City and Rural Commercial Banks in China: The New Battlefield in Chinese Banking?

By Vijaya Subrahmanyam

Introduction
China's vast rural areas and lesser known cities have become a focus of attention both for China's banking industry and foreign banks. A major signal of this trend came in 2010, when AgBank of China, one of the country's major banks, made an IPO that became known as the manna from heaven for the nation’s western, rural regions. The bank is now aiming at narrowing the gap with the affluent coastal areas.1, 2 Foreign banks, such as Canada's Bank of Nova Scotia and Spain's two largest banks, BBVA and Banco Santander, are increasingly investing in smaller Chinese banks in the hope of profiting from rapid growth in the financial sector3. Banco Santander, in fact, agreed to take a 19.9 percent stake in a joint venture with China Construction Bank Corp. to provide banking services outside China's major cities, according to The Wall Street Journal. Much of the interest by Chinese and foreign banks is focused on China’s City Commercial Banks (CCBs) and Rural Commercial Banks (RCBs), which largely serve small and medium-sized businesses sprouting up across China.

There are other indications that CCBs and RCBs could become the focus of a new wave of expansion in the Chinese financial sector. In December 2010, Chongqing Rural Commercial Bank, one of China’s largest lenders to farmers and small businesses, raised US$1.48 billion in an IPO in Hong Kong in what is expected to be the first in a wave of listings by smaller rural-focused Chinese banks4. In addition, four Chinese RCBs in east China's Jiangsu Province have won approval from the country's banking regulator for their IPO plans. China's Banking Regulatory Commission (CBRC) said it encouraged and supported qualified rural financial institutions to pursue listings. 5

A focus on rural areas and smaller cities could help ease the yawning and growing gap between China's largest cities and the countryside. Despite China's rapid urbanization, particularly in coastal provinces, the majority of China’s total population still lives in rural areas6. China’s rural-urban wealth gap has been an issue of concern, with the average annual income for a rural worker around RMB 5,150 ($750) while those in the cities earned RMB 17,180 ($2,510) on average in 20097. A recent study showed that the current banking system meets only about 60 percent of rural household financial needs, and about half of rural agricultural needs.8

This research focuses on assessing CCBs and RCBs as vehicles for easing gaps in China's economic development and as a sector of interest by foreign investors. The essay will include an explanation of the services they provide to growing and yet underserved small and medium-sized firms found in smaller cities and rural regions and an analysis of how and why foreign banks are looking to invest in these lesser known Chinese banks.9 The first task is a brief history of CCBs and RCBs.

Background

In 1995 the first of the CCBs came into existence with the key aim of boosting local economic development and small and medium enterprises (SMEs). China’s CCBs are joint-stock commercial banks established by local governments, enterprises and residents. These banks sprouted from shareholding reform and former urban credit cooperatives. They are allowed to open branches only within their home cities. Few of the CCBs have any private investment capital and have largely been used to finance local government projects. They are thus influenced by local governments, which are perhaps more bureaucratic and less developed than the central government. CBRC reports indicate that these banks are largely present to grant loans to SMEs that operate within city boundaries.

Several RCBs have been created since 2001 in order to improve financial services in the countryside. The four RCBs of Zhangjiagang, Wujiang, Changshu and Jiangyin have received approval for an IPO and, along with Chongqing RCB’s IPO in Hong Kong, they have placed RCBs in the forefront of China’s banking industry. Since the CBRC revised regulations covering rural banking in 2006, allowing foreign banks to operate alone or with partners, HSBC, Standard Chartered and City have all established their presence in China's interior.10
In a move to further close urban-rural income gap, the Banking Commission and the Chinese government are planning to increase the number of RCBs more than tenfold to 1,027 by the end of 2011. This development will be particularly focused on central and western China, where most people are farmers with little access to financial and loan services.12
The CBRC actively encourages foreign banks to engage in business with small and medium-scale enterprises, but most foreign banks believe these endeavors are relatively risky, and their financial information is not transparent. In addition, foreign banks lack the networks required to reach them. Thus an alternate route has been to invest in or create alliances with CCBs. Under similar encouragement from the CBRC, foreign banks are also increasingly involved with rural banking via RCBs. This helps them establish links across the nation in a more tangible fashion and meet the needs for banking services in the rural areas.

Research increasingly notes that it is beneficial for foreign lenders to team up with a CCB or RCB.12 CCBs and RCBs benefit both directly from capital investments as well as from knowledge transfer gained from experienced management and financial innovations in products and services obtained from foreign partners. CCBs and RCBs also benefit indirectly by being able to offer superior products and services that make them more competitive in the domestic market. In turn, these alliances with Chinese banks could potentially result in further endeavors for foreign banks. They not only are an easier route for foreign banks, but they also help the banks grow organically with local incorporation. Recently, Australia and New Zealand Banking Group Ltd. (ANZ), one of Australia’s top lenders, announced plans to invest in China via expansion of its branch network and seeking local incorporation.3 At present the bank owns a 19.9 percent stake in Shanghai RCB and a 20 percent stake in Bank of Tianjin, a CCB. Other banks in Australia also similarly hold stakes in CCBs. This is expected to lead to a rush of second-tier regional banks from the West investing in China with the intent of expanding into less urbanized areas.

City Commercial Banks

Recent research has been mixed on the performance of CCBs. A 2007 KPMG study noted that China’s banking sector assets grew at a compound annual growth rate of about 13 percent since FY 2000 reaching a massive $3.8 trillion; CCBs account for five percent of that total.13, 14 The study also shows that their performance has been less than stellar with poor capital adequacy, high non-performing loans (NPLs) and limited market penetration. Consequently, these banks have had regulatory mandates to reduce their NPLs to 15 percent by 2005 and maintain an eight percent capital adequacy ratio (CBRC, 2006 Annual report). In their defense, more recently, Giovanni Ferri (2009) finds that while CCBs have low market share, they boast of high growth and better performance than the State Owned Commercial banks (SOCBs). In addition, he points out that while their performance was a mixed bag, they had a 13.2 percent growth in assets in 2005, and their ROEs and ROAs were still higher than those seen in SOCBs. Ferri’s paper, although recent, was based only on a small sample of CCBs for which data was available in Bankscope.15

By 2005, there were 113 CCBs. That number rose to 140 by FY 2009. By the end of 2005, the average capital adequacy ratio of China’s CCBs was 5.14 percent, and the number of CCBs with the capital adequacy ratio up to eight percent rose to 36 from 18 in early 2005. CCB NPLs totaled RMB 84.2 billion in 2005, decreasing by RMB 21.7 billion in 2004, and loan quality improved; only 7.7 percent were non-performing in 2005, four percentage points less than the previous year and down from 30 percent five years previously. (CBRC Reports, 2006). 16

From 2006 to 2009, according to official Chinese statistics, CCB assets almost doubled.17 During this time both the average growth in assets as well as the share of CCB assets in proportion to all banking institutions rose each year (see Table 1). This perhaps reflects the growth of Chinese SMEs creating an increased need for CCBs.

Table 1: City Commercial Banks’ Quarter-end Balance, RMB 100 million, %

Fourteen of these 140 banks had assets that exceeded RMB 100 billion, more than 50 percent (70 banks) had assets of RMB 10 billion-100 billion and more than 50 banks held less than RMB 10 billion (CBRC report, 2009-10).  The NPLs in China’s banks had been in decline by 2005 and continued a downward trend from 2006 to 2009. The average outstanding balance on loans of RMB 75.8 billion had gone down to almost half of that, or RMB 46.2 billion, by FY 2009. Also, in contrast to the aforementioned KPMG (2007) study, the proportion of NPLs as a share of total loans declined in all commercial banks, and in CCBs, NPLs went from 6.29 percent of total loans in 2006 to only 1.76 percent in 2009, steadily declining each year (see Table 2). 

Table 2: Commercial Banks’ Non-Performing Loans (NPL) as of end-year, 2006-09

Source:  China Banking Regulatory Commission Report.

What has caused CCBs’ improved performance in the latter years, and is that performance sustainable? CCBs’ major advantage lies in that they are local, with capital and ownership derived from the communities they serve. They are expected to become prominent players in the future of China’s banking landscape since private enterprises in China—mostly SMEs—produce some 52 percent of GDP but account for only 27 percent of outstanding loans.18 Ferri (2009) finds that the performance of CCBs is significantly and positively related to the level of economic prosperity in the provinces where they are located. They have recently thus attracted foreign banks that are seeking strategic investment opportunities in China. The improved performance (decline in NPLs) may be a result of increased competition perhaps resulting in more efficient performance.

In a recent Pricewaterhouse Coopers (PWC) survey, foreign banks note that despite an increasing threat from domestic banks, China’s market appears extremely strategic with the expectation of aggressive development. As they expand into China’s large market base of lenders and focus on the SMEs, will they be able to sustain their growth?

Rural Commercial Banks

RCBs regard SMEs as their key clients to provide them with business operations aimed at serving the agriculture sector and other rural industries. Historically, bank lending to rural areas has not performed on par with lending to urban areas. In order to encourage banking to rural areas, the CBRC and central government have considered new incentives such as tax cuts, lowered capital requirement for rural banks, and subsidy programs that include infrastructure development, some of which have already been initiated. 19, 20 This effort has not gone to waste. Table 2 shows a dramatic jump in average outstanding loans for RCBs in 2009 and a definite reduction in NPLs over time showing movement in the right direction. The recent Agbank IPO and Zhangjiagang RCB IPO approval of December 2007 may improve the outlook for RCBs. 21
In December 2010 Chongqing RCB, the largest bank in the municipality, was the first Chinese mainland-based rural bank to list on the Hong Kong Stock Exchange.22 Upon its debut it did not perform to par, and its shares later fizzled in trading, reflecting skepticism among Chinese investors. However, it marked an important point in Chinese banking since it is expected to be the beginning of an era of similar listings by RCBs and CCBs in Shanghai and Hong Kong as these banks look to the markets to bolster their balance sheets and raise capital for expansion.23 It is also a test to gauge foreign-investor interest in the growth of China’s hinterlands. RCBs may be seen as a means to provide capital to rural areas, and foreign banks may find RCBs an easier way to penetrate rural markets, which still require extensive networks. Evidence of such is noted with banks such as ANZ Bank, which not only opened a rural branch near Chongqing last year but also has a 20 percent stake in the Shanghai RCB as well as in Banco Santander SA’s joint venture with China Construction Bank Corp. in rural banking. The future may lie there if a viable operating model can be developed to control risk and manage non-performing loans by perhaps requiring adequate capital.

Unfinished Agendas

In China, alongside a huge untapped market for financial services, many challenges still face both the CCBs and the RCBs. Banks operating in the inner provinces and in the rural banking market are faced with a lack of experience, lack of talent and the high costs of building infrastructure and networks. With the newer economic policies, foreign banks are increasingly attracted to CCBs and RCBs as a strategic option to penetrate the Chinese banking market thus diversifying their portfolios while simultaneously limiting their investment and hence risk.24 So far, foreign banks in China have displayed lower NPLs as a share of total loans than local commercial banks. Non-performing loans have gone from 0.87 percent of total loans in 2006 to 0.74 percent in 2009. Thus CCBs and RCBs are increasingly looking to foreign banks as a boon rather than a bane since this may be their opportunity to expand by obtaining more access to capital while simultaneously learning about new products and adapting new strategies without having to reinvent the wheel. In December 2007, HSBC became the first foreign bank to set up a rural bank in China and now has seven rural branches; the largest network among the overseas banks. Richard Yorke, HSBC’s former China CEO, recently commented: "The rural banking sector is under banked, so we are seeing strong demand for the right product and for the right services. There is strong untapped demand in that market.";25 Katherine Tsang, China CEO of rival Standard Chartered, has also said that her bank’s first rural branch in Inner Mongolia has been running better than expected. "Rural banking is a long-term commitment and we are not in a rush to make quick money. We will set up more rural banks, if the first one proves to be a role model."26
Alongside typical transactional issues, Chinese banking is rampant with issues such as lack of transparency, government interference, non-productive assets, NPLs and lack of technical know-how among others. As one ponders the future of Chinese banking, many of these issues need to be addressed both for the CCBs and RCBs that intend to expand, and foreign banks that plan to expand into China via mergers with these institutions. Strong support from the Chinese government and more incentive policies to support RCBs and CCBs are needed and may help with their long term sustainability and the future of Chinese banking.

References

Ferri, Giovanni, “Are New Tigers supplanting Old Mammoths in China’s banking system? Evidence from a sample of city commercial banks,” Journal of Banking and Finance, 33, 2009, 131-140.

Gale, Fred, “Financial Reforms Push Capital to the Countryside,” The Chinese Economy, 42 (5), Sep-Oct 2009, 58-78.

Brough, Paul, “China’s City commercial banks: Opportunity Knocks?,” KPMG,  2007.