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Improving risk management system of small, medium-sized banks

WANG LI and WANG XIANSHUANG | 2020-12-02
(Chinese Social Sciences Today)

Pictured is the Bank of Guangzhou's stand during a financial expo in Guangzhou, Guangdong Province. Photo: CHINA DAILY

With urban commercial banks and rural financial institutions as the main bodies, small and medium-sized banks play an important and fundamental role in China's financial system, contributing to inclusive finance and serving small and medium-sized private enterprises. Since the financial crisis in 2008, the assets of small and medium-sized banks have maintained a high growth rate. However, a rapid expansion of assets has been accompanied by increasing on-balance-sheet and off-balance-sheet risk exposures. 
The year 2020 is a crucial year for three major battles in China: preventing and defusing major risks, taking targeted measures to combat poverty, and preventing and controlling pollution. At the fifth plenary session of the 19th CPC Central Committee, a clear proposal was made to "improve financial risk prevention, early warning, disposal, and accountability systems." Small and medium-sized banks are an important part of China's financial system, but are currently the banking system's weak link. Therefore, it is of great practical significance to forestall and defuse risks of small and medium-sized banks.
Status quo
The non-performing loan ratio and provision coverage ratio are common indicators which reflect banks' on-balance-sheet risk exposures. From 2009 to 2019, the average non-performing loan ratio for small and medium-sized banks was significantly higher than that of large commercial banks and joint-stock commercial banks, and the provision coverage ratio was also lower. 
In particular, the risk exposure of rural-based commercial banks is troublesome. Since the second quarter of 2018, the non-performing loan ratio has remained at 4%, which is 2 to 3 times higher than that of large commercial banks and joint-stock commercial banks, and the provision coverage ratio is only 50% to 70% the ratio of the above bank types. The non-performing loan ratio for urban commercial banks also reached a peak level of 2.48% in the second quarter of 2019. 
From the perspective of off-balance-sheet activities, the capital balance of financial products in urban commercial banks and rural financial institutions is significantly higher than that of large commercial banks and joint-stock commercial banks. This means that the off-balance-sheet financial services of small and medium-sized banks have expanded at a faster pace in recent years, and their off-balance-sheet risks have skyrocketed.
In general, the high systemic risk of small and medium-sized banks hints at their deficiencies in risk management, and their vulnerability when adapting to external regulation and policy changes.
Formation of risks
The leading cause of risk to small and medium-sized banks could be attributed to both macroeconomic factors and bank governance. The economic slowdown, structural reforms, interest rate liberalization and regulatory reforms constitute the macro background for risk formation of small and medium-sized banks. Policy discussions about how to forestall and defuse risks to small and medium-sized banks are thus of strategic importance to the healthy development of the financial system and the maintenance of financial stability in China.
First of all, externality and moral hazards are direct causes of risk to small and medium-sized banks. As the center of social financing, banks' risk bearing and exposure have a strong externality, meaning that the gains which come from risk bearing fall into the pockets of shareholders or bank managers, whereas the costs of risk exposure are borne by depositors. Without sufficient supervision and good corporate governance, such a strong externality will lead to moral hazards for bank owners and could potentially lure them into adopting aggressive strategies. 
At present, through financial management, inter-bank markets, financial markets and other channels, small and medium-sized banks have expanded their business, and are further amplifying their network effects. Especially in recent years, the network centrality of small and medium-sized banks has been significantly improved, which makes risk externalities transferable to other economic entities at a faster speed. 
Second, the procyclicality of bank leverage ratios and implicit guarantees makes small and medium-sized banks more vulnerable to liabilities. When the size of a bank's balance sheet grows, the bank is more inclined to make active adjustments and increase its leverage levels. At the same time, implicit guarantees take a toll on bank's motivations to reduce their risks through low leverage, further amplifying the pro-cyclical nature of bank leverage. 
Compared with large commercial banks and joint-stock banks, China's small and medium-sized banks mostly develop on the basis of urban and rural credit cooperatives, and are an important force in local economic development. For a long time, small and medium-sized banks were under the implicit guarantee of local governments, with evident pro-cyclical features. 
In addition, studies have shown that the franchise value of a bank belongs to its shareholders and is lost in bankruptcy. So intuitively, a more valuable franchise would take less risks. However, due to the low franchise value that comes with implicit guarantees, small and medium-sized banks normally lack a strong incentive to reduce their own risks in order to enhance franchise value, which further leads to an accumulation of risks.
Third, interest rate liberalization and risk transfers lead to the excessive allocation of risky assets to small and medium-sized banks. When bank spreads are low, it intensifies moral hazards between banks and depositors, and banks are more likely to take on higher risks and then transfer investment risks to depositors. 
As China's macroeconomic growth slows, the return on investment in the real economy continues to decline, and credit resources tend to flow into infrastructure construction, real estate, local governments, and state-owned enterprises, which gradually weakens the comparative advantages of small and medium-sized enterprises and banks. Compared with large commercial banks and joint-stock banks, small and medium-sized banks have higher liability costs, and when gains in assets are fixed the spread is further reduced.  
Moreover, with the interest rate liberalization and downward economic pressure, the asset's return rate drops, while cost cuts on liability are more limited. Affected by confined regions and fewer branches, small and medium-sized banks face greater spread pressure. Therefore, they have a stronger incentive to allocate riskier assets to relieve spread pressure, and their risk exposure increases accordingly.
Policy advice
To this end, we propose to forestall and defuse risks of small and medium-sized banks on two levels. The key to responding to short-term events lies in choosing appropriate risk exposures and countermeasures to avoid the evolution of micro risks into macro systemic risks. Medium- and long-term risk prevention system design should aim at improving the operating environment for small and medium-sized banks and reducing the occurrence of risk.
Non-standard corporate governance directly causes the formation of risks in small and medium-sized banks, while the root cause lies in promoting the transformation and upgrading of its economic and financial systems. Therefore, it is crucial to standardize corporate governance, clarify shareholder responsibility and replenish capital. On the national level, risk prevention for small and medium-sized banks relies on optimizing regulatory environments and economic structures to alleviate institutional dilemmas.
Going forward, the deposit insurance system needs to be further perfected to reduce reliance on implicit guarantees and unlimited deposit insurance, and enhance market supervision and constraints on banks' risk-taking behaviors. 
We should continue to promote interest rate liberalization, while strengthening regulations and capital requirements, to not let banks take excessive risks out of downward pressure in interest rate spreads. 
Mergers and reorganizations of small and medium-sized banks may also help, to enlarge their capital pool and scale effects, and strengthen their capacities for technological advancement and talent cultivation, to fundamentally improve their operation quality. 
In the end, only by increasing the proportion of residents' incomes in wealth distribution, increasing the proportion of consumption and services in the economy, and constantly stimulating the vitality of small and medium-sized enterprises, can the comparative advantage of small and medium-sized banks be revealed. Apparently, this transformation process will be slow, calling for the joint efforts of fiscal and tax policies, financial structures, industrial access and other institutional reforms.
Finally, the scope and pace of risk exposure should be regulated to maintain market stability and liquidity, to avoid excessive contagion of risk events. If necessary, the central bank should assume the role of last resort lender and provide emergency capital to avoid a liquidity crisis.
Wang Li is from the Faculty of Economics and Management at East China Normal University; Wang Xianshuang is from the Development Research Center of GF Securities.
Edited by YANG XUE