Broadening ownership arrangements in the industry will facilitate risk management and mobilize market resources

The banking sector occupies a key position in China's financial system. The capital market in China is relatively underdeveloped and the banking system is the main source of domestic financing. The banking sector influences economic growth, poverty alleviation and the allocation of assets, hence it is critical to identify policies that encourage efficient bank operations.

The remarkable progress that China's banking industry has made in the last several decades has attracted a lot of attention around the world. The government has transformed the banking sector from a centralized and government-owned system to a more commercially driven system. The recapitalization and equitization of the four biggest wholly State-owned banks, namely the Bank of China, China Construction Bank, the Industrial and Commercial Bank of China and the Agricultural Bank of China, was one of the most recent and significant steps in moving bank restructuring forward. More importantly, the regulatory authorities have put more effort into regulating corporate governance according to international standards.

Many measures have also been taken to increase foreigners' access to the banking sector, such as subsidiaries and ownership of banks. By allowing foreigners to access the domestic market, a greater supply of aggregate bank credit has been provided to domestic borrowers, which has helped firms with financial constraints, although only a certain type of borrower has benefited. Foreign competition has also helped domestic banks to run more efficiently.

However, the domestic private ownership share of banks in China is rather low. There are various reasons for this. One explanation is China's judicial system is less efficient and the protection of private property is weaker than in Western countries. Thus many of China's domestic private firms are more short-term oriented. It is generally agreed that short-termism is associated with greater risk and this affects both corporate governance and asset allocation. Higher risk preference and the low quality of many domestic private firms' corporate governance have made China's banking industry regulators more reluctant to issue approval to open a private bank or a new branch.

China's foreign ownership share is not high either. Although China's financial openness is increasing, so far foreign bank entry still remains at a relatively low level. The percentage of bank assets at foreign-owned banks in China is still below 4 percent. China's economy is still in the process of transition and there is ample evidence that foreign banks are more efficient than domestic banks in transition economies.

Why is the foreign banks' ownership share still low after China joined the World Trade Organization? People in Western countries like to complain about unfair or inappropriate competition in China's banking sector. They argue the capital requirements are a de-facto barrier to entry and so foreign ownership has been effectively limited. Other complaints include overly restrictive requirements for a foreign bank to offer financial services in renminbi and a very slow and cumbersome process for obtaining approval to open a new bank or branch. Some claim that without the preferential treatment offered by the Chinese government, most of the State-owned commercial banks would have no competitive advantage over their foreign counterparts in China's financial markets.

Whether these claims are true or not is hard to test. But no one is able to deny that problems, though hidden, still exist in China's State-owned commercial banks. Although their profitability is increasing, there is a likelihood of a sharp rise in nonperforming loans if there is a big drop in housing prices or a wave of local government debt defaults. Besides, underground banking has been flourishing and hidden exposure has been accumulated, which is also likely to give rise to nonperforming loans in the banking industry.

To facilitate risk management and to mobilize resources, the ownership arrangements of China's banking industry should be broadened to introduce more competition. A higher degree of openness to both domestic and foreign investors is needed. Moreover, given the global trend, China's regulatory system should move toward supervision and away from regulation.

The author is assistant professor of finance, Nottingham University Business School, China.