When Bank of China named Lonnie Dounn chief credit officer in March last year, it was heralded by the management as a defining moment in the reform of the state-owned banking system. As the first foreign senior manager at a large Chinese bank, Mr Dounn brought more than 30 years experience, including six as HSBC's chief credit officer for Asia-Pacific, as well as a determination to help clean up one of the world's most opaque banking industries. More cynical analysts assumed Mr Dounn was hired to add a gloss of respectability to an institution with a dark reputation for corruption and slipshod accounting and a history of lending for policy reasons without much regard for credit risk. The predictable result was a heap of non-performing loans. 'Hiring a foreign manager from an international firm like HSBC was clearly designed to make the bank more palatable to foreign investors in the lead-up to the bank's [initial public offering],' said Fraser Howie, a co-author of Privatizing China - the stock markets and their role in corporate reform. If that was the intention, it was to prove short-lived. Mr Dounn resigned in April, less than a month before the bank's initial public offering in Hong Kong. He finished at the bank last month and will join Morgan Stanley as head of credit for Asia before the end of the year. By jumping ship, Mr Dounn did not sign off on the IPO prospectus. The move was widely seen as an implicit thumbs-down on the deal, although he never said so. The IPO prospectus included 30 pages outlining steps the bank has taken to improve risk management, a task that analysts say is far from complete less than three years after China's second-largest lender received a US$22.5 billion government bailout. Despite the inauspicious timing of Mr Dounn's departure, BOC's Hong Kong IPO was a big hit with investors, raising US$11.2 billion. Its shares rose more than 15 per cent on its June 1 trading debut. It took in a further 20 billion yuan in July from a Shanghai IPO, and saw its shares jump 23 per cent on its start. 'If [Mr Dounn] was hired as a facade, then they wasted a lot of money because the investors didn't care one bit,' a source said. 'And they're not going to care when it comes to ICBC either.' Industrial and Commercial Bank of China, the country's biggest bank, has already begun the roadshow for what could be a US$21 billion IPO, the world's largest to date. Its shares are due to begin trading in Hong Kong and Shanghai on October 27. The sale will mark a milestone for China's banking system that few expected would be attained this soon. Three of the Big Four banks, ICBC, BOC and China Construction Bank, along with others such as Bank of Communications and China Merchants Bank will have stocks traded overseas. Although mainland regulators and bank executives point to these sales as an implicit endorsement by international investors of China's bank reform efforts, others express amazement at this turn of events. 'It seems illogical that the poorest quality bank is going to raise the most money,' Mr Howie said. 'Everyone's going along with the Alice in Wonderland story that the banks are all fine when the system is still rife with poor accounting, poor risk management, massive bad loans and blatant malpractice.' China's banks have operated as commercial entities for less than a decade. To support their essentially non-existent capital base, the government has provided more than US$400 billion through cash injections and the purchase of bad loans. For that kind of money, you would expect improvement - and indeed, the banks are in better financial health. But just how much healthier are they? The government puts total remaining bad debts in the banking system at about US$206 billion, but Fitch Ratings estimates a further US$270 billion in problem lending, on top of the estimated US$197 billion remaining on the balance sheets of the four asset management companies responsible for disposing of the banks' historical non-performing loans. Even China's top economic officials are critical of the actual pace of reform. In late August, China Banking Regulatory Commission chairman Liu Mingkang said most Chinese banks have been too slow to reform and that the risk of a large new crop of defaults is increasing. Over the past few years the banks have been lending money freely in an effort to grow their way out of the hole. Loans in the first seven months of this year reached 2.35 trillion yuan, accounting for 94 per cent of the central bank's target of 2.5 trillion yuan for the year. With this sort of growth, analysts say there is no way the banks can avoid adding at least some new bad loans to their books. 'NPLs are still a big problem but the situation is much better than before,' Construction Bank chairman Guo Shuqing said. 'Our NPL ratio is going down, thanks to our loans increasing very fast and an OK performance in risk management.' The big listed banks all report falling non-performing loan ratios but 'these numbers understate the likely level of ultimate credit losses, given what we know to be the slow evolution of a strong credit culture and risk management practices and our suspicion that China's over-reliance on investment-led growth comes at a cost to bank credit quality', said Fitch Ratings analyst Charlene Chu. Official bad loan ratios at the big banks have decreased from more than 20 per cent two years ago to low single digits, with BOC reporting 4.19 per cent of lending as non-performing at the end of June, Construction Bank reporting 3.5 per cent, Bank of Communications 2.11 per cent and ICBC 4.1 per cent. However, the true scale of the problem is hidden by the fact mainland banks are 'being very liberal in their judgments of whether a borrower has the capacity to repay a loan', one senior banker said. The big listed banks now use the international five-tier classification system to rank loans as either 'pass', 'special mention', 'substandard', 'doubtful' or 'loss'. Under this system, special mention loans are considered performing, but at mainland banks the classification is applied to lending that would be considered non-performing in a more developed economy. ICBC's special mention loans made up 9.2 per cent of its total last year, while BOC reported 15.1 per cent, Construction Bank 11.8 per cent and Bank of Communications 12.1 per cent. 'In a downturn we suspect all of these loans would become non-performing,' Ms Chu said. 'There's no way the banks can have reformed that much in such a short time.' Residual problems in the state-owned banks extend beyond poor risk management. 'I've been told by people within my own bank that no large loan gets made without someone getting paid,' said one senior Chinese banker who asked that neither he nor his bank be identified. The list of executives accused of corrupt criminal behaviour includes Wang Xuebing, BOC president from 1994 to 2000, who was sentenced to 12 years in prison for taking millions of yuan in bribes and gifts, and former Construction Bank chairman Zhang Enzhao, who was arrested for corruption a few months before the bank's IPO in October last year and went on trial two weeks ago. So why, exactly, are investors going to eagerly join in on the world's largest IPO later this month? 'Some people are in it for the short-term pop and not worrying about the fundamentals, some are optimistic the banks can improve and some are assuming they've improved more than they actually have,' Ms Chu said. 'These investors are driving up prices.' Many large state-owned enterprises have been hired by the government to help support the IPOs. The main reason this latest IPO cannot fail is because Beijing sees it as the crucial last step in forcing the major banks to overhaul in preparation for competing with the foreign lenders that are supposed to be given full access to the Chinese market by the end of this year under the terms of China's 2001 World Trade Organisation accession agreement. As deadline looms, the banks are 'realising they have to do the things they said they'd already done in their prospectuses', a source said.