Banks therefore need added incentives to lend to private enterprises. One such incentive could be higher returns, but most banks in China are state owned and face limited competition, with the result that the profit incentive is weak. Furthermore, financial sector reforms focused on reducing the accumulation of nonperforming loans in the system are making banks more averse to risk. Banks concentrate on avoiding losses and show little interest in sharing the rewards of projects that may be riskier but have higher expected returns. In addition, there are controls on interest rates and transaction fees, although the government has been gradually relaxing some of them.
Interest rates are capped.
On loans to small and medium-sized enterprises, they are allowed to be 30 percent higher than prescribed rates, and rural credit cooperatives are allowed to charge interest rates up to 50 percent higher. Banks are taking advantage of this more flexible interest rate regime, but interest rates need to be liberalized further to encourage more lending to private firms. For the time being, banks and credit unions have found creative ways to circumvent interest rate controls, such as requiring compensating balances and charging false late payment fees. As a result, according to the firms surveyed, state banks charge effective interest rates that are comparable to those in the informal market. At the same time, most of the mechanisms used to circumvent restrictions on interest rates entail additional transaction costs, discriminate against smaller firms, and are too blunt to reflect differences in the risk profiles of projects.