Chinese Banks Are Making Easy Profits Off Of Artificially Low Interest Rates

Mao Swimming China

One of the challenges facing China is the rapid expansion of lending from its banks. Excessive lending can lead to loans of questionably quality, and thus future loan losses, which can undermine a financial system’s strength.

China’s lending binge is nothing new, and the government has been trying to restrict loan growth this year with questionable results. For example, China’s full-year quota for new loans was already reached within the first six months of 2010 according to Caixin.

Yet while many have blamed the Chinese government for promoting excessive lending, especially since many Chinese banks lend heavily to Chinese state owned enterprises (SOEs), Bank of China chairman Xiao Gang has recently explained why the government isn’t technically to blame.

The reason why Chinese banks have lent heavily to state owned enterprises isn’t so much because of direct government pressure and is more a factor of the distorted profit incentive which exists within Chinese banking:

Bank of China:

In China, because of the non-liberalized interest rate, net interest margins on yuan loans are almost double of that on foreign currency loans in the international market. In such an environment, which bank wouldn’t want to increase its lending? The more banks lend, the more profits they earn. Simple.

Interestingly, the banks have revamped the remuneration schemes top-down, closely linking their employees’ compensation and branches’ expenses to performance, in particular, to revenues and profits. The compensation usually consist of two parts: one is the basic wage related to the different positions, and the other is performance-linked bonus that generally accounts for 50-70 per cent of the total compensation. Those who do not advocate giving more loans (and therefore more profits) are, of course, not so popular within banking circles.

While expanding their loan portfolios, Chinese banks are smart enough to take the risk-averse approach and to focus on lending to large State-owned enterprises (SOEs). These SOEs often enjoy monopoly in their sectors and favourable conditions in an industry and enjoy quasi-government credit ratings. This can, in turn, explain why Chinese banks have steadily improved their asset quality and reduced their non-performing loans ratios.

As a chairman of a bank, I have never received any instructions from the government to lend money to any project. All decisions relating to business were made either by the board, or by the management.

The path of least resistance, based on profit and executives’ incentives, is thus to lend lots of money to China’s SOEs. The government doesn’t even need to make direct requests.

This is an interesting distinction, even if it still means the government is indirectly to blame given that it is responsible for the regulatory and institutional system it has created.

For more, you can read the full piece at the Bank of China site.

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