How Banks in China make Lending Decisions

Abstract

Based on interviews conducted in four major Chinese cities, this paper examines the determinants of lending by state-owned commercial banks (SOCBs) to manufacturing firms in China. The conventional relationship banking and transaction lending theories helps explain at least part of the lender–borrower relationship in China. The perceived lending bias against non-state-owned enterprises could actually be reconciled as rational decision-making by SOCBs, partly due to the higher risk involved and/or high transaction costs in the risk evaluation of such lending. The existence of unofficial lending criteria at SOCBs nonetheless provides golden rent-seeking opportunities for unscrupulous bankers to exploit the regulatory loopholes for financial gain.

Notes

^*Godfrey Yeung is an associate professor of economic geography at the National University of Singapore. He researches issues related to the economic reforms in China. The author would like to show his gratitude to a number of anonymous bankers and individuals who facilitated and participated in the survey. The British Academy's Sino–British Research Fellowship and Hong Kong Polytechnic University financed the author's field surveys between 2004 and 2006. He is particularly grateful to Dr Vincent Mok at the Hong Kong Polytechnic University and Professor Xiaoping Xu at the Shanghai University of Finance and Economics for helpful assistance, and the two anonymous referees and the editor of JCC, Professor Suisheng Zhao, for their valuable comments on the earlier version of this paper.

^1. Bloomberg, ‘Bank slams “distorted” estimate of bad loans’, South China Morning Post, (12 May 2006); Agence France-Press, ‘Ernst & Young withdraws “erroneous” bad loan report’, South China Morning Post, (15 May 2006).

^2. N. R. Lardy, China's Unfinished Economic Revolution (Washington: Bookings Institution Press, 1998).

^3. Agence France-Press, ‘China bank system one of the world's weakest, says Fitch’, South China Morning Post, (8 June 2006).

^4. The SOCBs include the Industrial and Commercial Bank of China (ICBC), the Agricultural Bank of China (ABC), the Bank of China (BOC), the Construction Bank of China (CBC) and the Bank of Communications (BOCOM). With the exception of ABC, SOCBs are by definition international holding financial institutions after their initial public offerings (IPOs) in 2005–2006. For the sake of simplicity and the fact that the state is still the majority equity holder of all SOCBs (ranging from 54.7% in BCOM to 75% in ICBC), this paper groups the ‘Big Four’ plus BCOM as SOCBs by following the classification system used by the China Banking Regulatory Commission (CBRC). S. J. Wei and T. Wang, ‘The Siamese twins: do state-owned banks favor state-owned enterprises in China?’, China Economic Review 8(1), (1997), pp. 19–29; R. Cull and C. X. Xu, ‘Who gets credit? The behavior of bureaucrats and state banks in allocating credit to Chinese state-owned enterprises’, Journal of Development Economics 71(2), (2003), pp. 533–559.

^5. Wei and Wang, ‘The Siamese twins’, p. 28.

^6. Cull and Xu, ‘Who gets credit?’, p. 547.

^7. A. Park and M. G. Shen, ‘Joint liability lending and the rise and fall of China's township and village enterprises’, Journal of Development Economics 71(2), (2003), pp. 497–531.

^8. Wei and Wang, ‘The Siamese twins’.

^9. Cull and Xu, ‘Who gets credit?’.

^10. China Minsheng Bank, established in 1996, is the first joint-stock commercial bank in China. A number of other city commercial banks are partly owned by foreign-investors but are ultimately owned by the local governments (foreign investors were not allowed to own more than 25% of Chinese banks before 2007). The joint-stock commercial banks include CITIC Industrial Bank, Everbright Bank of China, Huaxia Bank, Guangdong Development Bank, Shenzhen Development Bank, China Merchants Bank, Shanghai Pudong Development Bank, Industrial Bank, China Minsheng Banking Co., Evergrowing Bank, China Zheshang Bank, and China Bohai Bank.

^11. Lardy, China's Unfinished Economic Revolution, p. 83; Organisation for Economic Co-operation and Development (OECD), OECD Economic Surveys: China, 2005/13, (September 2005), pp. 21, 146–147, available at: http://www.oecd.org/.

^12. Lardy, China's Unfinished Economic Revolution, p. 83; Organisation for Economic Co-operation and Development (OECD), OECD Economic Surveys: China, 2005/13, (September 2005), pp. 141–143.

^13. In 1994, the ‘Big Four’ controlled over 80% of China's financial assets and issued over 60% of the country's total loans. R. J. Blanchard, ‘The heart of economic reform’, The Chinese Business Review, (January–February 1997), pp. 16–24. In 2006, the SOCBs (the ‘Big Four’ plus the Bank of Communications) controlled 55% of the 43.95 trillion yuan banking assets in China. CBRC, CBRC 2006 Annual Report, (2007), p. 133, available at: http://zhuanti.cbrc.gov.cn/subject/subject/nianbao/english/ywqb.pdf.

^14. A. W. A. Boot and A. V. Thakor, ‘Can relationship banking survive competition?’, Journal of Finance 55(2), (2000), pp. 679–713. Transaction lending incorporates financial statement lending, asset-based lending and credit scoring. A. N. Berger and G. F. Udell, ‘Small business credit availability and relationship lending: the importance of bank organisational structure’, The Economic Journal 112(477), (2002), pp. F32–F53.

^15. D. Diamond, ‘Monitoring and reputation: the choice between bank loans and directly placed debt’, Journal of Political Economy 99, (1991), pp. 689–721; R. G. Rajan, ‘Insiders and outsiders: the choice between informed and arm's length debt’, Journal of Finance 47, (1992), pp. 1367–1400.

^16. For borrower-specific information, see S. Bhattacharya and G. Chiesa, ‘Proprietary information, financial intermediation, and research incentive’, Journal of Financial Intermediation 4, (1995), pp. 328–357; and O. Yosha, ‘Information disclosure costs and the choice of financing source’, Journal of Financial Intermediation 4, (1995), pp. 3–20. For screening, see R. Ramakrishnan and A. V. Thakor, ‘Information reliability and a theory of financial intermediation’, Review of Economic Studies 51, (1984), pp. 415–432; and F. Allen, ‘The market for information and the origin of financial intermediation’, Journal of Financial Intermediation, 1, (1990), pp. 3–30. For monitoring, see D. Diamond, ‘Financial intermediation and delegated monitoring’, Review of Economic Studies 51, (1984), pp. 393–414; and A. Winton, ‘Delegated monitoring and bank structure in a finite economy’, Journal of Financial Intermediation 4, (1995), pp. 158–187. For liquidity transformation, see D. Diamond and P. H. Dybvig, ‘Bank runs, deposit insurance and liquidity’, Journal of Political Economy 91, (1983), pp. 401–419.

^17. Boot and Thakor, ‘Can relationship banking survive competition?’, p. 680; R. Cressy, ‘Funding gaps: a symposium’, The Economic Journal 112(477), (2002), pp. F1–F16.

^18. Loans classified in the ‘sub-standard’, ‘doubtful’, and ‘loss’ categories are regarded as NPLs. CBRC, CBRC 2006 Annual Report, pp. 72–73; OECD, OECD Economic Surveys: China, pp. 42, 145.

^19. The actual cut-off point of lending varies between different SOCBs. Field survey, interviewees 1–3, 5, 7–9, November 2004, and personal communication with Professor Xiaoping Xu, 31 August 2007.

^20. The actual cut-off point of lending varies between different SOCBs. Field survey, interviewees 1–3, 5, 7–9, November 2004, and personal communication with Professor Xiaoping Xu, 31 August 2007

^22. According to the latest policy on collateral, the usage right of land is classified as an invisible asset, while the properties built on the land are classified as visible assets in collateral by SOCBs in China. Field survey, interviewees 14–15, December 2006.

^23. Guarantee institutions proliferated all over China after the pilot programme in 1998. By June 2004, there were 2,136 guarantee institutions of various forms and ownership structures, with 200 billion yuan of loans carrying guarantees. OECD, OECD Economic Surveys: China, p. 152.

^21. The actual cut-off point of lending varies between different SOCBs. Field survey, interviewees 1–3, 5, 7–9, November 2004, and personal communication with Professor Xiaoping Xu, 31 August 2007 and interviewees 13–16, December 2006.

^24. Field survey, interviewee 1, November 2004.

^25. The sub-branch president has the right to veto but not the right to grant any loan application without the unanimous approval from other members of the Committee.

^26. Field surveys, interviewees 1–3, 5, 7–9, November–December 2004.

^27. Field surveys, interviewees 1–3, 5, 7–9, November–December 2004

^28. Field surveys, interviewees 1–3, 5, 7–9, November–December 2004 and interviewees 13–16, December 2006; OECD, OECD Economic Surveys: China, p. 153.

^29. Boot and Thakor, ‘Can relationship banking survive competition?’.

^30. M. Aoki and S. Dinc, Relationship Financing as an Institution and its Viability under Competition, CEPR Publication no. 488, (1997), Stanford University. Soft-budget constraint is a generic term used to describe the lax financial discipline of firms, normally state-owned institutes, i.e. decision makers expect that someone (the state) will pay for the firm's financial losses. J. Kornai, Economics of Shortage (Amsterdam: North-Holland, 1980); K. Lee, Chinese Firms and the State in Transition: Property Rights and Agency Problems in the Reform Era (New York: M. E. Sharpe, 1991).

^31. Field surveys, all interviewees, November 2004–December 2006.

^32. Wei and Wang, ‘The Siamese twins’.

^33. J. Laurenceson and J. C. H. Chai, ‘State banks and economic development in China’, Journal of International Development 13(2), (2001), pp. 211–225. Loans to private enterprises and individuals only accounted for 1.615 of the total short-term loans granted in 2004. National Bureau of Statistics, China Statistical Yearbook 2006 (Beijing: China Statistics Press, 2006).

^34. Field surveys, interviewee 8, December 2004.

^35. There are however some rare exceptions. For instance, the ICBC had offered a 2 million yuan patent loan to an enterprise based in Shanghai Zhangjiang High-Tech Park, and the Bank of Communications had offered a 1.5 million yuan patent loan to Beijing Kery Bio-Pharm Company in September and November 2006, respectively. L. Zhang, ‘Lenders now taking IPR as collateral’, China Daily, (16 November 2006), p. 12.

^36. Field surveys, all interviewees, November 2004–December 2006. Interest rates charged by saving co-operatives are normally 1–1.5% higher than those of SOCBs (Field survey, interviews with two owners of foreign-financed firms in China, November 2004), while pawn shops in Beijing charge much higher interest rates (3.2–4.7%/month versus 5.58%/year in SOCBs). Reuter, ‘China's trapped entrepreneurs fuel pwanbroking boom’, China Daily, (27 February 2006).

^37. Field survey, interviewee 5, November 2004 (italics added).

^38. Field survey, interviewee 5, November 2004 (italics added) (italics added).

^39. OECD, OECD Economic Surveys: China, p. 141.

^40. Field surveys, interviewees 1–3, 5, 7–9, 13–16, November 2004–December 2006. The NPL ratio for lending to small enterprises was 19.3% by the end of 2006. CBRC, CBRC 2006 Annual Report, p. 54.

^41. Y. Jiang, ‘Size matters’, China Daily: Business Weekly, (24 October 2005), p. 4.

^42. J. Stiglitz and A. Weiss, ‘Credit rationing in markets with imperfect information’, American Economic Review 71, (1981), pp. 393–410.

^43. Berger and Udell, ‘Small business credit availability and relationship lending’, pp. F37–F38.

^44. Field survey, interviewees 2–3, 5, 7 and 9, November 2004.

^46. Field survey, interviewee 5, November 2004

^45. Field survey, interviewee 5, November 2004.

^47. Policy lending (directed credit) is loans from the central bank to financial institutions that are used to finance specific projects identified by the State Planning Commission. In 1985, one-third of the total loans outstanding in China were policy loans. The corresponding figure dropped to one-fifth in 1995. Lardy, China's Unfinished Economic Revolution. Infrastructure accounted for about 25% of the total lending by CBC in 2006. CBC, CBC Annual Report 2006 (2007), p. 29.

^48. Cull and Xu, ‘Who gets credit?’, p. 540.

^49. Laurenceson and Chai, ‘State banks and economic development in China’, p. 214.

^50. In fact, the solvency ratio of SOCBs in terms of NPLs to GNP did not deteriorate rapidly during the 1990s, e.g. NPLs of SOCBs accounted for 13.8% of GNP in 1993, with the ratio increasing to 18% in 1997. Laurenceson and Chai, ‘State banks and economic development in China’, pp. 220–221.

^51. Field surveys, interviewees 1–9, November 2004–April 2005.

^52. Field surveys, interviewees 1–3 and 5–9, November–December 2004.

^53. Zhengyi Zhou used the HK$735 million loan from the BOC (Hong Kong) to repay the loan he used to buy control of Shanghai Land. The collapse of Shanghai Land also led to the arrest of Jinbao Liu, then vice-chairman and chief executive of the BOC (Hong Kong), who was accused of embezzlement. Vincent Lam, ‘End of road for Shanghai developer’, China Daily, (11 October 2005), p. 11.

^54. Field survey, interviewee 6, November 2004.

^55. Field survey, interviewee 6, November 2004 GITIC, the investment arm of booming Guangdong province, became the first non-banking financial institute bankrupted in China, in October 1998. This occurred because of its inability to meet outstanding debts. It had assets of 21.47 billion yuan (US$2.6 billion), but had debts from its 494 offshore and domestic companies of 46.7 billion yuan (US$5.63 billion) owed to banks in Japan, China, Hong Kong, Switzerland and the US. The former president, Yantian Huang of GITIC, was sentenced to 14 years in jail. Creditors of GITIC were eventually able to recover 2.54 billion yuan (US$307 million) of debt, with a ‘hair-cut’ (the unrecoverable proportion of debts) of over 87%. C. X. Zheng, ‘Former GITIC chief imprisoned’, China Daily, (30 June 2004), p. 3.

^56. CBRC, CBRC 2006 Annual Report, pp. 76 and 80.

^57. B. Hu, ‘CBRC gets tough on rampant scandals at lenders’, South China Morning Post, (1 July 2006).

^58. Field survey, interviewee 5, November 2004.

^59. Field survey, interviewees 14–15, December 2006.

^60. M. Dickie, ‘Bank vows scandal will not hinder IPO’, Financial Times, (19 May 2005), p. 28 (italics added). Should the credit managers and presidents be resilient for political lobbying, nonetheless, it is still possible for SOCBs to withstand the pressure from the government and refuse the loan application from major SOEs. As proclaimed by an experienced president at a ‘Big Four’ in Shanghai, ‘the major difference between now and then is that we have a bottom line—we can say “NO” to the government for the loans if we are sure it is a money-losing project and thus unable to generate enough cash for repayment. The government will not force us to lend to such companies’. Field survey, interviewee 5, November 2004.

^61. J. Anderlini, ‘Risks rising in China banking system: regulators call for tighter lending curbs as new bank loans top 1.8 trillion yuan’, South China Morning Post, (16 June 2006).

^62. The commercial banks' NPL figures have included the ‘Big Four’, joint stock commercial banks, rural credit co-operatives, and 3.1 billion yuan of NPL incurred by foreign-owned commercial banks. CBRC, ‘NPLs of commercial banks as of end-March 2007’, (16 May 2007), available at: http://www.cbrc.gov.cn/english/info/statistics/index.jsp. ABC is the second largest bank by assets in China but with the NPL ratio of more than 23% at the end of 2006. ABC, ABC Annual Report 2006 (2007), p. 2, available at: http://www.abchina.com. Together with the rural credit co-operatives, they are the most inefficient banking operators which incurred a typical double-digit NPL ratio in China.

^63. OECD, OECD Economic Surveys: China, p. 143.

^64. OECD, OECD Economic Surveys: China, p. 148; BOC, BOC 2006 Annual Report, (2007), p. 68; ICBC, ICBC 2006 Annual Report, (2007), p. 78; CBC, CBC 2006 Annual Report, (2007), p. 34. Figures on ‘special mention’ loans are not published in the annual reports of CBRC and ABC.

^65. Field survey, interviewee 8, December 2004.

Additional information

Notes on contributors

Godfrey Yeung

66 *Godfrey Yeung is an associate professor of economic geography at the National University of Singapore. He researches issues related to the economic reforms in China. The author would like to show his gratitude to a number of anonymous bankers and individuals who facilitated and participated in the survey. The British Academy's Sino–British Research Fellowship and Hong Kong Polytechnic University financed the author's field surveys between 2004 and 2006. He is particularly grateful to Dr Vincent Mok at the Hong Kong Polytechnic University and Professor Xiaoping Xu at the Shanghai University of Finance and Economics for helpful assistance, and the two anonymous referees and the editor of JCC, Professor Suisheng Zhao, for their valuable comments on the earlier version of this paper.