Zhou Xiaochuann: Preventing future accumulation of large NPLs by the
commercial banks after the present round of reform
Speech by Mr Zhou Xiaochuann, Governor of the People's Bank of China, at the China Summit of the
7th Beijing International Science Industry Expo, Beijing, 21 May 2004.
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Ladies and Gentlemen:
This Summit is a very important meeting. I appreciate this opportunity to share my observations with
all of you. The topic I am going to talk about relates to one of the functions of the institution I am
working for, which is how to prevent the commercial banks from accumulating new NPLs after the
present round of banking reforms.
The answer to this question and the resolution to the problem involve systemic engineering. To solve
this problem the utmost is that the commercial banks must take measures themselves to make sure
large amount of NPLs will not be accumulated in the future through strengthening internal reforms and
putting into place good institutional mechanism. Internal reforms refer to establishing good corporate
governance, setting up internal control system and risk management system, optimizing credit
procedures, updating the information system and establishing clear internal incentives of reward and
punishment schemes. The purpose of these reforms is to develop an effective new mechanism to help
commercial banks avoid accumulating large amount of new NPLs. Representatives from the
commercial banks must have deeper thoughts on this issue and should be invited to speak on this
topic. My speech today will focus on aspects of reform that goes beyond the internal reforms of
commercial banks and which cannot be accomplished by the commercial banks alone but rather with
the crucial help from other institutions and the whole society.
I am going to talk about the following issues:
1. Reforms of commercial banks' customers, especially those in the corporate sector.
After the structural change at commercial banks, the task of avoiding accumulating large amount of
NPLs, to a large extent, depends on the reforms and overall quality of their customers. In recent years,
despite the fact that the consumer lending and housing mortgage lending are in a surge, the major
client group of the commercial banks are enterprises that involve in different lines of business and are
of varied ownership. Whether the commercial banks can prevent large amounts of new NPLs from
occurring will hinge on the success of enterprise reforms. Only when the enterprises improve their
operation and profitability, can they strengthen their ability to repay debts, which will lead to lower loan
default rates and low NPL ratios.
Banks face different clients under different market conditions. In a mature market economy, bank
clients are of good quality and a credit culture is well established in the society. This in turn makes it
possible to maintain relatively low NPL ratios. In a transitional economy, it takes time for the credit
culture to be established and for enterprises to improve their quality. As a result efforts from the whole
society are required.
In the reform process, when applying for loans, enterprises should be required to provide true, reliable
and complete information, which include not only financial statements and the organizational structure
of the enterprise but also the true purpose of borrowing. For specific projects, the borrowing enterprise
should also be required to provide true information about the projects. In practice, there have been
cases where the enterprises provided false information to banks in order to swindle bank loans. False
information can take the form of manipulated financial statements, which depends on whether
accounting standards are appropriately applied and whether there is independent auditing. False
information can also take the form of the fraudulent information about the projects to be financed.
Recent fall-outs of a few enterprises reveal that before being exposed they had taken advantage of
complicated, non-transparent company organizational structure unknown to other people and a
complicated controlling structure to conduct connected borrowing through varied channels of financing
they controlled or through obtaining shares at a number of financial institutions or quasi-financial
institutions. From a legal perspective, using false information to defraud financial facilities from banks
or other non-bank financial institutions is illegal. Laws and regulations that can discipline and punish
such acts should be put into place.
The second aspect of enterprise reform is to quicken the steps of reform to build up enterprises'
capital. Generally, enterprises with inadequate capital pose a serious problem. Even though the
situation has improved compared to that in the early half of the 1990s, the enterprises' own capital still
remains at a low level in regard to the rules of market economy. This situation not only reflects the
financing structure of the whole society but also closely relates to the progress of enterprise reforms.
In a society where indirect financing is dominant, the first problem caused by low capital level is the
high leverage ratio, which implies relatively low risks for borrowing enterprises and high risks for
banks. In this regard, good risk management requires the banks to find out the proper leverage ratios
for different enterprises under different circumstances. If the enterprises fail to undertake necessary
reforms, it would be difficult for them to raise capital to appropriate levels. As a result, enterprises
would take on high external leverage ratios and expose banks to greater market risks and potential
NPL risks.
The third aspect is that attention should be paid to factors that affect normal default rates. Since risks
are inherent in all markets, in ordinary business activities enterprises may make investment mistakes
and be subject to risks in the market. This creates default risks for their banks. Defaults due to the play
of market risks are related to the location, the industry, the scale and the share-holding structure of
enterprises. Normal defaults are unavoidable. So attention should be given to differentiate the normal
and abnormal defaults. The default rates in economies in transition are different from those in market
economies. As a developing country, China's default rates are similar to those in other developing
countries. In emerging market economies, the default rates are subject not only to the workings of
market risks but also to abnormal institutional factors which are sometimes installed by administrative
intervention. An ordinary enterprise that is capable of servicing its debt may be liable to default under
administrative intervention. In the same vein, the default rates may also be excessively high in a
unsound legal or regulatory environment. In other words, if the conditions under which the banks
clients are operating remain unchanged, the default rates may be higher than normal levels due to
market risks as well as complicated institutional factors. If such factors are not addressed, it remains
possible for commercial banks to incur large amount of non-performing assets.
Furthermore, the enterprise reforms are conducive to strengthening budget discipline, which usually
determine the ability of enterprises to repay their debts and thus directly affect NPL level at banks. The
budget discipline of enterprises has evolved from a soft budget constraint in the 1980's to a much
harder one now. Further progress in this regard will have a bearing on the development of NPLs.
2. The development of NPLs will be closely related to progress in market-based interest
rate reform.
You may have noticed that many of the Party and government documents have listed gradually
moving toward market-based-interest rates as one of the directions and objectives of financial reform.
Although in the recent past the bands of interest rates fluctuation have gradually widened, they are not
determined solely by market conditions.
The relation between interest rate reform and NPLs is reflected in the discretion banks have in pricing
loans. In a market economy, the prices of loans vary due to the cost of funds, credit rating of the
borrowers and the outlook of projects to be financed. Since risks are always present in commercial
activities, the different risks of different borrowers and their different projects should be offset by
different risk premiums charged. This requires the commercial banks to charge interest to offset and
cover the risk premiums, which is also for the purpose of absorbing losses from defaults which have
low probability of occurring and account for only a small portion of the total loans. The nature of
banking business is to take deposits, issue loans and make profits out of interest spreads. Not all
loans issued can be recovered. There is always a percentage of loans that result in losses and need to
be absorbed by higher interest rate income. Thus, it is crucial for banks to be able to decide on the
prices charged to different clients so that they can prevent large amount of NPLs from forming or be
able to dispose of them. If a one-size-fit-all interest rate is charged to different types of enterprises, the
loss of some risky loans would not be covered. If accumulated, even losses on a small scale could
evolve into large amount of NPLs. In sum, the progress of interest rate reform will have a bearing on
the source and disposal of NPLs.
Market-based interest rate should not only be reflected in pricing of loan products and other assets,
but also be extended to pricing of all kinds of services and deposits. In absence of good customers,
the commercial banks could adjust their business strategy in two directions: one is to reduce activities
on the asset side and expand business on intermediate service, which surely involves pricing of
services; the other is to cut business on both the liability side and the asset side. Active management
of the liabilities, either expansion or reduction, would surely require commercial banks to exercise
discretion in pricing products on the liability side of the balance sheet, including deposits. In this
regard, deposit interest rates shall remain flexible too.
3. Commercial banks shall be allowed to make full provisioning and write off losses. The
related tax polices shall be revised accordingly.
Bank loans are always subject to a certain degree of economic risks, and at some stage of business
operation, the financial risks faced by banks are rather high. The commercial banks have to rely on
operational income and profits to offset losses. We can see that in mature economies, banks are
required to put aside all kinds of reserves, including risk reserves and others to guard against different
types of risks.
In the case of China, for a long time, commercial banks were not allowed to make full provisioning.
One reason was that the reforms of commercial banks had not been completed. The other was that
there was a lack of financial resources. It was not until mid 1990s the practice of provisioning was
overhauled. However, generally speaking, the proportion and scale of provisioning are insufficient,
implying that commercial banks are not financially strong enough to write off all of the bad loans. As a
result, only a small portion of the bad loans was written off and overtime, large amount of NPLs has
been accumulated. In order to prevent this from happening again after the reforms, commercial banks
should build up loan reserves based on stricter accounting rules and loan classification standards and
be given discretion to write off losses in a timely manner.
Directly relating to loan provisioning is the reform of relevant tax polices, which involves tradeoffs
between the state interests and the sound development of the banking sector. Banks in China are
levied not only the corporate income tax but also the unique business tax. If provisions are included in
the taxable income, commercial banks are subject to heavier tax burden and their ability to absorb
NPLs is weakened.
4. Markets to trade risk products and non-performing assets should be developed.
Just as Mr. Schwab has talked about a while ago, in order to help identify risks in bank assets, price
and transfer risks through normal transactions, we need to develop a market where risk products can
be traded.
In a typical market for risk products, the products traded are mainly CDS (Credit default swap) and
CDO (collateralized debt obligation). Through buying and selling risk products, the probability of
default is priced and traded. If such risk products are absent or a market where such products can be
traded is absent, it would be difficult for the banks to efficiently identify risks and estimate the potential
scale and value of loss if defaults materialize. In such circumstances, the commercial banks cannot
sell the risks they want to part with in managing their balance sheets. Meanwhile, institutions that have
financial resources and are willing to bear higher risks so as to receive higher returns, would find it
difficult to buy such risk products. In this regard, a risk product market is required to facilitate
commercial banks managing their risks.
Similarly, for the NPLs already accumulated by the commercial banks, a market to trade NPLs needs
to be established to facilitate disposal of NPLs according to the market rules. After the Asian financial
crisis, four asset management companies were set up in China in 1999 to dispose of the NPLs
removed from the books of four state-owned commercial banks. Foreign investors and domestic
institutional investors have been encouraged to get involved in disposing of NPLs. With these
developments, the NPLs transfer market is forming and developing. The existence and maturity of
such a market is crucial for the banking sector to solve the historical NPL problem.
5. Measures should be taken to encourage the development of a variety of service
intermediaries necessary for the growth of the banking sector.
The development of the banking sector requires the support of a variety of highly specialized
intermediaries. When banks screening customers, they need accounting firms to audit the financial
situation of these customers; when providing sophisticated financial services, they need law firms to
verify and justify the legality of the business of their customers; when estimating customers' assets,
they need professional asset quality estimators to determine their value; when conducting asset
management through transactions of financial securities, they need rating agencies to rate the
financial products for the purpose of pricing these products.
It is common understanding that the growth and development of these specialized intermediaries will
contribute to the development of capital market. From the prospective of developing the banking
sector, for the commercial banks to improve asset quality and effectively prevent the NPLs from
growing, we must place enough emphasis on the role and development of specialized intermediaries.
Usually, it takes a long time for the specialized intermediaries to grow and develop and often involves
complicated issues. Given the time constraint and that I have spoken about this issue on earlier
occasions, I will not further explore it. What I would like to emphasize is that we need to adopt a more
open attitude toward fostering the development of domestic intermediaries on the one hand, and
further opening the service sector and tapping external resources on the other. As a result, there will
be more high quality, accountable and specialized service providers in the credit market.
6. Consideration shall be given to removing the institutional barriers in the process of
improving corporate governance.
In the process of commercial bank reforms, many have stressed the importance of corporate
governance. It is noteworthy that in addition to the efforts by the commercial banks and their
shareholders, we should also consider whether there are some inappropriate policy constraints that
relate to our thinking and traditional practice.
As have been mentioned by Mr. Schwab, the concept of corporate governance has evolved into the
concept of international corporate governance that originated from a research on the subject by the
OECD in the early 1990's. Later the OECD released Principles on Corporate Governance. Although
the five principles are general guidelines, their implementation in China would encounter a few
institutional constraints. The expressions of some concepts are not applicable, such as the issue of
conflict of interest. In addition, there are some remaining administrative approvals, and institutional
and organizational arrangements that continue to hamper the development and improvement of
corporate governance. Following this vein, based on the common understanding of the importance of
corporate governance, we need to consider what the institutional constraints are and how to remove
them in order to establish good corporate governance.
7. In order to effectively prevent large amount of NPLs from being accumulated at the
commercial banks, actions shall be taken to smooth out business cycles.
Indeed, the biggest concern for banks is the ups and downs of the macro-economy. When the
economy is in boom, it is apparent that banks are in good conditions with handsome profits and better
asset quality. For example, in recent years all of us have seen that the NPLs of the state banks were
being reduced by 3 to 5 percentage points every year. However, once the economy experiences ups
and downs, especially during the down times, the encouraging trend might reverse and it is likely that
large amount of NPLs may emerge and make the situation difficult to manage. Similar situations
occurred before and after the Asian financial crisis as reflected in the NPL data of Thailand, Korea and
Singapore, where when the economies began to plunged into recession, the ratios of NPL rose
sharply.
In a market economy, the fluctuations in the business cycle are inherent. In transition economies, the
fluctuations in business cycles cannot be avoided completely. In this regard, the commercial banks
shall establish a capable macroeconomic research team, which can help make good judgments about
the coming shifts in the business cycle so that proactive measures can be taken to guard against
potential risks. In China, during the period of planned economy, the interest rates were set by the
state. The commercial banks and insurance companies regarded their losses due to the interest rate
changes being incurred by the related state policies. This perception has become out of date now. In a
market economy, the commercial banks as well as non-bank financial institutions must be capable of
predicting future economic fluctuations so that good performance can be achieved during booms and
risks be hedged during fluctuations. The commercial banks should especially consider how to improve
their work in this regard.
Here, I would like to cite an example. Two or three years ago, inflation in China was so low that there
was even a deflation. The Ministry of Finance issued 10-year and 30-year bonds with very low rates. A
number of big commercial banks purchased these bonds. Retail investors were not able to predict
future interest rate development due to limits in research ability. However, the big commercial banks
should have strong analytical capacity. If they also bought these bonds at a very low price, it might
indicate that they had not assessed the long-term risks adequately. This is an issue they should pay
attention to.
From a macroeconomic perspective, to prevent the economy from experiencing stop-and-go cycles, in
addition to deploying the appropriate monetary policy tools at appropriate time, we should especially
stress the importance of avoiding asset bubbles. Once bubbles have formed, it is difficult to make
adjustments. This is exemplified by what has happened in Japan. That is why we are going to do our
best to prevent asset bubbles from occurring. For China as well as for the rest of the world, the
greatest concerns lie in the asset bubbles in the equity and real estate markets. However, in China the
bubbles may occur in a different form, in that they may occur in the manufacturing industry, processing
industries or the raw materials in the form of excess capacity in production. If excess capacity exists,
the investments and consumption ratios and their proportion in regard to GDP would appear
disproportionate. In this regard, doing a good job in macroeconomic adjustment and aggregate
analysis will help the commercial banks not only to identify future risks, but also avoid accumulating
NPLs in economic downturns through mitigating fluctuations in business cycles.
Even though there are many more aspects that can be discussed on this topic, I have only focused on
the above seven points. Another interesting topic is building a society-wide credit system. Since I don't
have much time, I will not dwell on this topic. It is noteworthy that, sometimes even commercial banks'
internal reforms require support and assistance from outside. These reforms include how to retain
quality staff, how to develop effective incentive schemes, how to establish a favorable environment
that foster fast growth of good institutions and force poor ones to undertake reform, and how to help
the commercial banks to compete domestically and internationally when our commitments to the WTO
come due. All of these topics require in-depth research.
Thank you very much for you attention.