Understanding the High Profitability of Big Chinese Banks

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Conference: International Competition in Banking – Theory and

Practice

24-25 of May, 2012, Sumy, Ukraine

Prof. Horst Loechel

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Agenda

1. China’s financial reform – an overall success

2. Chinese banks: Low efficiency and high profitability

3. Why big Chinese banks are more profitable than their Western peers

4. Research results and further research

5. References (selection)

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Features of China’s financial system

- High intermediation level (but disintermediation under way)

- State-owned banks dominate (over 50% market share)

- Segregate banking system (but universal banks under way)

- Strong regulation and supervision (but gradual liberalisation)

- Low internationalization level (but internationalization under way)

- Managed interest and exchange rate system

- Still immature capital markets (particularly bond markets)

- Managed capital account

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China’s financial sector reform: Gradual approach with Chinese character

20112006 2009 20102003 2004 -20062000

Introduction of bad loan asset management

companies

Announcement by the state council to develop Shanghai into an

international financial center by 2020

Internationalization of RMB

Internationalization of banks

Opening of the market for foreign financial institutes

Spin-off of CBRC

• Recapitalization of big chinese banks

• IPOs (partial privatization)

• Strategic foreign investors

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China: Successful banking reform (I)

30 Years Banking Reform in China

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

800,000

900,000

1949-1978

1979-1983

1984-1993

1994-1997

1998-2002

2002 2003 2004 2005 2006 2007 2008 2009

in R

MB

100 m

illio

n

0

5

10

15

20

25

30

35

in %

Total assets % NPL

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China: Successful banking reform (II) Global top 10 banks by pre-tax profit 2007-2010

Bank Country US$ million Bank Country US$ million1 Bank of America USA 31,973 ICBC China 21,2602 Citigroup USA 29,639 CCB China 17,5203 HSBC Holdings UK 22,086 Santander Central Hispano Spain 15,8254 JP Morgen Chase USA 19,886 BOC China 12,6205 Royal Bank of Scotland UK 18,033 BBVA Spain 9,6406 Crédit Agricole Group France 14,060 HSBC Holdings UK 9,3077 Barclays Bank UK 14,009 Barclays Bank UK 8,8598 BNP Paribas France 13,921 ABC China 7,6599 Mitsubishi UFJ Financial Group Japan 12,824 UniCredit Italy 6,95210 Wells Fargo USA 12,745 Royal Bank of Canada Canada 6,077

Bank Country US$ million Bank Country US$ million1 ICBC China 24,494 ICBC China 32,5282 CCB China 20,316 CCB China 26,4483 Goldman Sachs USA 19,826 JPMorgan Chase & Co USA 24,8594 Barclays UK 18,869 BOC China 21,4635 Wells Fargo & Co USA 17,606 HSBC Holdings UK 19,0376 Banco Santander Spain 16,951 Wells Fargo & Co USA 18,7007 BOC China 16,319 ABC China 18,2308 JPMorgan Chase & Co USA 16,143 BNP Paribas France 17,4069 BNP Paribas France 12,222 Banco Santander Spain 16,07910 Itaú Unibanco Holding SA Brazil 11,521 Goldman Sachs USA 12,892

Source: The Banker

2007 2008

2009 2010

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The next steps (I)12th Five-Year-Plan (2011-2015)

„Financial market reform will encourage financial innovation, push forward

market based reform of interest rates, and expand the use of the Renminbi in

cross-border trade. In addition the government is continuing its efforts to

make the Renminbi convertible under capital accounts.“

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The next steps (II)Road map of the internationalization of the RMB

RMB as: Requirements: Time Schedule:

• Trade currency • Controlled capital account and managed exchange and interest rate system

• Since 2010

• Investment currency(FDI/ODI)

• Controlled capital account and managed exchange and interest rate system

• Since 2011

• Off-shore portfolio currency (Hong Kong)

• Controlled capital account and managed exchange and interest rate system

• Since 2011

• Reserve currency • Open capital account and flexible interest and exchange rate system

• Probably around 2020

Deg

ree

of In

tern

ation

alis

ation

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Chinese Banks: Contradiction of efficiency and profitability

Low efficiency High profitability

ICBC and CCB ranked No. 1 and No. 2 by pre-tax profit throughout 2008 to 2010 in the Banker global bank ranking

Average ROAA of 0.96% for the time period 2003 to 2010 of the “big four”, more than double of the average level of the top

international peer banks (0.45%)

No significant correlation between efficiency and profitability in Chinese banks (Feyzioglu 2009)

State-owned Chinese commercial banks have low efficiency (García-Herrero et al. 2009)

Contradiction between low efficiency and declining NPL-ratio

in Chinese state-owned banks (Allen et al. 2012)

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Chinese banks: Interest margin not correlated with loan quality

Normal China

aver

age

mar

gin

aver

age

mar

gin

NPL NPL

Interest rate margin and NPL-ratio (2003-2010)*

CorrelationObs.P value

0.00021460.9978

* all Chinese banks

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The sources of Chinese banks’ high profitability Comparison of key financials of the “big four” Chinese state-owned banks with international peers

Size Net incomeBusiness

diversificationGrowth

Total assets (million USD)

After-tax net income

(million USD)

ROAA (% )

ROAE (% )

Net interest margin

(% )

NPL-ratio (% )

Residential mortage loans/

gross loans (% )

Corporate and

commercial loans/

gross loans (% )

Other loans/gross

loans (% )

Loans/ customer deposits

(% )

Customer deposits/

total funding

(% )

Cost income

ratio (% )

Personnel expenses/

total assets (% )

Non-interest income/

gross revenue (% )

Growth of total assets (% )

Tier 1 ratio (% )

Total regula-

tory capital ratio (% )

Equity/ total

assets (% )

Big four Chinese banksAverage 1.022.078 9.623 0,96 13,16 2,69 5,90 15,45 79,18 5,37 61,71 90,32 38,42 0,58 15,23 18,78 9,24 11,23 3,44

International peersPeer average 1.443.900 5.367 0,45 9,83 1,41 3,09 35,85 25,44 34,45 103,33 54,58 64,44 0,74 46,26 9,91 9,26 12,93 4,59

Capital strengthProfitability Lending business Loan portfolio Refinancing Cost control

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Back up – Peer selection

Rank Bank Name CountryTotal assets 2010

million USD

1 BNP Paribas France 2,669,9072 Deutsche Bank Germany 2,546,2723 Barclays Bank UK 2,332,5584 Royal Bank of Scotland UK 2,046,5405 ICBC China 2,032,1346 Bank of Tokyo-Mitsubishi UFJ Japan 1,687,3137 CCB China 1,632,2638 Banco Santander Spain 1,626,8059 BOC China 1,579,348

10 Lloyds TSB Bank UK 1,579,10511 ABC China 1,560,85812 Société Générale France 1,512,65613 Bank of America USA 1,482,27814 UBS Switzerland 1,401,92315 HSBC Bank UK 1,249,99116 Sumitomo Mitsui Banking Corporation Japan 1,247,05317 ING Bank Netherlands 1,246,75718 UniCredit Italy 1,241,96619 Citibank USA 1,154,29320 Credit Suisse Switzerland 1,073,607

Peer average 1,631,189Big four average 1,701,151

Source: Bankscope

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Simulation (I): Why the big Chinese banks are more profitable than their Western peers

Margin stressed to international peer level

Hypothesis:The average asset return of the “big five” Chinese banks will fall below the international

comparative level if the current high average net interest margin falls to the international peer average level, based on ROAA OLS regression results.

NIM original NIM stress↓ ROAA original ROAA stress

ICBC 2.64 1.38 0.91 0.52

CCB 2.94 1.54 1.13 0.70

BOC 2.36 1.24 0.94 0.59

ABC 2.82 1.48 0.87 0.42

Big four average 2.69 1.41 0.96 0.56

Peer average 1.41 0.45

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Simulation (II): Why the big Chinese banks are more profitable than their Western peers

Combined stressed margin and increase in cost income ratio by 20%

Hypothesis:The asset return of the “big four” Chinese banks will fall below the international peer level if the average lending margin shrinks to international peer average level and the CIR ratio driven by

personnel expenses increases by 20%, based on ROAA OLS regression results.

NIM original NIM stress ↓ CIR original CIR 20% ↑ ROAA original ROAA stress

ICBC 2.64 1.38 35.89 43.06 0.91 0.34

CCB 2.94 1.54 37.56 45.08 1.13 0.51

BOC 2.36 1.24 40.16 48.19 0.94 0.39

ABC 2.82 1.48 40.08 48.10 0.87 0.21

Big four average 2.69 1.41 38.42 46.11 0.96 0.36

Peer average 1.41 64.44 0.45

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Identifying the whole picture

income

costCIR

Personnel cost

Margin spread

Corporate lending

concentration

Market power

Economic growth

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Simulation (III): Impact of business diversification

Combined stressed margin, cost income ratio and doubling in business diversification 20%

Hypothesis:Business diversification can provide a way out of the “profitability trap” in course of shrinking

margin and higher staff costs, based on ROAA OLS regression results.

NIM original NIM stress ↓ CIR original CIR 20% ↑ ROAA original ROAA stress NIIR original NIIR 100% ↑ROAA original ROAA stress

ICBC 2.64 1.38 35.89 43.06 0.91 0.34 12.85 25.71 0.91 0.52

CCB 2.94 1.54 37.56 45.08 1.13 0.51 13.29 26.57 1.13 0.70

BOC 2.36 1.24 40.16 48.19 0.94 0.39 20.84 41.68 0.94 0.68

ABC 2.82 1.48 40.08 48.10 0.87 0.21 13.95 27.89 0.87 0.41

Big four average 2.69 1.41 38.42 46.11 0.96 0.36 15.23 30.46 0.96 0.58

Peer average 1.41 64.44 0.45 46.26 0.45

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Back up – ROAA OLS regression resultsVariable BetaLnTA 0.0010 0.0046t value 0.08p value 0.9390Equity 0.0269 *** 0.4365t value 5.61p value 0.0000NIM 0.2823 *** 0.3619t value 5.74p value 0.0000NPL -0.0095 *** -0.2065t value -3.06p value 0.0030CIR -0.0254 *** -0.5893t value -7.36p value 0.0000Deposit 0.0065 *** 0.2983t value 3.51p value 0.0010NIIR 0.0140 *** 0.3085t value 5.37p value 0.0000Growth 0.0014 0.0461t value 0.91p value 0.3650Constant 0.2601 t value 1.04p value 0.2990F value 41.13R-squared 0.7444Adjusted R 0.7263Obs. 122*** / ** / * Statistically significant at 1% / 5% / 10% level respectively

OLS

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Research results so far

- Despite the successful banking reform the analysis shows that big Chinese

banks are making windfall profits due to non-competitive market conditions

and market power

- In a competitive environment their current business model would not be

sustainable

- It also poses an obstacle to the intention to internationalize the RMB

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Further research

- CIR-analysis

- Business model transformation towards universal banks

- Integrated financial supervision

- Shadow banking system (informal finance), disintermediation in China

- Impact of the internationalization of the RMB on banking and finance in China

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Limitation of the analysis

- Structural interruptions (e.g. banking reform, financial crisis)

- Quality of data (e.g. limited observations)

- Focus on bank-specific determinants only (e.g. impact of market structure and

economic growth)

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China’s banking and finance industry:The challenges ahead

- Internationalization of RMB

- Liberalization of interest and exchange rate system

- Upgrade of capital markets, esp. corporate bond market

- Opening of capital account

- Change of banking business models towards universal banking

- Vertical integration within banks

- Consolidation of CCB’s and rural banks

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References (Selection)

Allen, F. et al. (2012): China‘s Financial System: Opportunities and Challenges, NBER Working Paper No. 17828.

Chang, C. and H. Löchel ed. (2012). China‘s Changing Banking Industry, Frankfurt 2012.

Feyzioğlu T. (2009). Does good financial performance mean good financial intermediation in China? IMF Working Paper WP/09/170

García-Herrero A., Gavilá S., Santabárbara D. (2009). What explains the low profitability of Chinese banks? Journal of Banking & Finance 33, 2080–2092.

Goddard J., Molyneux P., Wilson J. O. S. (2004). The profitability of European banks: a cross-sectional and dynamic panel analysis. The Manchester School 72, 363-381.

Lu Y., Fung H. G., Jiang X. F. (2007). Market structure and pofitability of Chinese banks. The Chinese Economy 40, 100-113.

Sufian F., Habibullah M. S. (2010). Assessing the impact of financial crisis on bank performance. ASEAN Economic Bulletin 27, 245-262.

Vennet R. V. (2002). Cost and profit efficiency of financial conglomerates and universal banks in Europe. Journal of Money, Credit and Banking 34, 254-282.

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Contact

Prof. Dr. Horst Loechel Frankfurt School of Finance & Management

Sonnemannstraße 9-11D-60314 Frankfurt am Main, Germany

E-mail: h.loechel@fs.de