Effect of Foreign Banks on the Efficiency of Chinese Commercial Banks - Essay Example

? Effect of Foreign Banks on the Efficiency of Chinese Commercial Banks Findings - Data presentation/ analysis and discussion In the quest to ascertain the impact of foreign banking on Chinese Commercial Banks, it was necessary to use empirical formula rather than quantitative formula. Empirical study shows the relationship between the introduction of these strategic foreign investments and the resultant influence on domestic Chinese commercial banks. To estimate profit turnover of these domestic banks Berger and Mester (2005) proposed the Stochastic Frontier Analysis (SFA) .This is an empirical method that takes into account varying parameters that influence efficiency. Market average input prices were accordingly used to determine cost and give tangible results when used in SFA. Data Presentation The figure showing changes of profit efficiency of the Chinese banking industry This figure underscores the effect of penetration of foreign banks on Chinese domestic banks. During the initial stage of market penetration, domestic banks drop or stagnant in terms of profit efficiency. This is occasioned by the need to increase investment in technology and efficient systems in order to stay competitive. These measures drive the cost upwards resulting in decreased profit margin. The trend changes to that of growth after the necessary technology and efficient systems are in place. The exponential growth face exceeds the negative impact occasioned and this in general increases profit efficiency and by extension the efficiency of the domestic banks. These results indicate that City commercial banks are the most profit efficient whilst state-owned banks being the least in terms of profit efficiency. This is a deviation from the fact that state-owned banks (SOCBs) tend to be more cost effective. The reason for this is that SOCBs tend to have higher Non-performing loans (NPLs) than City commercial banks (CCBs). The situation is compounded by the fact that NPLs have to be included in loans as an output since no tangible data on NPLs exists in China. This therefore influences negatively on the cost efficiency of SOCBs and any increase in cost efficiency is offset by a decrease in nonperforming loans. There is a need to measure efficiency of banks from a different perspective and the following figures depict the mean technical efficiency in the Chinese banking sector by bank type: A. B. Model A is an experiment on profitability or income generation while model B examines the efficiency of earning asset production and growth. A quick comparison of these two models shows that within the first five years model B reached an efficiency at a faster pace than model A. This is an indication that banks here were more poised on asset building rather than profitability. In the year 2000 the graphs are flat indicating diminished growth occasioned by the banks being more profit conscious instead of first pursuing asset growth. Further interpretation of the data in model A shows that JSCBs are more efficient and better performers than all the other banks. This could be attributed to the fact that JSCBs are more autonomous and free of direct intervention by the Chinese government. JSCBs are also not faced with numerous challenges of NPLs like SOCBs. CCBs have a poor showing indicating bias or small sample size of these types of banks while researching. Chen et al (2005) findings are proven in model B whereby SOCBs outperform JSCBs in efficiency. This, however, is in direct contravention of known literature depicting the relationship between the government and the banking industry. A possible answer could be that the vast amount of state funds poured into SOCBs for their growth is having an impact and the banks are gaining stability. These two models of income based and asset based are another way to measure the impact that foreign banks have had on the efficiency of the Chinese domestic banking industry. A clearer picture is painted by including other parameters. Discussion For a very long time it has been almost impossible to accurately measure the impact of foreign banks on the efficiency of Chinese banks. This has been due to lack of tangible data that can be relied on. Research into banking in China has widely been restricted to state owned commercial banks neglecting city commercial banks and joint stock banks. However, the rapid growth of China has necessitated the need for research into such matters in order to remain competitive in the world market. Generally, entry of foreign banks into a market has two intentional consequences: To improve competition Improve efficiency However this entry into a new market has been faced with a couple of challenges. This has been especially true in developing and emerging markets, where China can be loosely grouped. These challenges include: I. Lack of proper and efficient management skills II. The problem of banks being segmented by economic sectors III. Poor or lack of competent credit analysis systems IV. Classes (1998) add the most crucial which is the dominance of the State of the banking system coupled with poor asset quality and weak oversight strategies. Furthermore, Chinese scholars and researchers have delved into this issue and Ye Xin (2006) drew a comparison between the extend of the entry of foreign Banks and their resultant impact on domestic market competition and efficiency. The result of this research was twofold: the supposed competition brought by foreign banks was limited and therefore its impact on efficiency of Chinese banks was minimal. On the other hand however, market competition was bound to increase efficiency in Chinese banks due to the increasing external competitive factors. Another study by Xiong Zhengde and Hou Lijuan (2009) confirmed the fact foreign bank entry into the Chinese market positively increased competition and efficiency. Zhang Jinqing and Wu Youhong (2010) realized a greater effect on Chinese banks as an effect of market entry by foreign banks. Globally two hypotheses have been postulated on the impact of foreign bank entry into the market. The home-field advantage hypothesis is of the view that domestic banks are generally more efficient and productive because of tailored organizational structure and ease of access of information at the right time. On the hand the Berger et al (2000) argues that the global advantage hypothesis is more viable since foreign banks have stronger management system and superior quality human capital. Berger et al., (2000); De Yong and Nolle, (1996) Sathye’s, (2001); Chang et al., (1998); and Peek et al., (1999) believe that the home advantage hypothesis holds in developed nations where domestic banks have developed systems and tend to be more efficient. In contrast Bonin et al. (2005b), Kraft et al. (2006) Rao (2005) and Jiang et al. (2009) ascertain that the home field advantage also holds in China and the United Arabs Emirates. The global advantage hypothesis holds mostly in developing and emerging markets. Financial Reforms Reforms in China have played a major role in enabling market penetration of foreign banks. These reforms were aimed at improving the effectiveness of resources distribution and allocation and to render strength of the financial foundations of the economy. To realize this, a framework of reforms has been underway albeit at a very slow rate. This includes: I. Attracting foreign banks by lowering the entry barrier II. Removing stringent credit controls III. Creating frameworks which enhance supervision IV. Making interests rates liberal V. Enabling privatization VI. Adoption of the five-category loan classification system as internationally required. In this sense empirical study of efficiency should consider the following important factors: Ownership Foreign bank entry Financial liberalization Deregulation policies Privatization I. Ownership Spong et al. (1995) sates that the important issue is to find a criterion to blend ownership and quality management skills to be able to compete globally. Developing and emerging economies have an especially high number of state owned financial institutions most of which are not optimally managed. Conflict of interest or reluctant to pursue more profit making ideas by the state are just some of the reasons why this is not favored. China has also moved from a state owned one-tier banking system to a more flexible and liberalized system of ownership to attract foreign banks. The inefficiency of SOCBs shows poor market discipline and inability to curb on this vice by indicting bank managers who indulge. This is in direct contradiction to privately owned banks which value results and seek to create a favorable public image. According to Bonin et al. (2005a); Fries and Taci (2005); and Yao et al. (2007) state owned banks in transitional economies are less profitable and less efficient as compared to privately owned commercial banks. II. Foreign bank entry As earlier stated there exists two schools of thoughts in regard to this matter. The home field advantage hypothesis and the global advantage hypothesis. Each of these has been discussed bearing in mind the merits and demerits of each. III. Market liberalization The ripple effect of market liberalization has trickled through the Chinese domestic banks whereby barriers of trade and investment have been lifted thereby paving way for Chinese banks to compete effectively in the global market. IV. Privatization Boubakri et al. (2005); Berger et al. (2005) and Williams and Nguyen (2005) have shown through an empirical formula that there is marked improvement in the banking sector after privatization. Privatization is achieved through two methods: Foreign banks buying into ownership of domestic banks and the second is through participation in IPOs by foreign banks. Berger and Mester 1997 found that listed banks tend to be more efficient in comparison to unlisted banks owing to the fact that the discipline of the capital markets is highly maintained through IPOs. V. Deregulation The effect of deregulation has been mostly viewed as positive during entry of foreign banks into the domestic market. Competition forces banks to be more creative and efficient by forcing them to rethink their input and output matrices, upgrading technologies and using market principles as the basis of making their operational decisions. Significance of foreign bank penetration into the Chinese banking sector It is not readily possible to ascertain the level of efficiency attained by Chinese domestic banks or the role the entry of foreign banks has played. However, there has been a significant rise in competition and the trend to employ the latest technology to cater for the needs of their ever-growing customer base. For instance in 2009 the top three banks in terms of capitalization were all from China. These were Industrial and Commercial Bank of China (ICBC), China Construction Bank Corporation (CCBC), and Bank of China (BOC). This has led to opening up of more of the Chinese market for trade thereby increasing revenue. There have been increased cases of mergers between foreign banks and Chinese domestic banks. These mergers have increased competition and efficiency since foreign-based banks apply the systems that have worked for them for so long onto the local scene. The clientele base also tends to grow exponentially owing to the fact that most of the foreign banks are well established and tend to instill more confidence in people thereby influencing their choices on which banks to use. Acquisitions have also been on the rise in China. For instance recently Bank of America acquired 9 % share in CCBC, American Express, Goldman Sachs and Allianz entered into an agreement with ICBC in return for a 10% share to the American banks. European banks have also been in the forefront of these acquisitions. Berger et al. (2009) says top on the list is The Royal Bank of Scotland, which teamed up with Merrill Lynch and Hong Kong tycoon Li Ka-Shing to acquire a 10% stake in BOC. These acquisitions led to these three Chinese banks being ranked in the top three in terms of market capitalization. Another positive aspect of brought about by foreign penetration has been increased customer base. The number of people that hold bank accounts has risen tremendously and this can be attributed to increased efficiency. This is particularly an enticing prospect to the poor who may not otherwise access these facilities. China as well as other economies around the world are finding it necessary to move towards efficiency in the financial sector. However this efficiency improvement by foreign banks is affected by three key factors: I. Condition of the developing economy II. Capital market operations III. Financial development of the domestic countries However these emerging challenges are addressed with equally unique solutions that are sometimes tailored to suit the current environmental conditions. Conclusion Foreign banks have opened up China to the world. This has in turn increased efficiency in the domestic banks in China. In 2010 there were 75 foreign banks belonging to some 25 countries that were operating in China. The total assets of these foreign banks were estimated to be 1740 billion RMB. This represents 1.9 per cent of the total assets in Chinese banking sector. This just underscores the effect of foreign bank entry into the effectiveness of the domestic banks. Both SOCBs JSCBs and CCBs have had a significant and rapid growth owing to the impact of these foreign banks. Over the last few years profit efficiency was on the increase. This has been at a higher rate than cost efficiency. This is attributed to the inclusion of non-performing loans the results leading to increase in the cost. Ownership has a significant effect on efficiency. In this analysis the effect of state running banks has greatly undermined the efficiency of SOCBs .CCBs tend to be more efficient and profitable due to the nature of their ownership which is private. Important to note is that foreign banks are more profitable than both JSCB and SOCBs. This can be taken as an application of the global advantage theory although this may be false as CCBs are way ahead of the rest, and they are domestic banks. China still has still a long way before attaining full modernization of its banking systems. The Chinese government has played a key role in attracting foreign institutions through policy change and a paradigm shift to a more liberated sector with adequate checks and balances, which are in place. Banks should strongly consider IPOs, which are a good source of revenue for the domestic banks. The government should be shepherded from a rigid policy-oriented approach to a more pragmatic approach profit orientation. In 2007, China’s premier Wen Jiabao during the National Financial Work Conference gave a keynote speech on the country’s banking system. While applauding the progress and strides achieved by the reforms, the premier noted six key areas that required urgent addressing. The objective of this was to open up China and bring more foreign investment to add a boost to the banking sector. These areas involved: 1. Increasing reforms and transparency of state owned commercial banks. 2. Enhancing and pioneering financial reforms in the rural areas to reach the unbanked rural population. This is estimated to increase competition, efficiency and innovation whereby banking products should be tailored to accommodate the poor inhabitants of these rural areas. 3. Increasing investment and facilitating development of both the capital and insurance markets. 4. Equipping financial services with the right systems and human resource to be able to adapt accordingly to economic developments and changes. 5. Streamlining rules that govern foreign entities on investing in China. 6. Increasing and strengthening of financial institutions. 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