reform, corporate governance and prospect

The state-owned banks in China:

reform, corporate governance and prospect

Liu Mingkang,

Chairman, China Banking Regulatory Commission, Beijing International Financial Forum, Beijing, May 19,2004

Mr. Chairman,

Distinguished Guests,

Ladies and Gentlemen,

I am delighted to be present at this conference co-sponsored by the Beijing Municipal Government, the People s Bank of China, China Banking Regulatory Commission (CBRC), China Securities Regulatory Commission and China Insurance Commission. On behalf of the CBRC, let me extend my warm welcome to the participants at home and from abroad. I will take this opportunity to share with you my reflections on the reform of the state-owned banks in China.

Progress in reforming the state-owned banks

China has achieved significant reform progress since early 1980s. A framework of a social market-oriented economy has been established. The country will continue to adopt, as before, a gradualist approach to reform, taking into full account the country s circumstances. One distinctive feature of this reform is the stress on experimentation at both the local and sector levels and then roll it out on a broader scale. This methodology is critical for China as the country strives to build a socialist market-oriented economy and there is no precedent and not much experience to refer to.

Following years of reform efforts, the banking sector in China has become more diversified where the large state-owned banks compete on an equal footing with other banking institutions. By the end of 2003, the total assets of the banking sector amounted to 27.6 trillion yuan, 90 percent of the total assets of all financial firms in China. As the structure of the banking industry continues to evolve, the market share of the state-owned banks has declined. By the end of 2003, the four state-owned banks managed 15 trillion of assets, 55 percent of the total assets of the banking sector.

For decades, the state-owned banks have played a significant role in funding the economic growth, supporting the economic reform and maintaining social stability. As the major players in the market, the performance of the state-owned banks has a close bearing on China s economy and financial sector development. Having achieved remarkable progress in reforming the corporate sector, the Chinese government moved decisively to address non-performing loans (NPLs), under-capitalization and weaknesses in corporate governance of the state-owned banks. As you know, in December last year the government injected US 45 billion of foreign exchange reserves into two pilot state-owned banks, Bank of China and China Construction Bank. The capital injection was intended to restructure the two banks into shareholding commercial banks benchmarked to good performing banks overseas within a timeframe of three years. It is no doubt that this reform is extremely challenging.

The capital injection this time differs in a significant way from the government injection of 270 billion yuan into, and the related off-load of 1.3 trillion yuan of non-performing loans (NPLs) from the four state-owned banks in 1998. To some extent, the government action in 1998 was to reduce financial difficulty of the banks rather than an overhaul of their inherent structural problems. It became clear soon that the 1998 capital injection was inadequate as the banks financial distress was more deeply rooted than had previously realized. Furthermore, a realistic assessment of their financial soundness or unsoundness was also difficult at the time. Bear in mind, though, that in 1998 the five-category loan classification system was still in making, the related supervisory loan provisioning standards were introduced in 2002, and the rigorous capital rules were issued only early this year. Indeed, based on the experience and lessons learnt, we recently outlined our approach to banking supervision, ie, improved results of supervisory loan classification, adequate provisioning, true and meaningful profitability and compliance with capital requirements. We asked that all major banking institutions should meet the capital requirements in 2007.

The capital injection this time has helped to strengthen the banks balance sheet and paved the way for the ensuing bank restructuring. The key of this exercise is to expedite internal management reform and introduce sound corporate governance. In addition to capital injection, the reform program contains other elements such as further disposal of NPLs, restructuring the banks into shareholding companies, offer of shares to strategic foreign investors and public listing on international and/or domestic stock markets.

To my mind, the most critical part of the reform is to bring an overhaul of the way that the state-owned banks are managed. In other words, the reform is all about cash in exchange for a new system. As far as the overall reform package is concerned, the government capital support for all the state-owned banks is just a matter of time. Specially, in addition to Bank of China and China Construction Bank, Industrial Commercial Bank of China and Agriculture Bank of China are also required to refer the reform strategy to speed up internal management reform and improve corporate governance so as to create the necessary conditions for further reform. We expect that this reform will bring in real changes in the way the state-owned banks do their business and perhaps even in the business they do.

Corporate governance issues are closely related to the creation of a sound corporate structure.

At the moment, the state-owned banks generally suffer all the inherent weaknesses and deficiencies of the non-financial state owned enterprises with respect to corporate governance. It is important to note that in September, 1999 the Basel Committee issued the guidance paper Enhancing Corporate Governance in Banking Organizations. It is clearly stated in the paper that effective banking supervision should be based on sound corporate governance . In light of our understanding of governance issues and international experience, we stress that creation of sound corporate governance is a key element of the state-owned bank reform. In this context, the CBRC recently issued a set of corporate governance guidelines for the two reforming banks. The guidelines ask the banks to set up a corporate structure comprised of general shareholders meeting, a board of directors, a supervisory council and a management team, to diversify ownership through share offering to strategic foreign investors, to develop a well-defined business strategy, to put in place a sound risk management system, to streamline the organizational structure, to introduce incentive-based system for management of human resources, to adopt the accounting rules and disclosure practice, to improve information technology, to strengthen staff training, and to capitalize on the professional services of intermediary institutions in corporate restructuring and public listing.

In my view, the key aspect of this emerging new corporate structure is a sound and responsible board of directors. The board is the ultimate corporate governing body of a banking institution. To facilitate its work, the board needs to set up at least three committees, such as the audit committee, risk management committee, and compensation and remuneration committee. In practice, important decisions are made by these committees rather than individuals. In addition, it is essential for the banks to transfuse new blood, namely, to engage the talents from outside. It would be preferred that some committees are chaired by such high caliber professionals from developed markets.

It is true that improvement of corporate governance will not take place overnight. By way of example, the 11 shareholding banks in China have created the basics for a corporate governance framework. However, large gaps still remain with respect to the effective of role of the board in decision-making and oversight, protection of minority shareholders and other stakeholders interest, disclosure for true and reliable information. Experience suggests that the appointment of independent directors is a most powerful weapon to effectively address if not eliminate these deficiencies. All these indicate that effective implementation of these guidelines is challenging particularly for the state-owned banks as they start from scratch. Therefore, the state-owned banks need follow the general guidance to design and implement sound corporate governance strategy and address various deficiencies, which are typical in the Chinese banking market.

At the present, Bank of China and China Construction Bank are moving ahead with the reform. With a view to ensuring its success, the CBRC set out for the two banks a number of prudential requirements as well as key performance indicators benchmarked against top 100 largest banks globally. These time-bound requirements and indicators cover capital adequacy, large exposure, provisioning coverage, ROE, ROA, and cost to income ratio. As the reform has just begun and detailed aspects of this comprehensive reform package are evolving, it is too early to assess the prospect of the state-owned banks. One thing is clear that following the changes already underway, the Chinese banking sector will become more robust and competitive than before. Just some quick observations.

First, once transformed into shareholding banks, the state-owned banks can no longer rely on the full backing of the government and will need to operate in the market based on their own financial strength. In the same vain, market participants will judge their credit standing in same the way as they do to other players in the market. In the end, it will be left to the market to decide whether they will come out the winners of the game.

Second, the state-owned banks with their advantages in many areas will remain large banks in China. As such, they should be more sophisticated in the areas of risk management, and lead the way forward for other banks in the country the best they can. As they operate globally, they need to demonstrate that they can meet Basel II requirements for managing credit risk, market risk and operational risk.

In the interest of time, now, let me conclude. In a recent speech on policy reforms in emerging market economies titled Meant Well, Tried Little, Failed Much, Anne Kruegger, Acting Managing Director of the IMF noted that in all too many cases, economic reform ends in tears . I am more inclined to believe that no pains, no gains. Despite the challenges to reform our banking sector, we are confident that our reform will be a success as long as we strive in pursuit of the targets already set and proceed following the right sequence and keeping the right balance.

Thank you very much for your attention.