Abstract: In this article, the author analyzed three gaps between large and smaller banks in China, i.e. those in corporate governance, risks management and technological capabilities.
Academics, practitioners, the central government, and local governments are all concerned about the risks posed by small and medium-sized banks. Poverty alleviation and pollution control are two of Chinese regulators' "three battles" that have delivered positive results, but there has been little hint of significant improvements in dissolution of financial risk. Regional financial risks and risks with small and medium-sized banks continue to merit our attention.
I don’t think small and medium-sized banks should take on excessive liabilities, nor should they increase interbank allocation and transactions on the asset end. In the interbank market, small and medium-sized banks are at a disadvantage. More liabilities lead to high costs, while interbank asset allocations lead to low returns. It isn’t a sustainable business strategy, if not resulting in losses.
In terms of transaction capabilities, this approach is a true test of a bank's capabilities of payment and settlement, custody, bond underwriting, and financial market trading, which are precisely the shortcomings of small banks. Even the large banks in China lag far behind their European and American counterparts in this regard.
Based on 2021 data, in terms of absolute volume, the custody, payment and settlement business of China's large banks is only about 40% of that of the top five banks in Europe and the US, and bond underwriting, 1/3. In terms of asset structure, the custody business of western banks is 4.4 times the size of their on-balance sheet assets, while for China's large banks, it accounts for less than half.
Despite their advantages in clearing and settlement capabilities, comprehensive systems, and talent, large banks have yet to fully make their mark, and small banks may find it even more difficult. Therefore, to study asset and liability management in small and medium-sized banks, we must first thoroughly examine their comparative advantages.
We should pay attention to three gaps between big and smaller banks.
The first is the gap in governance capabilities of large and small banks as they transform. Some dangers and concerns with small and medium-sized banks may gradually emerge as China's economy shifts from rapid growth to high quality development. Corporate governance is particularly critical at this stage, with issues such as the principal-agent relationship, related-party transactions, and major shareholders embezzling the assets of small banks being particularly relevant. A bank’s corporate governance guides the asset and liability management business. If the governance is poor, the business will not run well. Therefore, corporate governance of small banks is a topic that cannot be avoided.
From a regulatory perspective, it is essential to clarify the standards regarding related-party transactions, various types of concentration ratios, and risks over single exposure. We have participated in the disposal of Baoshang Bank and found that many regulatory requirements are ineffective in Baoshang Bank, which is a problem of corporate governance and corporate culture. In response to such problems, trying to improve asset-liability management alone won’t be enough, and it is necessary to address the problem from the perspective of corporate governance.
The second is the gap in risk management of large and small banks during the period of falling interest rates. Large banks usually have low non-performing loan ratios, high provision coverage ratios, and capital adequacy ratios, while small banks are just the opposite. In a period of falling interest rates, especially when interest rate spreads are narrowed, the problems of small banks become even more prominent. It is because small banks bear higher costs on the liabilities. In order to generate enough yields on the assets, they have to serve small and medium-sized enterprises that large banks are not willing to serve. Larger risk exposure thus incurred requires higher risk pricing and management capabilities of banks. If small banks cannot improve their risk management, their development will face challenges and risks, and it will be harder for them to meet the capital adequacy ratio requirement.
The third is the gap in the technological capabilities of large and small banks in the digital economy era. Large banks have advantages in technical strength and scale, and are able to make heavy investments in system development. In terms of technology, the large banks in China are not behind top international ones. However, small banks are at a disadvantage in terms of scale, talent and technology, and have a growing gap with large banks in these areas. In the era of the digital economy, the lack of technological strength will pose severe challenges to small banks in using big data and artificial intelligence for risk control and asset-liability management. Poor technological capabilities will hinder banks’ ability to tackle challenges in the digital economy era.
In the end, I would like to offer three suggestions.
First, small and medium-sized banks should strengthen corporate governance. At present, the legal representatives and chairmen of many small banks are former local government officials. Although they can be experienced in handling public affairs, bank management requires a high degree of professionalism and vigilance against market risks. It is recommended to provide training in risk and costs for local bank executives, and guide them to change their philosophy, better understand risks, and reverse the aggressive risk appetite with cases such as the Asian financial crisis, the subprime mortgage crisis, and the Baoshang Bank. Regulatory authorities should provide practical guidance as well as forceful constraints. Regulators can increase their tolerance of NPL ratios; but in terms of capital adequacy ratios, liquidity management, and qualifications of personnel, they should implement hard constraints.
Second, clarify the role of small and medium-sized banks. The original purpose of small and medium-sized banks is to serve the community economy and SMEs which are their most familiar and suitable service targets. If small and medium-sized banks give up their own advantages to do interbank business, it may be detrimental to their own development and the cultivation of customer groups. Currently, the regulators also encourage small and medium-sized banks to focus on SMEs. The central bank has two direct tools, and the government has also issued many preferential policies for SMEs and inclusive finance. If small and medium-sized banks can do a good job in developing inclusive finance, they can benefit more than from other businesses.
Third, encourage technological cooperation between large and small banks. In the digital economy, small and medium-sized banks cannot simply use offline methods to serve communities, SMEs and individuals, because the cost will be relatively high. They need to carry out business with the help of accurate user profiles, targeted marketing and risk controls based on big data. However, system development usually requires heavy investment, a long cycle and high cost, and there is no need for small and medium-sized banks to repeat the work of developing systems.
At present, China's large banks have internationally advanced systems, so small and medium banks are recommended to cooperate with large banks in developing their own systems. Small and medium-sized banks can use the risk control model of large banks to process their customers' financial indicators and obtain their credit ratings. Then they can set up certain standards, evaluate and conduct business with clients with lower ratings.
Whether small banks need to develop their own core systems is a different matter. But with regard to the risk control model, it is cheaper for them to cooperate with large banks. Because the sample size and time span of the business of small and medium-sized banks are rather limited, even if a model is created, its accuracy may not be able to stand the test; while the business of large banks boasts a long time span and a large sample size, the risk control model created by large banks can be more accurate. Therefore, I recommend large and small banks cooperate in this area to enhance technology empowerment.
This article was first published on CF40’s WeChat blog on March 14, 2022. The article is translated by CF40 and has not been reviewed by the author. The views expressed herein are the author’s own and do not represent those of CF40 or other organizations.
