Chinese_Econ_BankingReformAndCorporateGovernance

© 2009 M.E. Sharpe, Inc. All rights reserved.

ISSN 1097–1475/2009 $9.50 + 0.00.

DOI 10.2753/CES1097-1475420502

W ai-chung L o and M ichaeL c.M. n g

Banking Reform and

Corporate Governance

Abstract: Recent developments and problems of corporate governance in Chinese banks are reviewed. The central government has tried to improve corporate gov-ernance, but China still has a “market economy with socialist characteristics.” Key industries, such as banking, are firmly controlled by the state, and their leaders are appointed by the state. The China Banking Regulatory Committee was established in 2003 to regulate and monitor banks, but transparency remains elusive in the banking industry. An effective system of corporate governance is necessary for the Chinese banking industry to gauge the success of the banking reform and to inspire market confidence.

China began to reform its monobank system in the late 1980s. The People’s Bank of China (PBOC) was established as the central bank, while commercial functions were shifted to the four major state-owned commercial banks—the Bank of China, the China Construction Bank, the Industrial and Commercial Bank of China, and the Agricultural Bank of China.1 The goal of the second stage of the reform was to incorporate the state-owned commercial banks (SOCBs), but one of the pressing problems was the quality of their assets. Burdened with policy loans inherited from the monobank system and lacking an effective corporate-governance control mechanism, the number of non-performing loans (NPLs) increased rapidly. Official estimates showed that as many as 25 percent of the loans of the four SOCBs were nonperforming. In most market economies, the level of nonperforming loans rarely exceeds 2 percent. Unofficial estimates were even higher. As such, the state banks were

Wai-chung Lo is an assistant professor in the Department of Business Administra-tion and Economics at Worcester State College. Michael C.M. Ng is a lecturer at the School of Arts and Social Sciences, the Open University of Hong Kong.

2122 ThE ChinEsE EConomy

technically insolvent (Lardy 1998). To deal with the problem, the Ministry of Finance issued special loans to inject capital to the four SOCBs, and asset-management companies were set up to absorb the their NPLs. By the end of 2003, the NPLs of the Big Four were reduced to a still unacceptable 21.4 percent of total loans.

Two contrasting opinions arose regarding the nature of the NPLs. The com-monly accepted view was that the NPLs resulted from the hidden obligation of policy lending by the state banks inherited from the monobank system (Lo 2001). Since the state banks had shouldered the social responsibility that led to the high level of NPLs, the central government was obligated to absorb the NPLs so the state banks could function normally as commercial banks. The nonmainstream opinion held that NPLs are the consequence of poor corporate governance of the state banks. According to an anonymous Chinese official whose source was an analyst in Hong Kong, practically every case of NPL from 2000 to 2003 is connected to corruption or financial crime.2 An immedi-ate implication of this argument is that if the issue of corporate governance is not seriously addressed, the problem of NPLs is bound to persist.

The development of corporate governance in China is linked to the eco-nomic reform. The listing and trading of selected state-owned enterprises (SOEs) on stock exchanges in the early 1990s was a crucial step in trans-forming the SOEs into business entities under the market economy. The Company Law was issued in 1993 and the Securities Law was enacted in 1998 to provide guidelines for corporate governance. However, in spite of the rapid development of stock markets and enactment of related laws, cor-porate governance of most Chinese firms remained deficient. In fact, listed companies were often accused of grabbing insider control of corporate affairs, frequent insider trading, weak protection of shareholders’ rights, dealings and collusions in market manipulations, even falsification and fabrication of data. The WTO accession exerted pressure on China to seriously improve corporate governance.3

In 2003, the Chinese central government made plans to reform state banks, with the ultimate goal of transforming state banks into public companies. This new wave of reform consisted of a three-pronged approach: to lower NPLs and raise the capital adequacy ratio to acceptable levels, to invite foreign investors to state banks as strategic investors, and to list state banks on exchanges. To date, NPLs in state banks have been substantially reduced and corporatiza-tion of the major state banks is nearly completed. In fact, with the exception of the Agricultural Bank of China, the major SOCBs have gone public. In the process of corporatization, the state banks have improved their corporate governance structure.

sEpTEmBER–oCToBER 2009 25

Investment Company, through their repeated injections of capital, inevitably became the major shareholders of the corporatized state banks. The three major state-owned banks, with high levels of NPLs, had a much higher con-centration of ownership by state agencies than the Bank of Communication (BComm), which did not have problems with NPLs, as shown in Table 2. State agencies as major shareholders might have a negative impact on the banks’ corporate governance. For example, empirical research showed that the pay-as-incentive-to-perform scheme is less effective when the ownership is dominated by state agencies (Firth, Rui, and Fung 2006).

An important issue in corporate governance is the independence of the board of directors, critical for its role to serve genuinely as a “watchdog.” From a legal perspective, the members of the board of directors providing expert advice to management have broad fiduciary obligations to act in the best interest of the corporation.

According to guidelines issued by the China Security Regulation Commit-tee (CSRC), at least one-third of the board members should be independent directors. Although CSRC recommends, but does not require, that the CEO and the chairman of the board not be the same person, all the listed state banks, similar to many large SOEs, have separated both positions to enhance independence of the board. The boards of state-owned banks are dominated by nonexecutive directors, who are usually high-ranking state bureaucrats and seasoned members of the Chinese Communist Party (CCP). There are two reasons why the boards may not fulfill the task of watchdog. First, given their background as seasoned bureaucrats of a centrally planned economy, the board members may not know how to steer the state banks to market economy. Second, and even more disturbing, these seasoned members of the ruling party are likely to submit to normative influence. When pushed to make decisions based on limited information, they tend to go along with the value Table 2

Ownership Share of State Agencies

BOC

ICBC CCB BComm Ministry of Finance

035.33%00Central Huijin

.71%35.33%59.12%25.40%National Council of Social Security

3.30%

4.22%00Total 68.01%74.88%59.12%2

5.40%source: Shenzhen Securities Information Company, available at www.cninfo.com.cn.

26 ThE ChinEsE EConomy

and judgment of management, composed of seasoned members of the ruling party. Their private beliefs are prone to modification, hence their capacity to exert effective corporate governance control is attenuated.

Table 3 shows the backgrounds of the independent directors in the listed state banks. The independent directors are a mix of academics and profes-sionals in banking. It is noteworthy that many of the independent directors come from overseas, although it is unclear whether they can genuinely carry out the function of watchdog. Although overseas professionals account for 65 percent of the total independent directors, they are a mere minority of 19 percent out of sixty-three directors of the four listed state banks. “Boards with a majority of trustworthy but uninformed ‘watchdog’ agents can implement institutionally preferred policies.” Moreover, overseas professionals, though trustworthy, are uninformed, in the sense that they do not process all the infor-mation that insiders have (Gillette, Noe, and Rebello 2003, p. 1997). A survey T able 3

Composition of the Board in Major State-Owned Banks

Number of independent directors

Independent

Nonexecutive Executive Total BOC

4 8 416ICBC

3 7 414BComm

410 216CCB

6 7 417All 17321463Background of independent directors

Academic

Overseas professional Chinese professional BOC

1 21ICBC

1 20BComm

1 21CCB

1 50All 4112

source: Shenzhen Securities Information Company, available at www.cninfo.com.cn.

of corporate governance in China compiled by Fudan University and a German consultancy firm reveals that “Independent directors are mostly brought in to fulfill legal requirements and are limited to advisory roles” (Heidrick and Struggles 2006, p. 7).As such, it is unclear whether the boards of Chinese state banks could effectively perform the task of corporate control.

Corporate governance is generally weak when there is government interfer-ence (Braendle, Gasser, and Noll 2005). With the state as major shareholder, leaders of state banks are typically appointed by the state instead of recruited by the boards (Heidrick and Struggles 2006). Top executives appointed by the government are either seasoned financial technocrats in the banking industry or state bureaucrats.5 The criteria and mechanism of their appointment are opaque, exhibiting no clear linkage to their performance. In this regard, the nature of the labor market for top banking executives is very different from that found in a mature market economy.

The presence of strategic investors, all leading global financial institutions, is another marked feature of the listed state-owned banks. Table 4 shows the role of strategic investors in Chinese banks. Apparently, the purpose of introducing strategic investors into the banking system is not financial, but to help the banks streamline their operations. There is empirical evidence that foreign banks, acting as strategic investors, help Chinese banks improve their efficiency and profitability (García-Herrero and Santabárbara-García 2008). However, because strategic investors hold only minority stakes and do not play any significant role in the board room, they are not much help in improving corporate governance.

In short, China has gone a long way to corporatize its state-owned banks and has also strived to improve bank corporate governance. However, due to state ownership, there are limitations to the effectiveness of internal corporate control, therefore the external control exerted by the CBRC is crucial. Effec-tive corporate governance generally pays off. In a survey of global investors, the McKinsey Report (2002) finds that 80 percent of the respondents in all surveyed countries would pay a premium for firms with effective corporate governance. The premiums range from 12 to 14 percent in North America and Western Europe, 20–25 percent in Asia and Latin America, and over 30 percent in Eastern Europe and Africa. Apparently, investors perceive effec-tive corporate governance as a particularly important factor in regions with inadequate regulatory underpinnings.

Performance of State Banks from the Market Perspective

The estimation of stock returns is based on the stock price on the Stock Exchange of Hong Kong. The Hang Seng Index (HSI), Hang Seng FinanceT able 4

The Role of Strategic Investors in the Chinese Banks

Bank IPO

date

Strategic

investors Content

T erm of

agreement

BComm June 23, 2005HSBC Credit card cooperation August 18, 2014

Technical support and

assistance

August 18, 2007

Use certain trademarks

owned by HSBC

3 years

ICBC October 27,

2006Goldman

Sachs

—Provides technical

assistance

—Assists in developing

corporate and manage-

ment culture

—Assists in developing

nonlending products

5 years

Allianz Provides training and

consultation

Not specified American

Express

Credit card partnership Not specified

CCB October 27,

2005Bank of

America

—Strengthens risk

management

—Establishes manage-

ment framework for cor-

porate and retail business

units

—Credit card product

design and marketing

—Personal banking prod-

uct development

—Global treasury services

—Information technology

Until August 29,

2012

AFH,

Temasek

T echnical assistance Not specified

BOC June 1, 2006RBS Group,

RBS Bank,

RBS China —Corporate banking

—Retail banking

—General insurance

Not specified

AFH—PRC financial services

industry

—Corporate governance,

information technology

and training

Not specified

UBS AG—Investment banking and

related securities busi-

ness areas related to PRC

––Investment banking

clients and/or PRC

capital markets Not specified

ADB Internal control and

corporate governance

Not specified

source: Hong Kong Stock Exchange and Clearing Limited, Main Board, Prospectus Database (2008)

sub-index (HSIF), and Hang Seng Mainland 25 Index (HSM25) were chosen as market portfolios for comparison. The HSI was launched in 1969 and has been the most widely quoted performance indicator of the Hong Kong stock market. HSM25 was also selected as a benchmark because we want to dis-count the “China factor” when evaluating stock price performance. HSM25 is composed of the twenty-five largest China enterprises (H-shares) and red-chip companies listed on the Hong Kong Stock Exchange. It is perceived as a comprehensive index to gauge the performance of Chinese firms listed in Hong Kong. We will compare the stock price performance of the state banks in the first 500 trading days after issuing their initial public offerings (IPOs). Since the Industrial and Commercial Bank of China (ICBC) launched its IPO in October 2006, only 420 trading days were available for the analysis. Selected descriptive statistics of the time series are shown in Table 5.

If HSI and HSIF are chosen as the benchmarks, all four state banks show a similar pattern of tradeoff in risk and return. The average daily returns and the standard deviations are higher than those of the market portfolio. However, we have a different scenario when HSM25 is used as the benchmark. ICBC and BComm have returns and standard deviations higher than HSM25. The average return of CCB is lower and the standard deviation is higher than those of HSM25. The standard deviation of BOC is comparable to HSM25, but its return is substantially lower. In short, despite strong support from the government and the availability of strategic investors, the pattern of risk and return shows that these state banks did not outperform the market.

Next, the methodology of event study was employed to see how the market responds to a public listing of the state-owned banks. With this methodology, we assume that the return of a security should follow the return of the market

Table 5

Descriptive Statistics of Stock Returns

CCB ICBC

BComm

BOC Return

SD

Return

SD

Return

SD

Return

SD

Bank 0.25% 1.96%0.18% 2.71%0.25% 1.96%0.07% 2.16%HSI 0.15% 1.14%0.07% 1.91%0.08%0.91%0.09% 1.75%HSIF 0.11%0.94%0.04% 1.86%0.04%0.67%0.05% 1.67%HSM250.26%

1.61%

0.14%

2.47%

0.16%

1.34%

0.15%

2.28%

Sample period

October 27, 2005– October 23, 2007October 7, 2006– July 21, 2008June 23, 2005– June 11, 2007June 1, 2006– June 12, 2008

source : DataStream, finance database, securities database (2008).

banks. The average return in the second and fourth 100 trading days outper-forms the market if HSI or HSIF is used as the benchmark at the 5 percent level of significance. It outperforms the market in the first 100 trading days at the 5 percent level if HSIF is used as the benchmark. CCB also outper-forms the market at the 5 percent level using HSI or HSIF as the benchmark. There is no evidence for any other case where the state banks outperform the market. In particular, the performance of BOC is worse than HSM25 at the 5 percent level in the fourth 100 trading days and the 5 percent level in the third 100 trading days.

The cumulative returns are also computed for comparison. The results are consistent with our inspection of the descriptive statistic of the stock price time series. The cumulative abnormal returns are graphed in Figure 2. Apparently, only BComm outperforms all three benchmarks. ICBC and CCB outperform HSI and HSIF but are comparable to HSM25. The performance of BOC is the worst among the four state banks. It lags behind both HSIF and HSM25, and is only marginally better then HSI after 500 trading days.

The results of hypothesis testing the cumulative abnormal returns are shown in Table 7. BComm and ICBC have significant cumulative abnormal returns for all the sampled periods no matter which benchmarks are used. The cumulative return of CCB outperforms HSI and HSIF for all the sampled periods. It also outperforms HSM25 for the first 400 trading days, but lags behind after 500 trading days. Again, the BOC performance is the worse. It outperforms HSI for the first 200 trading days and HSIF for the first 300 hundred trading days, but lags behind both the benchmarks for the rest of the sampled periods. Its cumulative abnormal returns are negative at the 5 percent level except for the first 100 trading days if HSM25 is used as the benchmark.

Summing up, with the exception of BOC, the state-owned banks have satisfactory market performance. They outperform the market when HSI, HSIF, and HSM25 are used as benchmarks. The fact that stock returns of the state banks outperform HSM25 is noteworthy. It indicates that investors are confident about the development of the state-owned banks, including the development of the corporate governance framework among other listed state-owned enterprises.

Conclusion

Efforts to improve corporate governance are important steps in transforming the large state-owned enterprises to modern corporate entities. However, China is still a “market economy with socialist characteristics.” Thus key industries, including banking, remain firmly controlled by the state. In these enterprises,the enterprise leaders are appointed by the state. Dynamics among the state, management, and the board are complex.

The CBRC regulates and monitors the banks closely. It supposedly plays the major role in improving bank corporate governance. The framework of internal control has been installed in all the listed banks. As the authority to hire and fire remains with the state, it is uncertain whether the newly installed board system can effectively function as the watchdog. In spite of questions concerning the effectiveness of the corporate governance mechanism, stock returns of state-owned banks generally outperform the market. Apparently this is an indication of market confidence in the development of banking reform.

Opaqueness is one of the attributes of the banking industry and without effective corporate governance in place, managers are deemed to behave opportunistically (Levine 2003). The 2008 worldwide financial crisis origi-nated from the collapse of some major banks in the United States. This is a recent demonstration of the opportunistic, manipulative behavior of bank managers. An effective system of corporate governance is particularly indispensable for the banking industry in China, where the state plays the dominant role. An important benchmark to gauge the success of banking reform in China will be if the banks can establish an effective corporate governance structure.

Notes

1. Recently, the Bank of Communication has also been included as a major state-owned commercial bank.

2. “The Big Four Plan to Go IPO,” Economic information and Agency, December 1, 200

3.

3. When speaking at a business forum in 2001, the secretary-general of the State Economic and Trade Commission mentioned that improving corporate governance is of critical importance to the post-WTO Chinese economy. In particular, he admitted that insider control existed in many Chinese enterprises and called for the diversification of corporate ownership. He also revealed that the government will encourage major state-owned enterprises to go public along with cross-ownership between Chinese and foreign firms (people’s Daily, November 21, 2001, http://english.peopledaily. com.cn/200111/21/eng20011121_85011.shtm).

4. In 2006 alone, CBRC issued twelve new regulations/guidelines to the commercial banking sector. It plays an important role in personnel matters and is involved in the management of the supervisory boards of major state-owned banks. It conducts on-site examinations at banking institutions to monitor whether bank behavior complies with regulations. In 2006, the CBRC executed close to 70,000 on-site examinations, imposing disciplinary penalties on 243 senior management personnel.

5. For example, Li Lihui, president and also vice chairman of the board of directors of the Bank of China assumed his post in 2004. He had been the deputy governor of

sEpTEmBER–oCToBER 2009 39

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Hainan province from 2002 to 2004, and an executive vice president of ICBC from 1994 to 2002.

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