Opinion     

Bad assets overshadow banks' huge profits

Shanghai Daily, March 29, 2012

• Sun Lijian

  When asked by reporters on March 15 about how he perceived the huge profits of China's banking industry last year while the private sector was foundering on a shortage of bank loans, Zhou Xiaochuan, governor of People's Bank of China, said he thought banks' staggering profits were a natural result of readjustment of economic cycles.

  However, Wu Xiaoling, former deputy governor of PBOC and currently deputy head of the fiscal and economic committee of the National People's Congress, said there are grounds for criticizing banks' enormous earnings, which she said were indeed unjustified.

  Whatever the differences between the two seasoned banking regulators, my opinion is that banks' exorbitant profits are overshadowed by mounting risks over worsening bank assets comprised of local debts and home mortgages. Without realizing this fact, we cannot explain the contrasting, following phenomena.

  Contrasts

  On the one hand, a report issued by the China Banking Regulatory Commission in February said domestic banks generated a net profit of 1.04 trillion yuan (US$120.8 billion) last year, up 36.34 percent from 2010. Banks' daily profits stood at 2.85 billion yuan at the highest.

  Moreover, statistics show that 16 listed banks posted a combined profit of 700 billion yuan in the first three quarters of 2011, almost 40 percent of the 1.58 trillion yuan profit of all public firms on the Shanghai and Shenzhen stock exchanges.

  On the other hand, amid the prosperity of Chinese banks, China Huijin Investment Ltd, a state-owned investment vehicle, supported the joint bid by the "Big Four" - Industrial and Commercial Bank of China, Construction Bank of China, Bank of China and Agricultural Bank of China - to shed 5 percent of their dividend payout. The company also dramatically increased its holdings of the Big Four's stakes when the stock market was bearish in October. Such fund injections could happen again in the future.

  Fundamentally speaking, banks owe their profits to the rapid growth in new assets. For instance, banks extended a credit of 10 trillion yuan to go with the government rescue plan in 2008. Even though local debts and mortgages are now snowballing at a more controllable rate, the considerable capital gains made on loans over the past few years are still growing, in spite of the slowdown in the Chinese economy.

  But if we scrutinize banks' asset quality and the inherent liquidity risks, their whopping profits would seem almost negligible. In this sense, limits on high executive bonuses and efforts to force banks to share dividends work quite differently.

  Bonus caps are aimed at preventing speculation, which is key to the industry's stability. Bigger dividend payment appears to be a way of equitable distribution of wealth, but it adds to liquidity risks, with possible consequences like a scenario in which medium- and small-sized banks become insolvent.

  Given that asset quality is the biggest problem confronting Chinese banks, the government's line on regulating the property market is to stabilize it first and then bring home prices down. As a result, it has implemented a combination of policies.

  Avoiding hard landing

  On the one hand, to offset the risks of an economic hard landing caused by possible over-regulation, the government has encouraged local banks to lower mortgage rates on first homes.

  On the other hand, the authorities are committed to overhauling the real estate sector, in case idle speculative money keeps inflating the bubbles in already astronomical home prices.

  Meanwhile, the government is also trying to create more channels of investment through which bank loans can get into the real economy, so as to ensure that the quality of bank assets will improve as the economic recovery deepens. The aforementioned lowered dividend payouts and capital injections can free up some room for banks' liquidity and thus stimulate a new round of growth for non-financial industries.

  To change the conflicting reality of banks' ballooning profits yet deteriorating assets, the watchdog might do well to take precautionary measures like boosting banks' capital adequacy ratio and risk provision, so that amid its boom, the sector won't make loans recklessly. Otherwise, the cumulative systemic bubbles will one day boil down to a financial tsunami.

  And we must not harbor any illusion in the ability of collaterals to forestall a credit crunch. Japan's "lost 10 years," started by a real estate meltdown and subsequent banking miseries, are a textbook example of the price to pay for entertaining such myths. Besides, even if banks undergo the most conservative of stress tests for risk control, grave stress will still overwhelm them when collateral loans turn bad.

  Although openness and competition might dent banks' gains and improve services for depositors, myopic pursuit of short-term benefits will seriously jeopardize banks' assets in an age of prosperity. Therefore, in addition to beefing up precautionary regulation, the watchdog should also speed up the securitization of bank assets to divert worsening systemic risks, a natural byproduct of fast growth.

  To be sure, Chinese banks' profit model is also in dire need of reform. But if we miscalculate the best timing and order to do so, we will only reap unanticipated bitter results. This is especially the case in China, where at present the nation's financial resources are concentrated in its banks and disturbance in this sector is far more disastrous than stock market upheavals.

  Based on this understanding, the reform of domestic banks may proceed in four steps.

  First, strengthen the mechanisms of internal management, including the recruitment of top-notch financial talents and design of an appropriate salary package.

  Second, take precautionary supervisory measures but avoid over-regulation that strangles efficiency or loosening regulation in good times and resorting to tightening in bad times.

  Third, vigorously promote reforms of interest rate marketization and encourage healthy financial innovation on the basis of safer savings and maturing securities business.

  Finally, open up the banking sector to qualified private and foreign investors when time is ripe.

  The author is executive vice dean of the School of Economics at Fudan University. Shanghai Daily staff writer Ni Tao translated and edited his article from Chinese.

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