China’s banks are also in need of reform

More details are emerging from the Chinese Communist Party’s meeting to select leaders, and one of the reforms they’ll have to tackle is the banking system.

The Wall Street Journal reported today about the massive task of turning Chinese banks from loaning to large state-run companies to helping people start small businesses.

A Communist Party Congress meeting this week will select a new group of leaders for the world’s No. 2 economy. A key task: rebalancing the Chinese economy away from bank-fueled investment that has enriched banks and state-owned enterprises, and toward consumption, which would benefit households and job-creating private companies.

If that agenda gains traction, it will require a revolution in China’s banking system, one that for the past decade has largely relied on a government-controlled interest-rate regime. China’s central bank sets a floor on lending rates and a ceiling on deposit rates, allowing banks to live off a guaranteed spread between the two.

Critics say the interest-rate controls shield banks from pressure to compete for business, hurting smaller borrowers, and that the controls penalize the depositors that Beijing hopes will become more-active consumers. China’s four biggest banks reported a combined third-quarter profit of 190 billion yuan ($30 billion), almost triple the amount made by the top four U.S. banks.

A shift away from that model “poses huge challenges to commercial banks including our bank,” said Wang Hongzhang, chairman of China Construction Bank Corp., China’s second-largest bank by assets, at a news briefing on Sunday on the sidelines of the Communist Party’s 18th Party Congress. Mr. Wang said the bank will try to adapt to the new banking order by diversifying into credit cards, insurance, commodities trading and other fee-based businesses.

Still, experts say incoming leaders may lack the political will to carry out overhauls that could hurt profitability at large banks. China’s biggest banks are politically connected and often used to fund Beijing’s policy decisions.

The New York Times also covered a new conference where party leaders discussed working to manage the system:

China’s top banking regulators and the chairmen of the four largest banks tried to allay concerns on Sunday that the country was allowing its banking system to grow at a reckless pace as a way to sustain short-term economic growth.

The regulators and bank chairmen said during a rare joint news conference that they were managing the industry prudently and that effective measures had been taken to limit risk even as lending expands briskly.

“The risks are within control,” Shang Fulin, the chairman of the China Banking Regulatory Commission, said on two separate occasions.

Loans have been climbing steeply as a share of the economy for four years, prompting foreign bank analysts to question the sustainability of an economic model based on ever more debt invested in a wide range of industries that are already facing overcapacity.

Chinese households and businesses have also begun shunning the very low, regulated interest rates offered by the giant state banks in favor of more speculative financial products. The central bank has been helping commercial banks sustain extremely heavy lending this autumn by pumping record sums of money into the financial system.

At a time when the global financial system needs well-capitalized banks willing to make prudent loans, one of the world’s largest economies – and also least transparent – is being questioned about loan quality.

Also from the Times:

Foreign analysts have warned that borrowers in many industrial sectors have used bank loans to speculate in real estate, so that the banking sector may have an unintentionally large exposure to the country’s real estate market.

Foreign analysts have also been skeptical of the low proportion of nonperforming loans. They say that a torrent of loans issued in 2009 and 2010 to bail the country out of the global financial crisis has not had time to produce a lot of bad loans. They also suggest that a renewed burst of lending this autumn is helping troubled borrowers, at the risk of racking up even larger debt on which they may default later.

The rapid increase in corporate lending has helped pull the economy out of a downturn that occurred over the spring and summer, but it has also increased debt burdens considerably in the corporate sector.

This should give many investors, especially those holding shares of Chinese banks, as well as U.S.-based firms that do business with them, pause. With a global economy teetering on the brink of either gaining traction or slipping back into a recession, the health of Chinese banks will play an incredibly important role. Here’s hoping that the government will actually follow through with some of the regulations and oversight. We’re all somewhat dependent on it.