My AWSJ Op/Ed piece on Chinese bank management and the need for real privatization makes two main points:  Firstly, still operating according to SOE practices and culture, Chinese banks are hardly "managed" in the normal sense of the term.  Rather, they are objects of what might be crudely described as plunder by managers and staff.   Secondly, only real privatization will change this situation. 

From The Asian Wall Street Journal, November 25, 2002

Privatizing China's Banks

By STEPHEN M. HARNER

If you ask a Chinese banker the main problem with his bank, and he is in the mood to be frank, he is likely to say it is ownership. By this he will mean that the bank is government-owned, in other words it is a state-owned enterprise. Today all banks in China are SOEs, with the sole exception of foreign banks and perhaps one small listed bank, Minsheng Bank.

The perverse effects of state ownership have been widely documented elsewhere. But the case of the Chinese banking sector is of particular interest because it demonstrates the problems inherent in "market socialism" -- the model which the Communist Party ostensibly still espouses -- and why other sectors of the Chinese economy, lacking a steady stream of deposits and vigorous protectionism, have found this model to be unsustainable.

As in the Soviet Union, state ownership in China has nurtured a culture where the dominant objective, embraced by management and staff, is crudely but accurately described as plunder. In this culture, no decision is taken, no initiative is launched, no transaction is closed, no products are bought or sold, without a calculation at all levels of the concomitant benefit that will flow to the individual. This ethos is so pervasive and fundamental that it effectively drives operational management of all Chinese SOEs, the banks included.

Observers have long been puzzled by the extreme decentralization of the management of Chinese banks, with branches, sub-branches and even lower units operating virtually autonomously. Provincial branch managers are capable of making large investments, drafting policies and developing systems with hardly any need to notify their head offices.

The reality is that the banks, as with the remaining SOEs in other sectors of the Chinese economy, operate on a "contractor basis" between a head office whose responsibilities are largely confined to administrative work and quasi-independent operational units. The head offices do not produce detailed operating budgets, product strategies or quarterly reporting requirements, but a limited number of annual bottom-line targets and quotas. Delivering the quota numbers is usually all that is required from branch managers to keep head office satisfied, allowing the managers to use the resources under their control to pursue brazenly personal objectives.

These circumstances explain why China's banks seem uniquely prone to pillaging by senior managers, as in the $483 million theft case at Bank of China's Kaiping branch, and to the kind of bank official-customer complicity in fraud that was recently exposed in the Bank of China's operations in the U.S. But such blatant theft is still the exception. More common, indeed universal, is the situation of bank managers and staff taking advantage of the absence of budgets or cost controls to effectively expropriate bank property and funds from state shareholders.

A small but telling example is seen in one of the larger city commercial banks. This bank's head office authorized its branches to independently conclude agent sales agreements with insurance companies. The branches did so and simply divided the cash commissions among the managers and staff. No one at the head office felt compelled to stop this, no doubt because similar arrangements permeate the organization, up to the head office level. There is strong resistance to increasing transparency and accountability through the introduction of budgets and management information systems, as this would tend to circumscribe these practices.

For managers in the branches the current laxity provides scope for building up off-the-books "little treasure chests." These are funds under the control of branch management, often of the branch manager alone.

As in other SOEs, these constitute an indispensable tool for greasing relationships with individuals inside and outside the bank.

It is an interesting paradox that the internal controls in China's banks -- in the sense of the number of signatures required to authorize a transaction -- are in most case more elaborate than in foreign banks. But, in practice, managers and staff cooperate to narrow the scope and depth of these controls.

Is there a way out for China's SOE banks and their owner, the state? The People's Bank of China, the central bank, is offering a quick-fix solution in the form of recently promulgated, highly detailed operational-management guidelines for commercial banks. The guidelines direct banks to establish management information systems, budgetary management systems and reporting requirements, and to enforce management discipline throughout their gigantic organizations. But these are only guidelines, with no specific deadlines or penalties for non-compliance. Given the SOE culture and disincentives to good management built into the current system, little progress can be expected.

In a fundamental sense there is just one way forward for Chinese banks: privatization. Only by placing ownership in non-state hands can the culture and incentives within Chinese banks be changed so that the management ethic becomes capital creation rather than plunder.

Is China's bank regulator, the PBOC, prepared to accept privatization? One reason for optimism is a recognition of the urgent need to recapitalize China's banking system. Indeed, if a recent PBOC directive is to be implemented, requiring banks to take reserves against and write-off non-performing loans by 2005, the amount of new capital needed will be in the hundreds of billions of dollars, far beyond the capacity or interest of the state. On a political level, the signs are also promising. Staff in state banks have been told that one of the key themes of the 16th party congress is "min jin, guo tui" -- the entry of private interests, and the exit of the state.

Nonetheless the signals from the PBOC have so far been mixed at best. The central bank has signaled it is willing to allow private domestic investors to take majority interests in China's 108 city commercial banks, although foreign investors are still subject to a 15% ceiling. But for the 10 shareholder banks, including such names as CITIC Industrial Bank and China Merchants Bank, the PBOC appears to prefer partial privatization, through the public listing of 20% to 30% of shares, while restricting foreign direct equity investment to 15% or less, as in the case of Citibank and Shanghai Pudong Development Bank.

This approach, the dominant and frequently disastrous model for listing other SOEs in China, falls well short of effective privatization, leaving the previous management in place and control firmly in the hands of state interests. It remains to be seen whether Newbridge Capital of the U.S. will obtain PBOC approval for its plans to acquire 20% of Shenzhen Development Bank, so breaking through the 15% ceiling on foreign investors. But even if it manages to do so, with a 20% stake, or indeed anything less than 50% control, it is hard to see how the benefits of privatization can be realized.

Nor is privatization on the cards for China's big four SOE banks, although the Bank of China has listed a minority of shares in Hong Kong and the China Construction Bank hopes to list domestically within four years. But such partial listings will not substantially alter these banks' character, and for this reason, their management problems will remain largely intractable.

It may seem paradoxical, but for seasoned foreign bankers in China this prospect is not particularly welcome. They understand that -- whatever the commitments made as part of China's entry into the World Trade Organization -- the effective opening of China's banking market will not be allowed until domestic banks are ready to compete. A slow improvement in the internal operations of local banks means an extended wait for foreigners. But that is what will happen unless China is prepared to embrace the only solution to its banking problem -- privatization.

Mr. Harner is president of S.M. Harner and Company, a Shanghai-based financial industry consultancy, and author of "China's New Political Economy" (Westview Press, 1999).

Updated November 25, 2002

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