Bank of China’s 20-storey head office is almost the only tower block on Beijing’s “Financial Street”. So far, no other banks have moved there. The most prominent building is the Holiday Inn. In years to come this could turn out to be a booming financial district – or another failed government planning effort.
Fortunately, the Bank of China is familiar with the limitations of government planning and no stranger to the vagaries of Chinese history. As the bank looks ahead to the next century, it can boast that it at least survived most of the last one. Set up in Shanghai in 1912, the bank managed to weather the Communist takeover in 1949 and subsequent upheavals.
The key to its success – ironically, given its name – has been the large proportion of its assets kept outside China and its function as the country’s foreign exchange bank. Even during the Cultural Revolution, when all banks within China were subsumed into the People’s Bank, Bank of China managed to operate its branches abroad under its own name.
Today, as China’s banks struggle to transform themselves from being the finance arms of government departments into modern commercialized entities, Bank of China’s presence abroad has again served as a cornerstone. In 1995, over 60% of the bank’s profits were from its overseas operations.
The bank’s outlets span several continents: 89 branches and sub-branches in North America, Europe, Australia and Asia; nine subsidiaries in Hong Kong and Europe; a joint venture bank in Hong Kong; and an investment bank registered in Luxembourg. Including the four banks within the Bank of China group, mainly located in Hong Kong, there are a total of 500 overseas offices, employing 20,000 people.
The bank has no desire to relinquish its international focus. Its president, Wang Xue Bing, spent five years as head of Bank of China’s New York branch – and is said to have joked with World Bank president James Wolfensohn during his visit to China last year that he, too, was a New Yorker. The bank’s recruitment policy focuses on hiring foreign-language speakers.
Indeed, according to Mao Xiao Wei, general manager of the bank’s strategic development department, Bank of China has set the year 2010 as a target for becoming a “high-quality international player”, if not one of the biggest.
Such ambitions are some way from realization. After receiving a D financial-strength rating from Moody’s last August, it is clear the agency’s analysts do not think too highly of the bank’s “intrinsic safety and soundness”without the implicit government support which buoys up Bank of China’s normal Moody’s rating (Baa1).
A large percentage of the profits from the bank’s international operations are from its Hong Kong branches and subsidiaries. Strictly speaking, these are less than 500 days away from becoming domestic profits.
Foreign exchange strength
If not yet a first-tier international player, Bank of China is regarded by the Chinese as their most international bank. Whether borrowing or depositing foreign exchange, or arranging trade financing instruments, Chinese customers almost always go to Bank of China. Last year Bank of China held a 50% market share of foreign settlements. The bank also dominates the foreign exchange market in China with a market share of 70%.
Most of the characteristics of China’s banking system today are the result of government planning, and Bank of China’s foreign exchange strength is no exception. In the past, while China’s three other main state banks specialized in either industry and commerce, agriculture or construction, Bank of China was mandated to do all the country’s foreign exchange business, including managing a large portion of the country’s forex reserves.
The problem for Bank of China is that its monopoly is now a thing of the past. That means it not only faces competition from other domestic banks but, more worryingly, from foreign banks. As one Bank of China official points out, while Bank of China still has a 70% share of the domestic foreign exchange market, “two years ago, we had almost 100%”.
At the same time, it has had to play catch-up in the area of local currency transactions which in the past were not part of its mandate.
By the end of 1995, the bank had 3,359 domestic branches – far fewer than the other major state banks. Its total local currency deposits and loans stood at Rmb390 billion and Rmb100 billion respectively – low compared to other big banks.
This local currency weakness, bank managers argue, has to change if Bank of China is to realize its ambition of becoming a proper international bank. “We consider developing local currency business very urgent,” says Mao, “because, if you look at the biggest international banks, they have a lot of international business – but this is based on strong local currency business.”
The past five years have seen a rapid build-up of local currency deposits to Rmb390 billion from Rmb78 billion – a rate of increase of around 38% each year. Renminbi lending has risen at a rate of 16.8% per annum. New bank branches and sub-branches have been opened across China.
Bank of China has few illusions about being able to catch up with other banks in terms of branch coverage. But this may be the bank’s biggest advantage. If anything, other banks suffer from having too many staff and a branch network which is large for the sake of comprehensiveness rather than profitability. With 190,000 employees serving the domestic market, Bank of China has, by Chinese standards, a trim workforce.
“Compared with other banks, we’re quite small,” says Mao. “At the Industrial and Commercial Bank of China the total number of employees is more than double. What we are interested in is efficiency and profitability, not only the size of the operation. We even think the total size of our bank is too big.”
Most Bank of China branches are concentrated in the coastal and other prosperous regions. The aim is to focus primarily on cities. Says Mao: “We would like to be a city bank, and focus on city business. If we open new branches, it will be in the big cities.”
Elsewhere, non-profitable branches will be restructured or closed. “We have plans to do this, but it’s a little bit difficult to put into practice,” says Mao. “But this year we are really going to try to [identify] the offices that are not profitable and, in restructuring them, even close down those that performed badly.”
The fact that Bank of China officials publicly state their commitment to profitability rather than size is a victory against old-style Chinese banking. As Joe Zhang, a China banking analyst at WI Carr in Hong Kong, points out, with one bank for every 2,350 residents, China boasts a higher density of bank outlets to population than most of the industrialized world.
Says Zhang: “In China, the size of a bank is often interpreted as the most important symbol of its success and prestige. It is not return on equity (ROE), return on assets (ROA) or marginal profit on capital that guides banks’ growth strategy, but rather total assets – even if that means falling ROE and ROA, and negative marginal profit.”
Strategic development
Bank of China’s strategic development department was set up only this year. It testifies to the bank’s confidence that it is finally free to decide its own fate.
Chinese banks’ right to be independent of government interference became law on July 1 last year, when the country’s commercial banking law came into effect. Before that date, if even a local government official ordered a bank to make a loan to a venture – however unviable – the bank had no power to refuse.
This was hardly surprising: a local bank branch was considered the funding arm of the local government and not really a bank at all. Salaries were set according to the civil servants’ pay scale and, until the late 1980s, local governments had more of a say in the appointment of regional branch managers than the bank’s own head office.
The commercial banking law aims to break for good the close ties between banks and local government. For example, it prohibits banks from establishing a branch structure which coincides with administrative boundaries.
But even if, in future, all lending decisions are made on purely commercial terms, the banking industry will still be shackled with loans – many of which have turned bad – made in the past for political reasons .
Bank of China has been shielded to some extent by its overseas focus, but there is little doubt that it too is affected by the problems of the Chinese banking system, in which western analysts estimate about 15% of loans are non-performing or bad.
Bank of China itself puts this figure at 2%. The discrepancy could be explained by what one analyst calls China’s “liberal loan accounting practice”. In China banks are able to accrue income on overdue loans for up to three years. The comparable figure in the west is 90 days.
Banking supervisors at the central bank – the People’s Bank of China (PBOC) – are working on clarifying the issue of problem loans. PBOC officials are determined to have a banking system that is adequately supervised, with prudential regulations and a proper accounting system. But the Ministry of Finance is not so keen to confront the problem of bad loans immediately, as this could mean a big bail-out of the banks. (Bank of China, as a state-owned bank, technically belongs to the ministry and has to apply to it to raise capital.) According to Zhang, who formerly worked at the PBOC, “there is even fear that some institutions may be operating on negative capital”.
The Ministry of Finance allows less than 1% provisioning for bad debts each year. That is “something, but not nearly enough”, says one analyst. Resolution of the problem has been postponed, in the hope that the banking system will somehow muddle through.
It is not a simple issue. At stake is the whole problem of reforming state-owned companies. If loss-making state companies are to be bailed out by the government, banks may be right not to write off their loans.
The infrastructure in place for banks to make claims on the assets of bankrupt companies is inadequate. The official China Daily newspaper recently reported complaints that “the rights of banks and the debts owed to them were not properly protected during the bankruptcy process, with banks unable to collect on guarantees or mortgages they had been given”.
Bank of China officials are concerned. “The key point is how to assess the problem loans,” says Mao. “In some cases, there are a lot of very hard negotiations between the banks, the local government and the enterprises. The government – and, in most cases, when we say government we mean the local government – would like enterprises to go bankrupt and the debts to be written off, because then the state banks’ money will be kept in their province, and become their money.”
In view of the high tax rates on Chinese banks, the inflation of profit figures caused by ignoring bad debts only serves to deplete capital further.
In fact, Bank of China is likely to be the only major state bank to report a profit for 1995. Provisional figures given by the bank indicate profits will be about Rmb10 billion.
It has also been successful in boosting its capital by repeatedly begging the Ministry of Finance for more money to match the rapid growth – over 50% in 1994 – in the bank’s assets. Last year the ministry agreed. It raised the bank’s capital considerably – by Rmb22 billion – to Rmb52 billion.
As a result, according to Bank of China calculations, its ratio of core capital to total risk stands at 12.89%, well above the BIS’s 8% standard. But the bank says it is still not enough and that lack of capital could inhibit “business development”.
The hope is that the bank will be able to leave the legacy of the past behind by crowding out past poor assets with sound future lending. As the bank itself admits, however, in spite of the commercial banking law, not all future lending will be made on commercial grounds.
State banks can still be called upon to do some policy lending at the behest of the central government. The policy banks set up in 1994 to take this burden away from commercial banks are still too small to be able to take care of all policy lending.
Bank of China officials say they have no problem with this – provided the government gives them a subsidy to carry out this function. “We don’t think ‘policy loan’ is a bad word,” says Mao. “A lot of policy projects are good to finance: that has to be decided on a case-by-case basis. But we need a commitment from the government that, if necessary, they will provide us with a subsidy, following the commercial banking law.”
In practice, the pressure on banks to give in to government demands at local branch level is still enormous. “Sometimes it is extremely hard for branches to withstand local government wishes,” explains one bank official. “The government will say, ‘You have a branch in our province. You’ve got deposits from our people. You have to pay for that by extending loans for the project.’ And local bank employees find it hard to withstand these arguments.”
At the moment, the Bank of China is struggling to comply with the commercial banking law’s provision – designed to alleviate the problem of local government interference – that the basis for branch networks be unconnected with local government districts. The new structure of the bank remains undecided. “It’s possible we will work out a structure which will follow economic zones,” says Mao. “If certain provinces have the same level of economic development, we will consider them as one unit.”
This is a tough requirement for Chinese banks which have traditionally opened branches at every level of administrative unit. As a result of its special foreign mandate, Bank of China adopted this approach only in 1992 and it is now having to rapidly backtrack.
Bank of China managers are candid about the fact that bad loans are as much a problem of internal weakness, as outside interference. Says Wang, the bank’s president: “The major change we are facing now is to strengthen our internal management system. We need to learn more from [our] international experience. We need to work out our inherited problems.”
Analysts agree that management expertise needs to improve. “Last year banks as a whole lent less than before to the state sector, so they do seem to be finding new borrowers,” says one Beijing-based banking specialist. “The question is do they have the capacity to separate good borrowers from bad ones among these new customers? That’s the essence of the banking business. And I’m not sure that Chinese banks have the capacity to do this kind of work.”
Centralization
Bank of China’s overseas operations, and the opportunity this affords bank employees to gain experience outside China, give the bank another advantage over other Chinese banks.
The bank is moving towards “centralizing operations to reduce risks and increase efficiency and profitability”, according to one Bank of China executive. This has been most obvious in the area of foreign exchange dealing. This business has already been taken away from branches and is now run exclusively by head office. “We think this is the most risky business and should be controlled by head office,” says Mao. “In the past, branches used to be allowed to do a certain amount of foreign exchange business on behalf of customers, as brokers. But we have centralized that.”
That is good news. As recently as last month, details were published in the Chinese press of foreign exchange trading losses of $175 million at the bank’s Shandong branch. According to allegations in the Shanghai Securities News, the former head and deputy head of the branch’s foreign exchange division accepted bribes of $120,000 from a foreign financial institution to undertake the disastrous deals.
Overall changes in China’s financial system, particularly at central bank level, are easing Bank of China head office’s bid to exert greater control. One notable area is liquidity management. In the past, bank branches were required to meet high reserve requirements at local level, by depositing money at local PBOC branches.
In turn, if a bank faced liquidity problems, a branch would turn to the local PBOC branch for support: the central bank was a lender of first rather than last resort.
Since 1994, however, PBOC has shifted its lending to banks’ head offices. Although required reserves, at 13% of deposits, still have to be met at local level, required excess reserves, of a further 5% to 7%, are met on a consolidated basis.
This year also finally saw the introduction of a national interbank market, accessible only by head office, or branches authorized by head office. It is intended that this will gradually supersede the regional interbank markets.
The appearance of a national interbank market – in which interest rates for periods of less than 60 days are unregulated – also augurs well for another much-awaited event in Chinese banking circles: interest-rate liberalization.
The government’s aim in setting rates has been to prevent outflow of funds by keeping long-term deposit rates high but lending rates for ailing state-owned enterprises low. As a result, according to Zhang of WI Carr, “banks’ margins have been squeezed razor thin”.
Bankers look forward to the day when they will have more discretion on the rates they charge to lenders. “The basic rates of saving and deposits and of fixed-asset loans are legal rates that cannot be changed,” says Mao. “For working capital loans, the central bank announces the floating rates and gives financial institutions a margin: a commercial bank can make a loan within this margin under the approval of the monetary authority.” But, even for the working capital loans, the amount of discretion given to banks “generally speaking” is “not much”.
However fast the pace of change, Bank of China managers have gripes about other mechanisms now in place. The biggest constraint is the quota system used by the PBOC, in the absence of developed mechanisms of monetary control, to control inflation. At the beginning of each year, the central bank sets a lending limit, or quota, for each bank. This cannot be overshot, regardless of how much a bank raises in deposits.
This year, Bank of China, because of its size, was one of the few banks subject to a quota. Managers, however, are hopeful that within the next few years, the quota will disappear.
However much Bank of China suffers from its position as a big state-owned bank, too rapid a distancing from the government could be harmful. The growing distance between the bank and the government was the main reason for the downgrade by Moody’s last April from A3 to Baa1.
Few argue that the government would allow a state-owned bank to get into trouble. However, there is a danger that the bank’s interests will be less strictly guarded in future. As one analyst points out, “Chinese banks have a lot of services – in Bank of China’s case in particular for payments. The fees they are charging on a lot of those services are outrageous. The reason the banks can do it is because they are a monopoly. But what will happen when they face competition in these services?”
The most obvious challenge is foreign banks which are still allowed only one branch per city and are excluded from local currency business. At the moment, Bank of China says it has little to fear. Although foreign banks may be more experienced in foreign exchange transactions, their limited branch network prevents them from winning business from Bank of China.
If the twists and turns of the Chinese banking environment are enough to cause the average banker to pull his hair out, Bank of China executives remain unperturbed.
In fact, their plans are ambitious. Although traditionally a specialized bank, managers say that in future they would like Bank of China to be a “universal bank”.
The past decade has seen the bank making strides into a traditionally very limited area of banking in China, the retail market. Around Beijing, a newly designed logo sparkles above retail outlets in an attempt to attract individual customers. Radios blare with advertisements for the bank’s Great Wall credit card, ATMs can be found in most major shops and in parts of the country with developed communications systems – mainly coastal areas such as Shenzhen – telephone banking has been introduced.
Progress has not been impressive by international standards. China’s credit cards have turned out to be debit cards. And it is hard to find an ATM which works.
Home mortgages are another area of interest to the bank. Although Bank of China has not delved into it yet, Mao calls it “the area with the most potential for the banking business”.
One major area which will become out of bounds to commercial banks as a result of China’s reforms is merchant banking. This is a significant change. Traditionally most Chinese banks have had a trust and investment department – even at branch level.
Investment banking
All these are being hived off. Bank of China Trust and Consultancy – the bank’s merchant banking arm – is still a department of the bank, but the process of separation is likely to be complete by next year. Bank of China officials hope they will be able to keep it as a subsidiary and retain the Bank of China name.
This would involve a special dispensation from the government. But the fact that the People’s Construction Bank of China managed to get approval for a joint venture investment bank with Morgan Stanley – even though this was just before the law made investment banking business illegal for banks – shows that the authorities are prepared to make some exceptions.
Abroad no restrictions apply, and Bank of China is actively involved in investment banking through its Hong Kong branch and subsidiaries. The next plan is to open a merchant bank registered in London.
It seems that the bank is prepared to do anything. “Everything we’re allowed to do, we want to do,” says Mao.
Will Bank of China eventually move its headquarters to Shanghai, China’s designated financial centre? The bank is keeping its options open.
“Some people have been encouraging all the commercial banks, especially the biggest four, to move their offices to Shanghai. Maybe in future we will put focus on our Shanghai branch,” says Mao. “But it depends on how Shanghai develops as a financial centre. Hong Kong is a bigger financial centre within Asia, and we will have to see how Shanghai compares with that.”
