With China's new administration in place, the National People's Congress and Chinese People's Political Consultative Conference will meet again in March to come up with a new framework for the next stage of China's economic growth. Boosting household consumption and private-sector-led growth will be at the top of the agenda.
This will challenge the way many Chinese banks operate and how they lend money during the next phase of economic reform and development - particularly in areas such as interest-rate deregulation, relaxation of currency controls and the extension of loans to the private sector.
Historically, banks have not done a good job in supporting the private sector. Throughout the past 30 years, China's economy has been dominated by large state-owned enterprises, and these companies have commanded a large portion of bank lending.
There will be at least two negative effects if this situation is allowed to continue. First, it will limit the amount of loans that can be obtained by small private firms, in turn reducing the effect of the private sector's contribution to the overall economy. Second, the underwriting skills of bank lending officers will never genuinely improve because loans granted to SOEs are implicitly guaranteed by the government. No particular skill is required to make such loans.
China's banking industry has made a quantum leap in all aspects of its operations over the past 30 years of reform and restructuring. Banks have made record profits in the past few years as a result of the government's stimulus programme. But this does not suggest that their risk management capabilities are up to international standards.
A case in point: a majority of loans made were SOE-related infrastructure projects, or secured by real assets. Making these loans does not require sophisticated credit risk management skills. On the other hand, banks have not made sufficient lending to support research and development, intellectual property, patents, renewable energy or environmentally friendly projects. These are the sectors of the economy that desperately need funding support. This is one reason China has not produced any leading brands, despite being the second-largest economy in the world.
Moreover, banks seldom use techniques, such as score cards, to improve the efficiency and effectiveness in the credit evaluation process. More advanced risk management techniques such as stress testing, quantitative analysis of risk, risk-adjusted return and economic capital is either at a very rudimentary stage or non-existent.
The next phase of reform and development in China will be less dominated by SOEs and government-related projects and more focused on private-sector participation in the economy. In view of this, banks need to pragmatically assess their risk management systems and capabilities and make another leap to improve their skills in underwriting loans to micro businesses and small and medium-sized enterprises; loans to different phases of the supply chain; loans backed by commodities, and by intellectual property; loans supporting R&D and the green industry; and so on. In other words, banks will need to assess borrowers' repayment ability based not just on collateral or government support but on long-term business prospects and cash flow.
Another inevitable development in the next phase of reform is interest-rate deregulation. Deregulation of interest rates, although still a matter for the central bank to decide, is by and large a market phenomenon. When the market is ripe, it will be difficult for the central bank not to take action. As banks shift their focus from lending to government-related borrowers towards lending to private-sector borrowers, they need more flexibility to determine interest rates for both loans and deposits. Most Chinese banks do not have the capability to manage interest rate risk in a free-market environment. They need to improve and they need to act fast.
For Chinese banks, improving credit and interest rate risk management are just two areas where they need to catch up with their counterparts in developed countries. There is still plenty of room for improvement in other areas such as stress testing, quantitative analysis, and system and data management. Banking-sector reform will be an unavoidable part of the next phase of China's reform and development. Banks should get ready.
Frederic Lau is a managing director of Promontory Financial Group, an independent director of Ping An Bank, a former division head of the Monetary Authority and former senior examiner of the US Office of Thrift Supervision. The views expressed in this article are those of the author