Pitfalls of private-bank fever

Measured approach and tight supervision may help mitigate side effects, increase lending to small firms

Small and private banks are supposed to mainly serve small and medium-sized enterprises. Following that logic, one of the aims in allowing these banks to be set up in China is to help solve the financing difficulties that SMEs face, which has long been a problem.

However, now that China is moving toward setting up its first private banks in a real sense, it should not be taken for granted that establishing small, private lenders will provide the solution. Regulations and supervision, as well as restructuring the whole banking industry, are needed to harness all the advantages of private banks to ensure they can focus on SMEs and mitigate risks.

Compared with big state-owned banks, private banks have a different gene that naturally draws them closer to SMEs. If stakeholders of a bank are mostly private business owners who usually get rich from scratch, they surely better understand small businesses and have an innate attraction to them.

State banks tend to serve large, government companies, because these lenders believe SMEs, without strong background and financial brawn, are prone to default.

But with business acumen and a well-built information network in the local market, private banks can excel in that area.

At least one case illustrates that living off SMEs entails few risks and can be profitable.

Taizhou Bank in East China's enterprising Zhejiang province is an existing Chinese bank that is closest to being a pure private bank. Its stakeholders are mostly private companies and individuals, with state companies having a minority stake. Its clients are essentially SMEs and individual business people.

The bank's net profit-asset ratio stood at nearly 2.2 percent in 2012, against the national average of 1.3 percent. Its bad loan ratio was 0.43 percent that year, against the national average of 0.95 percent. Its risk-control ability is outstanding compared with its counterparts in Zhejiang province, where its banks' bad loan ratio stood at 1.6 percent, on average, at the end of 2012.

Another example of how privately run lenders can efficiently control their risks while making handsome profits is the existence of numerous underground banks often run by individuals in villages and townships. In Zhejiang, Fujian, Jiangsu and Guangdong provinces, these illegal entities, whose customers are mostly tiny-business owners and farmers, are popular. They can easily beat government-backed rural credit cooperatives and rural banks in profit margins and risk control. Their superb skills in collecting information and their crude but effective ways of evaluating risk are impressive.

My research of four cases of illegal rural lenders in Zhejiang and Jiangsu provinces shows that their profit margin could be 10 percentage points higher than local rural cooperatives after their profits were adjusted by deducting tax and extra gains from higher-than-required lending rates.

So it is fair to expect the establishment of purely private banks to run well and help alleviate SMEs' long-term complaints about financing.

But this will happen only with due regulation and supervision.

Between last July, when the central government announced plans to allow private banks, and the end of the year, 67 such banks had passed pre-approvals of the State Administration for Industry and Commerce. The China Banking Regulatory Commission has made setting up private banks its top priority this year.

However, what mostly drives the rush to set up private banks is the desire to make easy money rather than the desire to serve SMEs. As China's rate system remains under control and its banks are not fully open for all investors, a distorted interest gap and a status of monopoly ensure that banks can comfortably reap fat profits, a scenario former premier Wen Jiabao criticized in 2012.

Lured by huge profits, chances are high that private banks will learn from their state peers to put a large part of their capital into high-return projects such as properties and trust funds instead of focusing on real-economy sectors and SMEs, which is something other than what policymakers want.

The other concern is that some private investors will set up banks to give themselves a convenient platform to raise money. Their using the banks as private coffers may eventually be detrimental to the interests of depositors.

To reduce all these potential problems, policymakers should adopt a measured approach in deregulation and put in place due regulatory scrutiny.

Private banks should be allowed to be set up in small numbers and in batches at the beginning, and it would be good to allow them to first operate at a regional level. By doing so, adverse effects are likely to be controlled.

A private bank's loans to its stakeholders directly or indirectly should be limited. Its ratio of loans of a single largest customer, now set by the government at 10 percent for all lenders, can be set at a lower percentage. These measures will help prevent the bank loans flowing back to its stakeholders, who may use the money for speculation in high-risk areas.

Private banks' off-balance-sheet operations must also be checked to make sure funds go to real-economy sectors.

The author is a Shanghai-based analyst. The views do not necessarily reflect those of China Daily.

(China Daily Africa Weekly 01/24/2014 page11)