——张化桥在美国富瑞投资银行 Jefferies 研讨会上的发言
 

China Banking Reform: What the (Under)dog Saw
        A speech at a conference Jefferies hosted in Hong Kong on 10 July 2012.

Ladies and gentlemen, thank you for giving me the opportunity to speak to you today. My name is Joe Zhang, and I am chairman of Wansui Micro Credit in Guangzhou. I'd like to speak about China's banking reforms from an SME perspective.

Broadly, my take on the banking reforms is this:
(1) First, interest rates have been largely liberalised, with the exception of rates for household deposits; I am very surprised by the stock market view that interest rate liberalisation (and the latest interest rate reductions) will lead to lower interest margins for banks. I do not believe the government will relax controls over interest rates for retail deposits in the next few years, but I feel strongly that banks will help themselves on the lending rates. There is clearly substantial scope for lending rates to go higher from here.

(2) Second, I believe that in the name of prudential supervision, regulators are stifling financial innovation and equal access to finance, hurting SMEs badly;

(3) Third, there is a huge opportunity for banks if they are allowed to collaborate with micro credit companies (MCCs).

First of all, let me briefly introduce my tiny company and our less tiny sector. At Wansui Micro Credit, our portfolio of Rmb225m is made up of 2,000 small loans, ranging from a few thousand yuan to Rmb3m apiece. The average size of our loans is 120,000 yuan.

The licensed micro credit industry came into being in 2008. Today, there are about 5,000 independent MCCs across China. We are licensed and regulated by the finance departments of local governments, not by CBRC, though CBRC has a huge influence on our lives. With some exceptions, the typical MCC is staffed by 6-10 people, has no IT infrastructure, is capitalized at Rmb100m, has no branches, and only makes large loans (a few million yuan apiece).

Wansui operates in Huadu District of Guangzhou. Unlike most of our peers in China, we have three branches – one in a leather market, and two at community centres.

We normally do not wait passively in the office for borrowers to call. We advertise, make cold calls, and send marketing officers out to shops, restaurants and leather goods retailers, furniture shops and fish farms. Our marketing officers make preliminary assessments on loan applications, and take a one-page form with vital statistics back to the head office. We typically make a final decision within three days. Our rates are 20-25% pa. Our typical payment schedule is monthly amortization.

As a well-conducted MCC, we have borrowed Rmb75m from China Development Bank at prime rate (6.7%). Last year, a government-owned trust company sold an Rmb20m loan portfolio for us, at an all-in cost of 12.5%.

Our financial data in 2011 looked like this:
1) Loan portfolio: Rmb225m
2) Sales: Rmb56m,
3) 5.56% business tax and surcharges,
4) Rmb12m labour costs (55 employees),
5) 2% NPL provisions,
6) Expenses such as rents, utilities, etc,
7) 25% enterprise income tax,
8) Net profit: Rmb25m,
9) ROE: 16.7%.

Any future improvement in ROE will have to come from one of these three sources:
(1) Increased leverage, or securitisation,
(2) Service income (acting as service agents for banks or corporate customers), and
(3) Fee income from managing other MCCs.

When making loan decisions, our strategy is to emphasise cash flows and downplay the significance of collateral. We do require collateral for large loans (above half a million yuan each), but for smaller loans, a guarantor is enough. Regular borrowers of small loans do not even need a guarantor.

How do we control risks? Unfortunately, we do not have a magic formula. We believe diversification is the golden rule. If you make a large number of small loans, you stand a very good chance of limiting defaults. Secondly, we make loans to genuine businesses with predictable cash flows. Collateral is important for big loans but collateral by itself does not guarantee one gets the loan. We make sure that our market niche is sustainable, and we do not want to compete with banks.

If the government wants to lower the interest burden on SMEs, it should allow MCCs to increase leverage, so that we can get a decent return. Only such a measure, along with increased supply of credit to our segment of the market, will force interest rates down.

You may wonder what kind of business can afford a 20-25% annual rate of interest. To answer the question, let’s ask, what kind of business can afford the internal rate of return of 30% a private equity firm expects? Like a PE firm, we select the best of the best from loan applicants. For companies that have high asset turns, the key challenge is not high interest rates, but availability of funds. On the flip side, many SOEs cannot survive even if you finance them at zero interest rate.

I often hear people say, the micro credit industry is prosperous at present only because of the tight monetary policy. That is a myth. Even in 2009 when the government flooded SOEs with silly money, SMEs did not get much relief. In my view, the prosperity of the micro credit sector rests on having a low-cost base, being nimble, and keeping one’s focus on SMEs.

How big is the SME credit sector? Some say it is merely Rmb5 trillion. But it depends on how you define SMEs. As supply of credit to the sector grows, so will demand for credit by the sector. Concerns about a credit bubble in the SME sector are probably premature.

Life at an MCC:
They say everything in life comes full circle. When I joined the central bank in Beijing in 1983, I never expected to be chanting the slogan of bank deregulation from the opposite side of the regulatory counter some three decades later. Indeed, I had not expected to be a noisy advocate of fair competition in banking today.

When Premier Wen recently announced that the government wanted to break a banking monopoly, he did not mean it literally, in my view. After all, there is already fierce competition among the few hundred banks. Take Guangzhou as an example: all the top-10 Chinese banks have an extensive presence there, and competition is almost cut-throat. In addition to national banks, many local banks from as far afield as Harbin have opened shop there. Guangzhou's local banks such as Guangzhou Bank and Guangzhou Agri-Business Bank are also defending their honey pot aggressively.

Guangzhou is not alone. Tough competition in banking is the name of the game in every city, and every county. Strictly speaking, there is no banking monopoly in this country. What frustrates Premier Wen, in my view, is the banks' inability and reluctance to lend to small business (SMEs), despite their huge loan portfolios and sprawling branch networks.

Let’s look at the facts. Despite credit tightening in the past two years, SOEs as a whole still readily get bank credit at prime rates of around 6.5%. At the same time, most SMEs are either denied credit, or pay 20-30% per year to alternative financial institutions. I know this, not only because I have been a micro lender in the past year, but also because of my personal investment in a few similar lenders across China. Licensed MCCs in general charge borrowers up to 4x the prime rate, but unlicensed lenders are free to charge whatever they can get away with. Note that this is legally permitted.

Chinese banks do lend to SMEs directly, but on a small scale. In addition, banks lend to MCCs a total of about Rmb150bn, also a tiny sum. There is political pressure on banks to lend more to SMEs, but banks only pay lip service to this decree. Why the inability or reluctance?

My friends at bank branch level complain about excessive regulation, too much work and stress, not enough sleep, and not enough time with families. Their KPI (key performance indicators) is a long list: attracting deposits, making profits, selling funds, controlling NPLs, etc. Unfortunately, lending to SMEs is not on the list.

A rational approach for a bank is to lend to MCCs or buy their loan portfolios. However, draconian regulation caps their loan size at 50% of MCCs’ equity. On the other hand, these micro lenders’ packaged loan portfolios are typically small (Rmb20m to Rmb50m), not enough to get bankers interested, particularly when the bankers have other priorities.

Several banks such as China Development Bank and Merchants Bank have launched joint lending programs with MCCs, under which MCCs act as both loan service agents and guarantors. The guarantee requirement has severely limited the size of this program.

It is fashionable to talk about risk controls. No regulator will lose his job for being tough on anything. Sadly for China, the term has become a convenient shield for regulators to stifle financial innovation, or stay lazy.

Countless government agencies have made countless announcements about their eagerness to support SMEs or agriculture. In recent years, they have made bolder announcements about allowing the private sector to set up banks. Initially, these announcements were music to my ears. But after a while, you find they are not worth the paper they are written on. If you are credulous and actually go and apply for a bank license, you will find that you are the only naïve soul standing in that queue.

Let me tell you some of the rules MCCs are subject to.
(1) If a bank kindly agrees to a joint lending program with an MCC after extensive lobbying by the latter, the bank regulator (CBRC) will dictate that the thousands of tiny loans must also go through the bank’s risk control apparatus, effectively killing the economics of the program, and killing the bank managers’ appetite for continued efforts.
(2) In November 2011, CBRC told trust companies not to raise money for MCCs, and not to do business with MCCs.
(3) In early 2012, the Zhejiang Provincial Government issued a circular, paving the way for banks to lend more to MCCs. But so far, no bank has lent MCCs more than half their equity, for fear of the CBRC’s displeasure.
(4) With a few exceptions, the 5,000-odd MCCs across China must limit their debt to half of their equity. Securitization is off-limits to them. They are also subject to restrictions on the qualifications of each shareholder, and their maximum stake.

Does China need more banks? Probably not. But that is not the question we should be asking. There are many banks, and there is fierce competition. But these banks are too similar, and their products are too commoditized. They either have no creative ideas, or their creative ideas have been killed by regulators in the name of risk controls.

In the past year, banks were prevented from lending to local government entities. However, I have seen banks come up with innovative solutions to bypass this: they launched several private-equity funds to invest in government entities (infrastructure, or low-cost housing). In reality, these PE funds were underwritten by the banks. When the government entities fail to go public in a few years, the PE funds’ exit strategy is to sell the stakes back to the local governments. There are also BOT arrangements to by-pass regulation.

If China is to foster SMEs, or to boost efficiency in the economy, regulators must allow more risk-taking on the part of banking institutions. Key steps include:

(1) Remove the ceiling on MCCs’ leverage ratios;
(2) Permit trust companies and banks to raise money for MCCs;
(3) Widen cooperation between different types of financial institutions, to achieve better efficiency.

As to interest rate deregulation, my sense is, lending rates have been largely deregulated. In my work with banks, I do not feel that they are in any way prevented from charging higher rates. When lending to the likes of Petro-China or China Mobile, the banks’ inability to charge higher rates is due to competition or long-term business considerations, not due to regulation. To other borrowers, some banks and AMCs do charge as much as 18% pa. A 10% p.a. rate is commonplace, 40-60% higher than the prime rate. Banks do not even dress up the higher charges as management fees or other fancy names.

Attracting deposits is the biggest priority of all banks. I feel this is the only area where rates have not been liberalized. All banks offer the highest permissible deposit rates.

In the past few years, banks have seen very few bad debts. So have MCCs. But in recent months, loan demand has weakened, and market rates have declined, as the economy softened. If this persists, we are likely to see NPLs rise quickly. A year ago, my company reported no bad debts. In the past five months, however, we have seen 2-3% bad debts.

This is my brief introduction, and I look forward to your questions.