At the Gate’s Opening: Full Foreign Access to Chinese Banking

1. At the Gate’s Opening:Full Foreign Access to Chinese Banking Gates of the Forbidden City Nick Roersma

2. Communist Banking 1949 Reform Era 1994 2006 Gate Opening Summary Timeline "The scale of what is happening has never been seen in the world" – U.S. Treasury Secretary John W. Snow.

3. Communist Banking 1949 1994

4. 1949 1994 2006 People’s Bank of China • Communists aggregated all banks into singular bank People’s Bank of China (PBOC) • Sole bank from 1953 until end of Cultural Revolution • Performed dual-role: commercial bank & central bank • Few banks resurrected for particular purposes (agriculture, industrial funding), but not independent from PBOC and often dissolved bank into PBOC

5. 1949 1994 2006 Big Four • Resurrected banks slowly achieved independence (1984) and became Big Four • Bank of China (BOC) • China Construction Bank (CCB) – medium & long-term project loans • Agricultural Bank of China(ABC) – for agriculture sector, farmers, and TVEs • Industrial Commercial Bank of China (ICBC) Big Four are State-Owned Commercial Banks (SOCBs), but not only But don’t let “Commercial” fool you…they were state controlled policy banks (i.e., not operated for profit or prudential reasons)! In 1985, CPR wholly substituted SOCB loans for state grants to SOEs; Big Four became only source funding and de facto subsidies to SOEs!

6. 1949 1994 2006 Communist Importance • “Communist banking” did not resemble “Western banking” • Bottom-line (profit) was not a primary consideration • Banks served to aggregate national savings and aid party allocation of monies throughout the country • Made little or no disclosures • Run by party and cronyism • As important, many Chinese banking consumers unfamiliar with Western financial services

7. 1949 1994 2006 Communist Legacy • Big Four (SOCBs) Dominate Chinese Banking Market • 2003 Statistics • 55% of banking loans; 59% of deposits (exceeding $1.05 trillion) • Assets of each make them members of 30 largest banks worldwide • Present Criticisms about Past • Party may control (and at least appointed senior management of each) and still hold great sway • Party may subsidize SOEs via these banks • Chinese unfamiliar with Western bank accounting • Present Competitive Fears from Past: Guanxi (connections)

8. 1994 2006 Reform Era Gearing up for & making WTO commitments Actions post-WTO accession Legal Reforms: Banking Law amended, Financial Reorganization Capital Injection Addressing Criticisms Legal Reforms: Policy Banks, Bankruptcy, Securities, Banking Laws Bank Creation: Policy Banks, AMCs, Foreigners

9. 1994 2006 Policy Banks • Financial System Reform, 1993 • Created Policy Banks to replace Big Four’s government spending functions (de facto subsidies) • Purpose • Alleviate difficulties of SOCBs dual roles of commercial & policy banks • Better aid rationalization of state resources • Agriculture Development Bank of China (ADBC) • China Development Bank (CDB) – infrastructure • Export-Import Bank of China (Chexim) • Characteristics • Financially independent • Responsible for protecting assets value • DO NOT compete with commercial financial institutions (SOCBs or otherwise)

10. 1994 2006 Further First-Steps • Local Coops  City Coops • PBOC reorganized urban credit cooperatives into City Cooperative Banks (2003: 112 coops, with 5,116 braches) • Provided more capital and further accreditation of their services • 1995 Law of PBOC • Formalized PBOC (after 45 years) as central banker & banking sector supervisor acting in coordination with provincial banking administrations • Provided power to promulgate guidelines (with force of law) and penalties • Issuer of PRC government bonds • Interest rate control over commercial banks • Continued dual-oversight and influence of PBOC and local officials (who possessed guanxi with SOEs) over commercial banks

11. 1994 2006 1995 Law of Commercial Banks • First Banking Law of PRC! • Provided for state-guidance: “commercial banks to develop their lending business under guidance of state industrial policies based upon the requirements of the national economy and social development” • But... • Provided for independent loan granting process • Required independent credit analysis and obtainment of guarantees before credit extension • Forced Bank Management to be liable for bank bankruptcy • Created basic banking requirements • 8% capital sufficiency ratio (int’l standard) • Loan portfolio cannot exceed 75% of deposits • Short-term assets to short-term liabilities should not exceed 25% • Single debtor cannot have outstanding liabilities greater than 10% of bank’s capital • Now Allowed • Private Chinese Banks (wow!) • Minsheng Bankincorporated in 1996 as first private bank in PRC; 6 were exchange listed (Shanghai/Shenzhen) in 2003 • Others include Bank of Communication, CITIC Industrial Bank, Hua Xia Bank, and many more (generally more profitable than Big Four) • Joint-venture banks (13 by 1998) (first allowed in Shanghai in 1991)

12. 1994 2006 Foreign Financial Institutions • FFIs existed before revolution, but all left… first special foreign branch re-established in 1982 • Provided for limited access until 1996 project • Solely foreign currency business for businesses • Uncertain regulations and reporting requirements; all requirements more onerous than those for Chinese banks • Foreign Banks allowed to RMB business, 1996 project (1994 regulation) • Further development of Shanghai JV project • Required long process (1 yr approval) and larger reserve requirements • Allowed business in Shanghai • Domestic currency services for business and consumers

13. 1994 2006 Pre-WTO Legal Developments • Securities Law (amended 2005) • Providing defined reporting and oversight requirements in excess of PBOC requirements • Requiring for 8K-light disclosure (including statements for 10 major “changes”) • Bankruptcy Law (1988) • Cannot file against public utilities an enterprises of major importance to national economy or general welfare whose debts are payable via subsidies or other state arrangements (takes SOEs out of it!) • Liquidation Committee (LC) takes over debtor (continue operation or liquidate) • Creditors may approve conciliation or distribution of assets, but LC retains final say

14. 1994 2006 Asset Management Companies (AMCs) 1999 Great Wall – ABC Orient – BOC Cinda – CCB Huarang - ICBC • Purpose • Purchase non-performing loans (NPLs) from SOCBs created pre-1996 at book value • Complete via Debt-Equity swap • Finance • RMB10 billion from state • PBOC loans formerly intended for SOCBs • Issued bonds to SOCBs (implicit guarantee?) • Characteristics • State-owned, non-banking financial institutions • Financially independent: responsible for bottom-line and asset value • Match up 1-1 with SOCBs • Auction of NPLs • Morgan Stanley purchased 4 of 5 asset pools from first Huarang offering for over RMB10 billion (believed to be 8-9 cents on dollar) • Valuation difficult because mostly SOE loans burdened with socio-economic obligations and bad assets!

15. 1994 2006 Asset Management Companies (AMCs) 1999 Great Wall – ABC Orient – BOC Cinda – CCB Huarang - ICBC Didn’t the PRC already attempt to solve this with policy banks? Yes, and failure exposes serious problems of communist legacy & NPLs! • SOBCs had NPLs accounting for 25% - 40% of loan portfolio at this time (and through 2003) • Problem of minimal disclosure requirements and inadequate loan classification (still using local 4 tier) • SOE management (responsible for 69% of NPLs) burdened with communist hold-overs and local bureaucrats

16. 1994 2006 WTO Commitments • Will remove all non-prudential limitations by Dec. 2006 (Id.) • Ownership (not wholly) • Geographic Operation • Juridical Form of Financial Institution • Banking Sector to be open (“I. Horizontal Commitments”) • Taking Deposits • Lending • Financial Leasing • Payment & Money Transmission Services • Guarantees & Commitments

17. 1994 2006 WTO Commitments • Must end subsidies (loans via SOCBs), violate Protocol if • SOEs are prominent recipients of such subsidies or • SOEs receive disproportionately large amounts of such subsidies or provided such beneficial terms (Protocol for Accession, ¶ 10.2) • 7 year subsidy exception (but hopes to not use and not aggressive exception) • Current Non-Prudential Limitations • Ownership • Max 25% foreign interest in Chinese bank • Strategic investment required (5%+ stake, not greater than 20%) • Cannot purchase interest in more than two Chinese banks • Operation • Geographic limitation • Different regions provided for consumer and business services

18. 1994 2006 WTO Commitments Should Bind Chinese Bankers to other int’l standards • Basel Committee on Banking Supervision (Core Principles, 1999) • Minimum capital requirements • Supervisory review of institution’s internal assessment process and capital adequacy • Effective use of disclosure to strengthen market disciple and complement supervisory efforts • IMF • Provide stability • Foster orderly economic and financial conditions)

19. 1994 2006 WTO Commitments Was China ready to meet all its banking commitments immediately? NO! • Need to create “western” banking ideology to compete • Provide disclosures to create investor and public confidence (not diminish it) • End SOEs’ subsidy reliance

20. 1994 2006 Foreign Banks Post-WTO • Could immediately provide • Limited consumer foreign exchange services in Shainghia and Shenzhen (extension of 1996 project) • 31 banks approved for business in 2001 • No geographic restrictions as of Dec. 11, 2006 • Approval process being quickened (1 year wait removed), but not a fast process • Expanded • Total of 62 foreign banks were approved for some sort of business in country in 2004 • Geographically • 13 cities were approved for business service in 2004; 25 cities in 2005 • Only 4 were given initial approval to provide services in new cities in 2004 • Still subject to more onerous reporting requirements; but laws lowered capital requirements

21. 1994 2006 2003 Amendments to Banking Law • Removed direct government influence • Allowed for banks to invest in other sectors of economy: trust investment and stock operations • Not • Non-financial industry investments • Securities investments if bank majority state-owned • Real estate • Why? Banks had funneled money for such investments through Trust and Investment Companies (TICs) which directly engage in investments, creating inflation • Real estate investments without state approval lead to bad run in 1988 (Notice of PBOC on Policy Issues of Clearing Up Real Estate Companies Owned by Specialized Banks, 1990) • Much speculation already in hot Beijing and Shanghai real estate markets (among others) and securities market underdeveloped

22. 1994 2006 Chinese Banking Regulatory Commission • Purpose • Expressly, to assume the “regulatory function of PBOC over AMCs, trust and investment companies, and deposit-taking financial institutions to ensure stability of operations” • Implicitly, to expedite solid SOCBs balance sheet before for listing: “The government will no longer pay for the losses made by commercial banks” – Liu Mingkang (CBRC chief) • Arm of State Council! • PBOC remained central bank for monetary purposes (analogous with Fed Reserve)

23. 1994 2006 Disclosure Changes • PBOC required banks to use 5-tier loan evaluations (international standard) in 2002 • Promoted in 1994, and allowed for use in 1998 • No one used it, but continued with old 4 tier (which understated NPLs by 15%) • Standard requires bank evaluate loans before calculating profit and capital adequacy requirements • MOF providing new accounting rules for businesses • CBRC requires quarterly reports • More and more banks exchange listed and subject to securities reporting requirements (which are more thorough than the CBRC requirements)

24. 1994 2006 Cracking Down on Corruption • Alleged banking frauds are ridiculously large and frequent • Crack down • DEATH PENALTY (though suspended sentence) imposed on former head of BOC Hong Kong • PRC claims • Over 50,000 defrauders caught • Estimates 5,000+ have fled abroad (U.S. has provided extradition on specific terms excluding death penalty, torture, and sometimes limiting prison sentence) • Foreigners on the Look Out • DOJ recently charged three in Vegas on scheme to defraud BOC exceeding $400 million • CCB chief resigned for “personal reasons” and bribery allegations in 200 (case filed in CA) [Note: Bank listed with a year of resignation]

25. 1994 2006 International Investment • All major banks in China have sought capital from foreign investors, especially the under-capitalized SOCBs • Major international financial firms have invested: Bank of America, AMEX, Royal Bank of Scotland, and more • Have provided over $40 billion to date • Cannot invest in more than two banks; forego independent branch operations in country • Justifications • Chinese banks, generally, are under-capitalized and have low-implied NPLs of 7.7% and recent PBOC disclosures claim NPLs may be around 5% (though Western banks average <1% NPLs) • Opportunity for foreigner bankers to become acquainted with Chinese market • Opportunity for Chinese bankers to become acquainted with international standards

26. 1994 2006 International Investment Next Steps • Greater Interests? • Citi leading foreign group to purchase 85% of Guangdong Development Bank • Chinese government has suggested it may allow greater foreign interest than 25% but have not ruled on this application • Consumer Credit? • Credit cards & short term consumer credit is small (90%+ of plastic carried is debit); great expanses seen in Eastern Europe in this market • Credit ratings created in 2000, regionalized but being nationalized

27. Opening the Gate 2006

28. Independent Banks Small - Only 2% of banking assets in PRC NPL problems - 23 foreign banks (30% of foreign banks) had NPLs in excess of 20% in 2004 (problem is SOEs) Gain marketplace understanding and market presence; many hedging bets (Citi) InvestingBanks Ownership and interest conflicts with present management and party Gain foothold for regulation and further investment opportunities and negotiations Forego opportunities to expand business operations in country for time being Subject to lower tax rates (33% as opposed to 55%) Foreigners at Gate 2006

29. Too much state control or influence (at least possible) Disclosures are not all adequate, should subscribe to Basel II Continue to reduce NPLs (and improve SOE governance) Controlled savings rates for smaller accounts and fixed loan spread Bankruptcy Lawdoes not provide adequate protection CBRC control interest rates paid to depositors (little competition at base consumer level); controls loan spreads Limited investment amount Under developed securities markets Popular Complaints 2006

30. Grow capital markets, establish confidence in securities and other financial sectors Increase confidence in CBRC and PBOC Exchange list all SOCBs Utilize growth to advantage of PRC (e.g., capital investments of state pension funds) Refine allowedbank financial investments EU - universal style US - financial holding corp. Stop dumping capital into SOCBs ($270+ billion over last 15 years) Develop consumer credit and complex instruments markets; expand banking services internationally Chinese Goals 2006

31. Chinese banks will continue to be successful at acquiring foreigninvestment CCB listed late last year and garnered $9 billion (largest in the world since Kraft in 2001) BOC to list, hoping to garner more than $12million BOC and CCB were recently improved to “investment grade” (Moody’s) Huge assets and establishment, much to gain from management synergies, great national savings habit, and an extraordinary growth market Face stiff market in services: Chinese firms, including banks, favoring foreign underwriters (Morgan Stanley and Goldman lead) Chinese banking will succeed in the global marketplace Significant PRC recapitalizations Chinese banks are taking interest in international banks and establishing more prominent braches Short term uncertainty, however, remains justified SOEs remain problem at home, but much interest exists both within and outside the banking sector to rein them in Remains greatly susceptible to macro-economic swings State to retain majority control of Big Four post listing (62.5% of BOC) Observations 2006

32. It took a myriad ofchanges to arrive at Gate’s Opening More remains to be done (Complaints & Goals), but CPR proven willing to make drastic changes in banking market National Observations "The scale of what is happening has never been seen in the world." - U.S. Treasury Secretary John W. Snow.

33. Questions?