu Lin, Demystifying the Chinese Economy (Cambridge, UK: Cambridge University Press 2012), 66. 17 See Jones, Cultures Emerging, for discussion of the literature on this subject and for his own views on how the
extent to which cultural dependence of economies is limited by the mutability and flexibility of culture. 18 Jones, Cultures Emerging, 32, 36.
16 China’s Banking Transformation
Michael A.  Witt, in their book The Future of Chinese Capitalism, make the case for a cultural perspective on economic systems, maintaining that within a society, attitudes and behavior patterns are
all based in the fundamental ideas of the society about the conduct of life. Such ideas shape the institutions and become manifest in them. The rules of conduct rest on ideas about what the conduct is for. The means are shaped by the ends, and the ends come from the society’s ideals, its culture. This is what allows it to remain a society, for without that integration of accepted meanings, it loses its order and its coherence.19
Even in the most extreme market capitalist economies, the government plays a sig- nificant role. Differences between nations’ banking systems lie in the degree of govern- ment involvement. In a recent book, Fragile by Design, authors Charles W.  Calomiris and Stephen H. Haber maintain that “there are no fully ‘private’ banking systems; rather, modern banking is best thought of as a partnership between the government and a group of bankers, a partnership that is shaped by the institutions that govern the distribution of power in the political system… . Banks are regulated and supervised according to tech- nical criteria, and banking contracts are enforced according to abstruse laws, but those criteria and laws are not created and enforced by robots programmed to maximize social welfare; they are the outcomes of a political process… .”20
Calomiris and Haber describe the development of the dissimilar banking systems of the United Kingdom, United States, Canada, Brazil, and Mexico to demonstrate that the banking systems of each country arise out of particularistic political circumstances. Examination of different political processes leading to very different banking outcomes in these five countries makes it clear that “universal laws” of proper banking with mini- mum government interference, as espoused by Wall Street, are actually “the outcomes of a political process.”
In its national history, the United States has experienced fourteen banking crises. Over the same period of time, its next- door neighbor, Canada, has experienced one crisis— in 1839.21 The distinctive historical development paths and cultures of the two countries, leading to different political processes, explain why the banking experience of the two countries should be so different.
Echoing the cultural economics approach of Reddy and Witt and the “outcome of a political process” argument of Calomiris and Haber, I describe in this book the opera- tions of China’s banks as generally consistent with today’s international norms of best
19 Gordon Redding and Michael A. Witt, The Future of Chinese Capitalism (Oxford: Oxford University Press, 2007), 16.
20 Calomiris and Haber, Fragile by Design, 13. 21 Calomiris and Haber, Fragile by Design, 283.
China’s Hybrid Banks 17
banking practice, but the economic role and rationale, the ownership structures, and the corporate cultures of Chinese banks arise out of China’s history, are embedded in a cul- tural context that traces its roots back millennia and serve the interests of the political power structure.
China’s humiliation for over a century by the West, the turbulence of civil wars and revolutions, and the role of the Communist Party in unifying and governing China all form part of the historical path out of which the present day Chinese market economy and banking system have arisen. Over the last century and a half, China has been search- ing for the right institutions and technologies of the West to graft onto China’s cultural roots to restore China to the position of “wealth and power” that it had attained in earlier centuries.
Despite three decades of Maoist attack vilifying China’s traditional culture as being “feudal,” China’s cultural legacy has deep roots in today’s China, influencing how mod- ern technology, modern management techniques, and modern economic institutions are absorbed into the society and economy. Redding and Witt write: “To understand any society today requires a coming to terms with its history, and this is especially true of China. Few societies have been so shaped by a consistent way of running a country over two millennia. … China lives with, and is shaped by, its ancient and modern history in a very compelling way.”22
The core of China’s traditional culture is the humanistic, pragmatic philosophical tradition called Confucianism, first espoused in the fifth century bc by Confucius, which then evolved through various reinterpretations over the next two millennia to be the dominant influence on how China’s government and society functioned. Confucian philosophy is most simply a formula for ensuring harmonious relationships at all levels of society, starting with cohesive, patriarchal, and hierarchical families as the fundamental units of society, and building up to a well- ordered nation. The turbulence of the past 150 years, and indeed the occasional periods of bloody political breakdown over the long stretch of Chinese history, have reinforced Chinese conviction of the importance of maintaining social harmony and order. Chinese fear chaos (luan); they accept some curtailment of personal autonomy in return for governance that keeps chaos at bay. This is not an irrational response to China’s historical experience. As Douglass C. North points out, Americans in particular and Westerners in general take for granted a degree of order in society and politics that has dulled our awareness that for most of human history, existence has been plagued by the uncertainties brought about by lack of order.23
Acceptance within the family of hierarchy and of the authoritarian figure of the pater- familias leads to acceptance of hierarchy more broadly in society and to entrusting the
22 Redding and Witt, Chinese Capitalism, 36. 23 North, Economic Change, 7.
18 China’s Banking Transformation
state to manage affairs on behalf of the people. The Communist Party has taken on the mantle of traditional Chinese authoritarian rule through a bureaucracy composed of a meritocratic elite, but with a Leninist party format rather than an emperor.
This authoritarian political system enables the state to develop comprehensive national development strategy and to intervene in the banking system in a way that the American government would never seek to equal, and indeed which the American people would find unacceptable. 24 Americans, however, are wont to forget that, despite the enormous sway of America’s soft power and of its economic model, in fact the American version of banking is actually an outlier. No other major country’s banking system so emphasizes shareholder value or so little constrains the workings of the free market in the banking system as does the American system.
The role of the Communist Party and of the state in the financial system place Chinese banking as an outlier on the opposite side of the spectrum from America’s. There are, however, other banking systems which either now resemble, or have in the recent past resembled, China’s by providing a major role for the state in owning and guiding the banking system and influencing the allocation of credit. They include Japan, Korea, Singapore, and also France and the region of Taiwan.
China rarely copies exactly the models of what it borrows from overseas. It borrows selectively what it feels will best suit its needs, discards the unsuitable, then adapts the borrowing to work within its own culture and system. In the banking sphere, the result is not a clone of Western institutions, but rather a hybrid system, which is indeed an outcome of a political process, just as Calomiris and Haber argue. China’s modern political economy is based on millennia of cultural evolution along lines independent of the West; strengthened by borrowing of Western technology and institutions over the past 150 years, grafted onto the root of Chinese cultural essence; developed over the past few decades as part of the remaking of China under Communist Party governance; and dedicated to serving the national commitment to restoration of China’s wealth and power to the levels it had once attained at the height of its strength under imperial dynasties.
China’s history since the latter part of the Qing Dynasty has mostly revolved around debates over how much of the national cultural essence (ti, literally meaning “body,” but extended to mean the “essential substance”) should be retained, how much foreign methods and technology (yong, literally meaning “use,” “apply,” or “usefulness”) should be grafted onto the Chinese ti, and the form that political governance should take— the lat- ter ultimately being resolved with the ascendancy of the Communist Party (dang, mean- ing “party”). Much of my analysis of China’s banks revolves around these three concepts of ti, yong, and dang.
24 Stephen Roach, Unbalanced: The Codependency of American and China (New Haven, CT: Yale University Press 2014), 83– 101
China’s Hybrid Banks 19
Hybrid Banks
A foreign banker, looking at China’s market socialist banks, will see financial institutions that in most respects appear comfortably familiar and similar to the banks of market capitalist systems. The essential financial intermediation functions, organizational structure, manage- ment processes, and operations of Western banks, the broad outlines of which are generally shared among Western banking systems, are all present in Chinese banks. The similarities are to be expected, since the rebuilding of the banks after the problems of the 1990s was based on modern banking techniques learned from the West. So of course Chinese banks look much like Wall Street banks. On closer examination, however, the hybrid character of China’s banks, or in a sense their distinctive “Chineseness,” becomes apparent.
The first hybrid characteristic is the economic rationale for ba