New push to reshape China banking landscape

"If the banks won't change, we will make them change." The confident and prophetic words from e-billionaire Jack Ma five years ago still ring true as China introduces a round of intensive changes that are poised to rock China's banking sector.

On Tuesday, authorities said China is likely to drop interest rate controls within two years, giving a clear timetable on interest rate liberalization after years of talk.

On the same day, authorities said they will approve five private banks on a trial basis, the latest move in opening the previously closed sector to private capital.

Some bemoan the passing of the good old days for the banks as these imminent policies mean they cannot reap easy and fat profits from the previous spread between a ceiling on the savings deposit rate and a floor on bank lending rates. Others are cheered by the prospect of better financial services as competition is sure to escalate when more players join the game.

Whether they welcome or dread the shift, they have to realize that the upcoming banking reforms are inevitable as China busies itself with retooling the economy. The best response is to prepare for the changes.

DIVERSIFIED PLAYERS

Though the People's Bank of China, the central bank, has long encouraged banks to diversify their portfolios by providing more services to the private sector, banking dinosaurs have been reluctant to do so.

Loans to large state-owned firms have always been a preferred choice due to stereotypical thinking that their payment is guaranteed. In contrast, small and medium-sized enterprises (SMEs) are often given a cold shoulder, even though they account for over 60 percent of gross domestic product. Without government backing, loans to SMEs are considered risky.

Moreover, banks have chosen to ignore the needs of small businesses and individual consumers as profits are hefty and assured already due to the government-imposed ceiling on the deposit rate and a floor on bank lending rates.

Though the authorities have made headway in interest rate liberalization over the years, they have felt strong opposition from the banks when it comes to the last part of the process, namely freeing up savings deposit rates.

The stale banking landscape has been shaken up as a handful of Internet companies, such as Jack Ma's Alibaba, weighed in to offer a wide range of investment and financial services.

Internet financial products like money market fund Yu'ebao created by Alibaba have been instant hits among the Chinese public. They have pulled money from traditional banks, which offer a maximum interest rate for one-year deposits of 3.3 percent, and moved it to web-based money market funds like Yu'ebao, which offer a seven-day annualized yield of nearly 6 percent. The better interest rate enabled Yu'ebao to attract 81 million users with aggregate deposits estimated at around 500 billion yuan ($81 billion) in just nine months.

Though Yu'ebao and its peers are labeled "blood-suckers" by some commentators, they have recently won government recognition. China won't ban web-based financial products like Yu'ebao, but will strengthen regulation to guide the healthy growth of Internet finance, authorities said.

By creating an alternative to state banks, these Internet innovations have been, in essence, prime movers in pushing interest rate reforms endorsed by China's financial authorities.

It is expected that new blood from the private capital will also invigorate the banking sector as these five private banks would be small or medium lenders, targeting small businesses that haven't been properly catered for.

NEW CHALLENGES

Tuesday's announcement does not come from nowhere. China has taken incremental steps toward interest rate liberalization, such as a move in July to scrap the floor limit for bank lending rates, and a guideline in December for piloting negotiable deposit certificates on the interbank market.

Still, these changes have been bold and intense enough to cause worries, and economic pundits have advised caution.

Ma Weihua, former president of China Merchants Bank, said interest rate liberalization contains big risks even though it is key to China's financial reform.

In the five years after the United States completed its interest rate liberalization, nearly 200 small and medium banks went bankrupt every year, Ma said, adding that Taiwan's banking sector was generally in the red following its interest rate liberalization.

Experts have also cautioned that the process, if not handled well, will not only hurt the banks but the real economy as well, citing expectations of a hike in deposit interest rates in the short term, which will likely be translated into higher lending rates by banks to minimize losses.

Though the private banks are billed as capable of spurring positive changes, their flexible operations are not risk-free either.

Shang Fulin, head of the China Banking Regulatory Commission, stressed that private banks would be subject to the same supervisory regime as existing commercial banks, with better monitoring of risk and shareholder behavior.

Lu Ting, an economist with Bank of America Merrill Lynch, proposed that the optimum sequence of reform is to liberalize interest rates for large amounts and long-term saving before turning to small amounts and short-term saving.