Liberalizing the last untouched interest rate would help cure many of system's ills

Chinese banks have enjoyed unprecedented growth over the past few years. With broader credit expansion, some of China's largest banks have also become some of the largest banks in the world. The banking sector in China contributes more than half of the total profits produced by Chinese listed companies, highlighting the sector's influence.

But there have also been increasing frustrations and dissatisfaction with the nation's banking sector. Small- and medium-sized enterprises have blamed banks for restricting loans, which they say has hurt their development, even threatening their survival. Mature businesses also have joined the clamor, cautioning that the banking sector has become so strong that it has eroded profit margins for nearly everyone else in the economy.

So naturally when the central government initiated reform in the banking sector this year, it attracted domestic and overseas attention.

This year, the China Banking Regulatory Commission agreed to hand out licenses to a few privately capitalized banks, such as Suning Bank and Webank, which is owned by Tencent Holdings Ltd. Banking is one of the most heavily regulated sectors in the country and a coveted receiver of private capital investments, creating the impression in people's minds that this move is a harbinger for more fundamental reforms in the near future.

Given that bank loans remain one of the cheapest ways to finance private enterprises and because bank loans are only available to a select number of private enterprises, many private companies are aiming to take the problem into their own hands by operating their own banks. In short, if private companies want to obtain financing, they feel they need to establish their own banks.

But once they satisfy their own capital needs, private banks will soon be faced with the same problems that traditional banks currently face. Because the lending-deposit interest rate spread is so vast, the most attractive measure to take is to expand a bank's balance sheet, which is exactly what existing banks are doing.

Unfortunately, being late to the party, newly established banks have not found any advantage in this type of competition. In addition, because this simple strategy is so lucrative, newly formed banks will most likely try to mimic traditional banks and come up with ways to circumvent the capital reserve requirement and lending-to-deposit ratio.

Such attempts will, eventually, lead to the type of shadow banking problems that regulators such as the CBRC have been trying to rein in, though without much success. The clandestine system is one of the reasons the Chinese financial system has witnessed tremendous growth in many high-yield trust products and wealth management products over the past few years.

On the one hand, shadow banking is attractive because it provides a large increment of financing for not only small and medium-sized enterprises in China, but also for real estate projects, local government debt and local government financing vehicles.

On the other hand, many shadow banking projects promise unrealistically high returns without properly disclosing their risks. As a result, shadow banking brings potentially catastrophic risks to the Chinese financial system.

Many investors in shadow banking products believe, or at least they pretend to, that trust products and wealth management projects are safe.

Even though there are clear stipulations in many trust product prospectuses that there are no guarantees for the security of the principal, investors believe that trust companies and related commercial banks will guarantee the safety of their investments, both because of regulatory concerns and the firms' reputation.

To make things more interesting, many of the trust products are structured, packaged or distributed by banks. If anything, it is the commercial banks' creditworthiness that makes the trust products and wealth management products so "safe" and "attractive".

But after several defaults were allowed to happen in recent years, regulators and banks have sent a strong message that they intend to sever the implicit guarantees behind such contingent liabilities. Interest rate liberalization remains the key to truly restore market forces in China's banking and financial sectors and to truly give the newly established private banks a level playing ground to thrive and compete with the giant banks.

After a decade-long interest rate liberalization reform, only one critical interest rate, the savings account interest rate, has yet to be liberalized. This last interest rate happens to be the most crucial for Chinese banking reform.

Imagine that through their better understanding of business or better risk management, new and small private banks could offer more attractive savings rates. If this happens, the new banks could meaningfully compete against existing banks and transform China's banking landscape.

In addition, with regulated private banks offering more attractive interest rates, investors would have less incentive to put their money into riskier trust products and wealth management products. Because savings rates are transparent and formally guaranteed by bank regulators, liberalizing the interest rate for savings accounts should diffuse the accumulating uncertainties in the nation's shadow banking sector.

Last, but certainly not least, if savings rates became truly transparent and determined by the market, banks' lending rates would have to adjust accordingly. When the cost of deposits increased, many banks would no longer be able to afford subsidized and irresponsible loans, both of which have propelled Chinese investment-driven economic growth over the past few years. If this shift in banks' lending decisions occurred, the behavior of local governments and state-owned enterprises would change accordingly, eventually pushing for further reforms in other fundamentally important areas in China's economy.

The author is a faculty fellow at the International Center for Finance at Yale University and deputy dean of the Shanghai Advanced Institute of Finance at Shanghai Jiao Tong University.

(China Daily European Weekly 11/07/2014 page9)