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Dissertation Mingyu Xiang

The Analysis of the Credit Risk and X-Efficiency for Commercial Banks

in the Chinese Banking Industry

By

MINGYU XIANG

Supervised By Maximilian Hall

October 2013

MSc Risk Management


University of Nottingham


Abstract

Along with China’s fast economic growth, the development of its financial sector has also attracted

with attention. After a series of reforms, the banking system remains dominated the financial sector

and impacts significantly on the country’s overall growth. In this paper, using an unbalance panel of

39 banks during the period of 2005 to 2012, we are trying to test the change of efficiency levels of

the Chinese commercial banks. The parametric approach, Stochastic Frontier Analysis (SFA) is

employed for the empirical test. In general, we concluded that in average, the efficiency level of the

Chinese commercial banks has deteriorated over the sample period and this might because of the

unfavourable economic environment in China, the unstable financial system triggered by the

financial crisis and the worsening of the European debt crisis over the past few years. Among the

various banking type, the state-owned banks were found of achieving constant improvement in their

efficiency and this might because of their bigger size and monopoly power over the market. In

addition, among the six variables which try to capture the factors which may impact on the banks’

efficiency level, four of them were found of statistically significant. They are the return to asset

ratio, the equity to asset ratio, the loan to deposit ratio and the listing status. For banks that are more

willing to accept risks, it may impact negatively on their efficiency level.

Key words: Stochastic Frontier Analysis (SFA), State-owned banks, Joint-equity commercial

banks, Chinese banking sector

I


Acknowledgements

I would like to take this opportunity to express my sincerely thank to my supervisor, Dr Hall for his

supervision, encouragement, patient and advice throughout this dissertation project. Without his

help, it would be impossible for me to complete this dissertation on time.

In addition, I would also like to thank Teresa who helped me go through a difficult time and gave

me lots of encouragement. Also I would like to thank for my classmates, Peng Peng who gave me

some useful suggestions for written works.

Last but not least, my thanks would go to my beloved parents who have always been helping me out

of difficulties and supporting me without a word of complaint. Without their selfless love and trust,

I am not able to out of the woods and do not have brave to move on.

Ⅱ


Table of Contents

Abstract………………………………………………………………………………Ⅰ

Acknowledgement…………………………………………………………………...Ⅱ

List of Tables………………………………………………………………………...IV

List of Figures…………………………………………………………………….. ...V

Abbreviations………………………………………………………………………..VI

Chapter 1 Introduction...................................................................................................1

1.1 Research Topic........................................................................................................................1

1.2 Objectives and Research Questions........................................................................................1

1.3 Structure of the Dissertation....................................................................................................3

Chapter 2 Background Review and Development of Chinese Banking Sectors in

China..............................................................................................................................4

2.1 State-owned Banks..................................................................................................................7

2.2 Joint Equity Commercial Banks............................................................................................17

2.3 City Commercial Banks........................................................................................................19

2.4 Foreign Banks Entered into Chinese Banking Market..........................................................24

Chapter 3 Literature Review........................................................................................29

3.1 Define Efficiency and X-efficiency.......................................................................................29

3.2 The Frontier Methods for X-efficiency Study.......................................................................30

3.3 Literature Related to X-efficiency Study..............................................................................32

Chapter 4 Methodology and Data................................................................................40

4.1 Methodology.........................................................................................................................40

4.2 Data and Variables.................................................................................................................42

Chapter 5 Results of the Empirical Analysis...............................................................46

Ⅲ


Chapter 6 Conclusion..................................................................................................50

Reference.....................................................................................................................55

Ⅲ


List of Tables

Table 1 Non-Performing Loan Transfers of 1999-2000.....................................................................10

Table 2 NPL Disposal of the “Big Four” SOBs.................................................................................11

Table 3 Foreign Strategic Investors of the Four SOBs and Their Business Cooperation..................12

Table 4 Size and Ownership of China’s Big Four SOBs....................................................................14

Table 5 NPL ratio and ROA ratio of the big four SOBs: 1999-2012.................................................15

Table 6 Shareholdings of China’s JECBs...........................................................................................17

Table 7 Comparison of NPLs between JECBs and SOBs..................................................................19

Table 8 Foreign Investment in Chinese City Commercial Banks......................................................21

Table 9 Sample Shareholding Structure of City Commercial Banks.................................................22

Table 10 Number of Foreign Banks, Branches and Assets during 1985 to 1996...............................24

Table 11 Foreign Investors in Chinese Banking Industry..................................................................26

Table 12 Foreign Banks Operations in China 2004-2011..................................................................28

Table 13 Number of Banks in Each Year...........................................................................................43

Table 14 Correlation Coefficient of the Input and Output Variables..................................................44

Table 15 Summary Statistics of the Variables....................................................................................45

Table 16 Correlation Coefficient of the Independent Variables.........................................................45

Table 17 Results of the Stochastic Input Distance Function..............................................................46

Table 18 Average Efficiency Score of Different Banking Types: 2005-2012....................................50

IV


List of Figures

Figure 1 China’s Banking Overview 2007...........................................................................................6

Figure 2 Share price movements of the SOBs after IPO....................................................................16

Figure 3 City Commercial Bank Assets from 2004 to 2012..............................................................23

Figure 4 Efficiency Level of All Banks by Different Types: 2005-2012...........................................50

V


Abbreviations

1. Names and Abbreviations of Chinese Commercial Banks

Abbreviations Full Name of the Banks

ABC Agricultural Bank of China

BOC Bank of China

BOCOM Bank of Communication

CCB China Construction Bank

CITIC China CITIC Bank

ICBC Industrial & Commercial Bank of China

2. General Abbreviations

AE Allocative Efficiency

AMCs Asset Management Companies

CBRC China Securities Regulatory Commission

CCBs City Commercial Banks

CE Cost Efficiency

DEA Data Envelopment Analysis

GDP Gross Domestic Product

HKSE HONG Kong Stock Exchange

IPO Initial Public Offering

JECBs Joint-Equity Commercial Banks

M&As Merger and Acquisitions

NPLs Non-Performing Loans

PBOC People’s Bank of China

ROA Return on Assets

ROE Return on Equity

SFA Stochastic Frontier Approach

SOBs State-Owned Banks

SOEs State-Owned Enterprises

VI


SSE Shanghai Stock Exchange

TE Technical Efficiency

WTO World Trade Organisation

VI


Chapter 1 Introduction

1.1 Research Topic

Represented by the bankruptcy of Leman Brothers, the US financial crisis was broken out in 2007

and it has violated the stability of the world financial environment. Many of the world famous

banks have fell into financial difficulties. As the second biggest economic entity in the world,

China’s development has always attracted wide interest, in particular its financial sector. How the

system has been developed after all these reforms and how it has been influenced by the financial

crisis are some of the topics that been widely studied in recent years. As we know that after all the

reforms, China can be said of in processing of one of the biggest banking sectors in the world. By

the end of 2012, among the world’s biggest 10 banks measured by market capitalization, China

accounts for four of them. Especially for the Industrial and Commercial Bank of China (ICBC), it

is constantly been considered as the most profitable bank in the world with the largest customer

base. These banks jointly dominate the financial sector in China and therefore, the effectiveness

of the sector would impact significantly on its overall economic development.

Over the past decade, various reforms have been conducted on the Chinese commercial banks

and it was until 2010 that China has finally helped all of its state-owned banks obtained stock

listing. During the financial crisis period, the Chinese commercial banks seemed more resilient to

the negative influence from the Western world but it was claimed that it was because of their

limited exposure to the US securities (Yao et al., 2010). In future, since China has become more

and more integrated into the rest of world and its financial sector has been fully opened for

foreign competition by the end of 2006, its banking sector would inevitably subject to increased

competition and risks. How to manage these risks effectively and how to improve their

operational efficiency continuously would be the major concern for the Chinese government

nowadays. Therefore, in this paper, I am trying to shed light on these issues.

1.2 Objectives and Research Questions

Efficiency is not only one of the core theoretical questions of economic research, but also the

target of commercial banks in the actual operation and management. The efficiency of the

1


banking industry not only reflects the banks’ own management performance, but also the

immanent quality of a country’s economic development. In China, the banking industry is heavily

depended on the local market, credit business and corporate business. So that is why the assets’

quality and business performance of the Chinese banks are highly relevant to its domestic

economy.

The aim of this paper is to give insight on the efficiency and risk management of commercial

banks in China to improve their efficiency and competitiveness further so as to help the banks.

On the other hand, this paper is also expected to provide empirical evidences based on Chinese

data to support the X-efficiency analysis. More specifically, there are four major objectives of this

research:

First of all, over 30 years’ reform, as the profits of the Chinese banks have increased and the non-

performing loan ratio has decreased year by year, this may indicate that the overall operational

efficiency of the banks have been improved. In this dissertation, I am planning to quantify such

improvement. To what extent has the Chinese banks improved their efficiency over the past

decade?

Secondly, Chinese SOBs (state-owned banks) were allowed to be listed on the stock exchanges

since 2005. This research also tries to find out the changes of efficiency before and after the stock

listing.

Thirdly, after China entered the World Trade Organisation (WTO) in 2001, many foreign banks

entered into the Chinese banking market. It was agreed that starting from 2007, the whole

Chiense financial market would be fully opened for foreign competition. This has resulted in a

sharp increase in the total market share and the numbers of foreign banking branches in China.

This dissertation will also test whether the efficiency of the Chinese banks would be affected by

such increased foreign appearance.

Finally, after the US financial crisis, it has been argued that a bank has to improve its risk

management capacity so as to survive in the current highly volatile financial environment. In this

dissertation, using two indicators--loan loss reserves to total loans (LLR/TL) and loans to

deposits (LD) to represent the risk exposure of the banks’ loans--I am also planning to find out

2


the relationship between banks’ efficiency and their risk management.

Based on these four objectives, the following research questions will be addressed in this

dissertation:

How the recent financial crisis has influenced the efficiency of the Chinese commercial

banks?

Whether the ownership structure of the banks is still able to influence their efficiency?

Whether the foreign banks could maintain a higher efficiency than the Chinese domestic

banks once they entered into the country?

What is the change of efficiency level of the Chinese banks over recent years?

If the bank is willing to take more risks, would this act positively on its efficiency?

1.3 Structure of the Dissertation

This dissertation is comprised of six chapters. In the first chapter 1, the research topic, objectives

and research questions will be introduced. Then in Chapter 2, a comprehensive background

review about the development of the Chinese banking sector will be presented. In particular, the

current situation of the Chinese banking system and the impacts of increased foreign entry on the

Chinese commercial banks will be discussed. Chapter 3 will first define the meaning of x-

efficiency, and then a detailed review about the existing literatures on banks’ efficiency will be

conducted. Chapter 4 will compare the two efficiency measurement techniques, the parametric

approach, Stochastic Frontier Analysis (SFA), and the non-parametric approach, Data

Envelopment Analysis (DEA), and the discuss their relative advantages and limitations. In

addition, the variables used in this study will also be defined and discussed. Chapter 5 will

conduct the empirical analysis and then summarise the findings. The last chapter 6 will conclude

the whole paper, talk about the limitations of this research and also propose some policy

implications based on our tested results.

3


Chapter 2 Background Review and Development of Chinese Banking Sectors in China

When China was established in 1949, it could be said of adopted a mono-bank model which can

be characterised as of having highly centralised power and unified management. According to

Allen et al (2005), during that period, the People’s Bank of China (PBOC) was also the only bank

in China. It served as both of the central bank and a commercial bank. It carried out two roles, the

commercial operations and policy lending simultaneously. The bank controlled about 93% of the

total financial assets and almost 80% of the deposits of the country during the following

approximately 30 years. Since 1978, this situation has been gradually changed in accordance with

the country’s comprehensive economic reform. As stated by the central government, the major

target of the Chinese banking reform was to establish a modern banking system which could

provide the needed support to the country’s economic reform. It aims to restructure the whole

sector to become more diversified, competitive and profit-driven (Yao et al., 2007). This Chinese

banking system reform was directly related to the country’s overall economic and financial

development. It has played a crucial role in improving financial resource allocation efficiency and

consequently assisted the enhancement of overall economic efficiency and the opening-up policy

in China (Fu & Heffernan, 2007). Up to now, four stages of reform have been implemented:

Initial stage: 1974 to 1984

The first structural reform began in 1974 and ended in 1984. The mono-bank system was changed

to a two-tier banking system gradually. It meant that the central bank and the commercial banks

were separated and the PBOC was no longer the only bank in China. Indeed, during the same

time, the banks’ system reform has also been promoted. One is the gradual establishment and the

completion of the functions of the central bank and the other was to set up a system for the

commercial banks.

The second stage: 1985 to 1994

The second stage of banking reform lasted about ten years from 1984 to 1994, during which the

“Big Four” SOBs had gained a certain level of independence and the overall banking system had

become more diversified. However, according to Allen et al (2005), although the reforms

focusing on the financial system had achieved significant improvements and the market was

4


opened up for new competitors, activities of the Chinese commercial banks were still subject to

various influences from both the central and local governments. Therefore, proper legal and

regulatory systems needed to be established. In addition, this period also witness the emergence

of the joint equity commercial banks (JECBs) across the country.

The third stage: 1995 to 2001

The third stage can be characterised as the deregulation period across the banking system. Since

1997, the Asian financial crisis, the Chinese government started to realise the importance of

banking commercialisation. It has therefore adopted some positive policies, such as the

establishment of China’s two stock exchanges, the promotion of continued commercialisation of

the SOBs and the construction of multi-level and multi-type financial institutions.

The fourth stage: 2002 to present

Since 2001, when China joined the World Trade Organisation (WTO), the banking system reform

could be said of being pushed into the fourth stage. This is also a critical period as the entrance of

WTO has created more incentives for the Chinese banking sector to become more competitive,

innovative and efficient. Starting from 2002 the Chinese government has implemented drastic

reforms on the regulation of the SOBs, JEOBs, city commercial banks (CCBs), rural financial

institutions and the foreign banks. In addition, the Chinese Commercial Banking Law was issued

in 1995. This was the first time that the commercial banks’ rights and obligations were specified

clearly in legal form. Since then, banking system has been strengthened on internal management

and risk control. In 2003, the China Banking Regulatory Commission (CBRC) was founded.

After that, the Big Four SOBs began to join the share-holding reform and finally were listed on

the stock market successfully.

Although the reform is still ongoing, at this point great changes have been achieved across the

Chinese banking industry. The state only maintained full control over three policy banks while

other banks tend to adopt a mixed ownership structure. It is not necessary for the central or local

government to be the major holder in these banks. Meanwhile, the Chinese banking sector has

been transformed from the one that was government-driven to the one that is market-oriented.

Although market-oriented reform of interest rates and exchange rates may lead to heightened

5


market risks, it is imperative that China’s banking industry transforms its past operating model

and reshapes its banking structure to achieve sustainable development in the future.

During the fourth stage of the banking reform, the modern multi-tier framework has almost been

established with various financial institutions coexisting in the system. The current structure of

the Chinese banking industry can be demonstrated by Figure 1.

Figure 1 China’s Banking Overview 2007

Based on the statistics of the CBRC’s annual report (2007), by the end of 2006, there were

approximately 343 commercial banks existed in the Chinese banking industry. It consisted of five

SOBs, 12 JSCBs, 113 CCBs, almost 200 foreign banks and 13 rural commercial banks. After

nearly 30 years’ reform and development, all the Chinese commercial banks have been improved

to a greater or less extent, in particular the SOBs. They have made significant improvements been

transformed into shareholding companies, and finally been listed on the stock exchanges

successfully during 2006 to 2008. By the end of 2012, a total of 16 Chinese commercial banks

had been listed on the stock exchanges successfully. It includes four SOBs, eight national JSCBs,

three CCBs and one rural commercial bank (RCB).

The 2008 U.S. sub-prime mortgage crisis and the recent European debt crisis have put the global

6

Source: China Banking Regulatory Commission, 2007


economy into difficulties. There were many uncertain factors in the macroeconomic environment.

Because of the negative impact of the U.S. financial crisis, the Chinese banking industry faced

more severe risks and challenges under the current international macroeconomic environment.

These may include credit risks, operational risks, liquidity risks and legal risks. With the market

risks continuing to emerge, the CBRC (2009) said that China’s banking industry would endeavor

to deliver constant superior performance, consolidate its own development, further deepen the

banking reform and strengthen the banks’ overall management in the coming years. Since the

Chinese government has taken a cautious attitude towards the opening policy of the financial

industry, only six listed Chinese banks were found to be in the possession of a small amount of

the US subprime mortgage bonds. It was reported that more than 95% of the revenue and profits

of the Chinese banks were generated from the domestic market. Therefore, although the financial

crisis has influenced the Chinese banking industry negatively, the banks’ liquidity position has yet

been seriously damaged. That explains why the Chinese banking industry was able to avoid the

financial tsunami that hit. In the next part, with reference to the different ownership structure of

the banks, I will talk about their reform process one after the other.

2.1 State-owned Banks

Since 1979, the Chinese government has been constantly pushing the gradual and wider market-

driven banking reform program. The PBOC used to be the only central and commercial bank in

China. During 1979 to 1984, the commercial functions of the PBOC have gradually taken over by

the “Big Four” SOBs. After that, the PBOC acted exclusively as a central bank which was an

effective resource allocation mechanism in the central-planning economy. It was mainly

responsible for implementing monetary policy and supervising the financial system and all other

financial institutions under the regulatory framework (Fu & Heffernan, 2007). In order to

improve the production and operational efficiency, the Chinese government established four

state-owned specialised banks to replace the commercial banking functions of the PBOC. They

included the Agricultural Bank of China (ABC), the Bank of China (BOC), the China

Construction Bank (CCB) and the Industrial and Commercial Bank of China (ICBC). To serve

the specific needs and support the developing strategies, these newly set up SOBs were specified

7


with different functions (Yao et al., 2008). For instance, the main domestic business of the ABC

involves engaging in rural financial services, providing funding needs for agricultural related

sectors, cooperating closely with rural cooperative financial organisations and promoting the

integrated development of the rural financial system. It also provided wholesale and consumer

banking services to farmers, townships, village enterprises and other rural institutions (Yao et al.,

2008). The CCB was in charge of the management and allocation of financial resources to urban

construction projects. In addition, it was also responsible for providing funds, medium and long-

term loans to support the urban building, engineering projects and housing development in China.

The ICBC is the biggest specialised state bank in China measured by various aspects, such as

total customer number, total employees and total assets. The main business of the bank included

providing financial resources for urban industrial and commercial business, as well as settling

international transactions (Chiu & Lewis, 2006). And finally, the BOC was a dominant foreign-

exchange bank. It was designed to be responsible for unified management and centralized control

of foreign exchange business throughout the country, such as foreign exchange rate setting and

the development of international transactions. In order to provide more convenient services and

deliver superior value to the customers, each of the “Big Four” SOBs had established a large

number of branches across all key cities, municipalities and overseas.

With the establishment of the four SOBs, the Chinese banking system reform had been pushed

forward into the next stage. However, many problems of embedded in the system started to

emerge. Although the operation of the SOBs had been separated from the PBOC’s, they remained

controlled by the Chinese government. Long-term government intervention has made the

operation of the SOBs depend highly on the government. The production and operational

efficiency of the SOBs were quite low and there was virtually no competition within the system.

According to the government’s instructions, the SOBs tended to provide more services to the

state-owned enterprises (SOEs). For instance, the loan and fund applications from the SOEs were

normally treated with priority above the applications submitted by the other types of companies.

Moreover, the interest rates offered to the SOEs were again more favorable and no late payment

punishment was imposed on them. Consequently, since the SOEs were mostly government-

related organizations and they care little about their own profitability, this resulted in the four

SOBs accumulating a large amount of non-performing loans (NPLs). If this problem could not be

8


solved, it was hard to achieve the reforming target of banking commercialisation, enterprisation

and marketisation.

To solve this issue, the government adopted two approaches. The first one was the establishment

of three policy banks in 1994. They were the Agricultural Development Bank of China (ADBC),

the China Development Bank (CDB) and the Export-Import Bank of China (China Ex-Im Bank).

The ADBC’s primary function was to provide financial supports to China’s agricultural

institutions and its rural residents. The core function of the CDB was to provide financial services

to major development projects, such as infrastructure projects. The China Ex-Im Bank, as

suggested by its name is responsible for facilitating the import and export of Chinese capital

goods. It was expected that once these policy banks had been founded, they would release the

SOBs from engaging into policy lending activities. Then the operation of the former four

specialized SOBs could become purely driven by the market and may could be transformed into

real commercial banks. However, after all these reforms, it was found that the original intention

of separation of commercial and policy lending activities of the banks was hard to be fully

achieved. This was mainly because during the early period, the four SBOs had already

established lots of branches across the country with easy access to local customers. It was almost

impossible for the three new policy banks to expend their network as widely as the SOBs (Luo et

al., 2011). As a result, local governments still preferred to go to the four SOBs for their finance

needs. Therefore, the establishment of the three policy banks did not help remit and solve the

problems of non-performing loans (NPL) significantly.

In 1997, a serious Asian financial crisis was broken out. This has forced the Chinese government

to realize that a large amount of NPLs and weak risk management are the key risk factors

embedded in the Chinese banking system. If the NPLs continue to grow rapidly, it may lead to

banking crisis. Based on the statistic of (Yao et al., 2007), by the end of 1997, the total assets of

the four SOBs were RMB 8.72 trillion, but their liquidity assets was only about RMB 0.31

trillion. This has made their capital to risk-weighted assets ratio (CRAR) equal to 3.5%, a level

which was much lower than the 8% requirement set by Basel I. Therefore, the huge amount of

NPLs and a severe shortage of capital suggest that the next stage of reform could not be carried

9


on. The establishment of three policy banks could not reduce the NPLs of the big four effectively.

The Chinese government has to adopt a second method that was to inject money directly to help

them solve the bad debt issue and improve their asset quality. In order to help the financial

restructuring of the four SOBs and prepare for the WTO entry, four Asset Management

Companies (AMCs) were set up in 1998. They are China Asset Management Company, China

Huarong Asset Management Company, China Great Wall Asset Management Company, and

Oriental Asset Management Company. They are responsible for managing and recovering the

NPLs transferred from the four SOBs, as shown in Table 1.

Table 1 Non-Performing Loan Transfers of 1999-2000

Source: Fung et al., 2004

In 1999, with a total NPL of RMB 2.5 trillion, the Chinese banking system was virtually

insolvent. This has pushed the government to stripe off RMB 1.4 trillion NPLs from the four

SOBs in 1999. However, despite the stripping off, the average NPLs ratio of the four SOBs

remained high at 20%. To help the Chinese financial sectors reach the international standards, to

create a favorable investment environment, and to get ready for the WTO entry, the NPLs of the

four SOBs need to be further disposed off by the central government. This could be summarized

in Table 2. The second round of NPLs disposal could be said of happened during 2003 to 2004. A

total of RMB 475.6 billion bad debts were stripped off from the BOC and the CCB. By the end of

2005, almost RMB 2.6 trillion NPLs of the SOBs were stripped off (Garcia-Herrero & 10


Santabarbara, 2008).

Table 2 NPL Disposal of the “Big Four” SOBs

Source: Yao et al. (2008)

Since China joined WTO in 2001, the Chinese market was opened gradually to the rest of the

world. In order to cope with increased international competition and enhance the Chinese banking

sector’s own competitiveness, the Chinese government implemented shareholding reforms on the

‘Big Four’ while continuing restoring their financial health. The shareholding reform was first

conducted on two pilot banks, BOC and CCB, and the government pumped an additional $ 45

billion into these two banks in 2004. During the following year, the ICBC implemented

shareholding reform with registered capital of RMB 248 billion. It was until 2008, that the

shareholding system reform of the “Big Four” SOBs could be said of formally completed. The

last one, ABC got RMB 130 billion capitals and the approval from the State Council about its

shareholding reform plan in 2008 (Luo et al., 2011). Through the implementation of the

shareholding system reform, the asset quality and profitability of the SOBs have been improved

significantly. This has greatly assisted the enhancement of the financial sustainability across the

whole system. By the end of 2009, the CRAR of the BOC, CCB and ICBC are 11.7%, 11.14%

11


and 12.36% respectively. Meanwhile, just one year after the shareholding reform, the CRAR of

ABC has also been improved to over 10% and the bank has made RMB 65 billion worth of net

profits (Bank scope, 2013).

With the stripping of the NPLs and the shareholding reform of the banking system, the country’s

banking industry has been transformed into a customer-orientated market with multiple capital

structure. The country’s financial environment has been improved significantly and become more

attractive to the foreign investors. Starting from 2005, the four SOBs welcomed its overseas

strategic investors successively. CCB was the first SOB which introduced its strategic investors.

In June 2005, the Bank of America (BOA) invested $ 3 billion to acquire 10% share ownership of

the CCB. It has also signed agreement to cooperate with CCB in the field of seven areas, such as

corporate governance and risk management. Later in the year, BOC also received a total

investment of approximately $ 3.67 billion from three foreign investors, Royal Bank of Scotland,

Swiss Bank Corporation (SBC) and the Asian development bank (ADB). As a result, the

ownership structure of the BOC has been changed into 15.47% of foreign shareholding and

84.53% of domestic shareholding. Table 3 summarises the foreign strategic investors of the four

SOBs and their areas of cooperation.

Table 3 Foreign Strategic Investors of the Four SOBs and Their Business Cooperation

12


Source: Yang, 2009.

After all the preparation, the central government began to list the SOBs in both Hong Kong and

Shanghai stock exchanges. It is believed that once the stocks of the four SOBs went public, it

would help the bank to improve their performance and capital structures, establish an incentive

mechanism within the SOBs, and enable them to raise funds from a more diversified background.

In 2005, the first listed SOB was CCB. It issued 26.5 billion shares on the Hong Kong stock

exchange (HKSE) and raised approximately $ 8 billion (Mitchell, 2006). In the following year,

BOC listed on both of the Shanghai Stock Exchange (SSE) and HKSE successfully. The initial

public offering (IPO) of BOC raised $ 11.2 billion and it was larger than the world’s biggest

public share offering during that six-year period. The IPO of ICBC was conducted in both of the

SSE and HKSE in October 2006. It helped bank get $21.9 billion funds and set up a new world

record. After the shareholding reform and stock listing, the size and ownership of the four SOBs

has been changed and it could be summarized in Table 4.

Table 4 Size and Ownership of China’s Big Four SOBs

13


Bank Market Capital State Holdings of Outstanding Shares

Major U.S. Holdings of Outstanding Shares

ABC $1.019 trillion 83.13% None

BOC $1.084 trillion 67.53% None

CCB $1.717 trillion 57.0% Bank of America – 10.9%

ICBC $1.810 trillion 70.7% American Express – 0.2%

Goldman Sachs – 4.9%

Source: Martin, 2012

Since the outbreak of the U.S. subprime crisis in 2008, the global financial environment has

entered into an extremely volatile period. However, since the central government still retained the

majority control of the four SOBs and adopted a prudent investment approach, these banks have

not been severely damaged by the 2007-2009 global financial crisis (Allen et al., 2012). In

particular, according to the study of Berger et al (2009), the strategic investors were good at

improving the operating performance of the SOBs. In addition, the HKSE LISTING OF THESE

SOBs were the other important step in reforming them and consequently made they outperform

may large banks from emerging and developed countries during the 2007-2009 crisis period.

Suggested by Allen et al (2012), the four SOBs displayed superior and stable performance during

the financial crisis period. For instance, the IPO of ABC raised over $22 billion from SSE and

HKSE during the post-2008 global financial crisis period. In 2008, ICBC achieved a total profit

of RMB 111.2 billion, representing an increase of 35.2% from a year earlier (Hawser, 2009). In

the meantime, the net profits of BOC and CCB have also increased by 14.4% and 34%

respecting, reaching the RMB 92.6 billion and RMB 64.4 billion respectively (Piggott, 2009).

Therefore, based on the statistics of the Banker (2009), three of China’s SOBs were now among

the world’s top five most profitable banks. Table 5 summarizes the changes of NPL ratio and

ROA ratio of the big four SOBs over the period of 1999 to 2012. It shows clearly that they now

14


have a much healthier balance sheet and generate much higher profits, in particular after they

have been listed on the stock markets. It is worth to be noted that even during the financial crisis

period, these Chinese SOBs were managed to reduce their NPL ratios and enhance their

profitability continuously.

Table 5 NPL ratio and ROA ratio of the big four SOBs: 1999-2012

Source: Bankscope (2013).

Unfortunately, despite making a higher ROA ratio and in processing of limited amount of the US 15


sub-prime mortgages, share price of these four SOBs were still badly hurt during the crisis

period. As can be seen from the Figure 2 below that after reaching a record high in 2007, share

prices of all these fours SOBs plummeted and remained low afterwards. None of them has

recovered to the pre-crisis level even until today. Recently, the slowdown of the Chinese overall

economy has imposed additional pressure onto the banks. Facing increased foreign competition

and the changing operational environment, how to survive and remain profitable have become

key challenges to the Chinese commercial banks in the near future.

Figure 2 Share price movements of the SOBs after IPO

Source: http://uk.finance.yahoo.com/.

2.2 Joint Equity Commercial Banks

The second category of the Chinese commercial bank is joint stock/equity commercial banks

(JECBs). It could be regarded as the new source of competition created by the central government

in the banking industry. Compare with the SBOs, the JECBs were smaller and normally have

multi-ownership structure. Stating from 1985, many JECBs were established national wide under

the consent of the State Council of People’s Republic of China (PRC). The first domestic JECB

was the Bank of Communication (BOCOM) and it was established in 1986. One year later, the 16

http://uk.finance.yahoo.com/


Shenzhen Development Bank (SDB) and the China Merchants Bank (CMB) were founded. In

1991, the SDB was successfully listed on the Shenzheng Stock Exchange (SZSE) (Lin & Zhang,

2006). In 1988, the Guangdong Development Bank (GDB) was set up and it has become a

shareholding bank listed on the SZSE successfully in 1992. It had three main shareholders,

including that are the BOC Group in Hong Kong, the Hong Kong Chinese Banking Group and

the Ministry of Finance. In 1996, the China Minsheng Bank (CMINB) which was also the first

privately funded bank was established. All of its shareholders are non-government entities. In the

meantime, some other JECBs such as China Everbright Bank (CEB), Huaxia Bank (HXB), China

CITIC Bank, Shanghai Pudong Development Bank (PDB) and Fujian Industrial Bank (FIB) have

also been founded. Table 6 presents the equity structure of the 12 JECBs by the end of 2010.

Table 6 Shareholdings of China’s JECBs

17


Source: Annual report of each bank

Note: Data for Evergrowing Bank is for 2009. 2010 annual report not available

The shareholding structure and the number of shareholders of the 12 JECBs varied. For instance,

the CMINB reported that the bank had 1,123,423 shareholders in 2010 while the China Bohai

Bank was only reported of having seven shareholders during the same period. Since the majority

of the JECBs were established after the initiation of China’s banking reform, they tended to have

a lower level of government ownership and were expected to be responsible for their own

financial performance. Such market driven nature has led the JECBs to generate higher profits

and have better asset quality. As shown in Table 7, compared with the SOBs, the NPL ratio of the

JECBs was constantly lower than that of the SOBs.

18


Table 7 Comparison of NPLs between JECBs and SOBs

Source: Wong (2001) China Banking Regulatory Commission

Similarly, after the implementation of the open up policy in China, the JECBs have also attracted

a large number of foreign investors and seven of them had also achieved stock listing on both of

the HKSE and SSE over the past decade. In recent years, they have become more and more

important in the Chinese banking sector and imposed lots of pressure to the SOBs. According to

the statistics of the CBRC’s Annual Report, the 12 JECBs have got RMB 23.5 trillion total assets

and 17.61% of the market share in banking industry by the end of 2012.

2.3 City Commercial Banks

The City Commercial Bank (CCBs) is regarded as the ‘third tier’ of the Chinese banking system.

Since 1979, a large number of urban credit cooperatives (UCCs) were founded in many major

cities. They were designed to assist the SOBs providing financial services to the local small-and

medium-sized enterprises (SMEs) and household and promoting the local economic

development. However, alone with continued banking reform, many potential problems started to

emerge, including low productive efficiency, weak internal management capital adequacy ratio

and the relative small size but high risks. In order to solve these accumulated problems, about

5,000 UCCs were merged and restructured into CCBs during the 1990s by the city governments.

In 1995, the Shenzhen City Commercial Banks, which was also the first CCBs in China, was set

up. By the end of the initial restructuring period, about 3,240 UCCs were transformed into 88

CCBs by 1998. When the CCBs were first established, their business operations were confined

within their city boundaries and were only allowed to set up branches inside of their respective

19


cities (Han, 2000). This has also made the CCBs more vulnerable to the increased market

competition. Meanwhile, CCBs were mainly controlled by the local governments. According to

the research report of KPMG (2007), in average, 75% shares of the CCBs were taken by local

governments, and around 70% of the loans were used to support the operation of the four SOBs

and private SMEs.

Due to the poor risk management, government-driven operation and limited market penetration,

the CCBs have encountered even greater problems than the four SOBs in terms of high NPLs

ratios and poor capital adequacy ratio during the period of 1990s. In particular, some CCBs were

estimated to have a NPL ratio of over 50% (Martin, 2012). In 1998, to reduce the NPLs and

attract foreign investors along with the open policy, the state council decided to restructure and

transform the CCBs into shareholding organisations. In 1999, Bank of Shanghai received $ 220

million foreign investment from the International Financial Corporation (IFC) and became the

first CCBs with foreign investors strategic. However, since the IFC was not a commercial bank, it

was unable to provide the needed experiences which could assist the bank realising business

integration. In December 2001, the Hong Kong and Shanghai Banking Corporation (HSBC)

purchased 208 million shares of Bank of Shanghai, accounting for 8% of the bank’s ownership.

This was the first case for a foreign-funded commercial bank to become a shareholder in a

Chinese domestic bank. Since 2005, the CCBs started to invite national and international private

institutions to take shares of the banks widely. By the end of 2007, about 12 CCBs were

restructured with at least one foreign investors sitting on the board of directors, as summerised in

Table 8.

Table 8 Foreign Investment in Chinese City Commercial Banks

20


Source: KPMG analysis of media reports and press releases

The foreign investors did not only bring in additional capitals to the CCBs, but also advanced

technologies and management experiences. In the meantime, the ownership structure of the CCBs

was further diversified with more private enterprises and individuals becoming key shareholders

of the banks. Table 9 listed the shareholding structure of five samples CCBs. Consequently, the

improvement in risk management, the implementation of asset restructuring programs and the

injection of foreign capitals have all helped the CCBs achieve high profits and lower average

NPLs ratios. By the end of 2006, the average NPL ratios of all the CCBs were reduced from

17.72% in 2002 to 4.78% (Wong & Wong, 2001).

Table 9 Sample Shareholding Structure of City Commercial BanksIn percentage of outstanding share

21


Source: 2010 annual reports (in Chinese) of each bank, available online

Notes: Legal entities includes investment companies, bank and other corporations which may or may not be wholly or partially owned by government agencies

With the domestic financial market fully opened up the central government and CBRC relaxed

the geographic restrictions imposed on the CCBs, allowing them to operate and establish

branches outside of their respective cities. It aimed to enhance the CCBs’ competitiveness and

help them gain additional market share in the overall banking system. In April 2006, the first

cross-regional CCBs branch was set up by the Bank of Shanghai in Ningbo (Tan & Fu, 2007).

The CCBs have gradually expanded their business scope and started to play a more important

role in urban economic development. From 2007 to 2009, the CBRC issued many new policies,

such as the ‘Notice on Adjusting the Licensing Policies for the Branching by Small and Medium-

Sized Commercial Banks (Tentative)’. It granted the CCBs with more autonomy allowing them to

set up branches in western and northeast regions and also removing the limitations on their

operating funds. These policies stimulated the fast expansion of the CCBs. Consequently, the

Bank of Jinzhou established a branch in Tianjin; the Bank of Chengdu set up a branch in Chongqi

and the Bank of Zhengzhou built a branch in Nanyang (Wang et al., 2008). According to the

statistics of CBRC, by the end of 2010, 62 CCBs have carried out their cross-regional

development and established 103 branches in other citites.

After a series of reform and policies incentives, the growths of the Chinese CCBs have

accelerated. In 2007, three CCBs Bank of Beijing, Bank of Ningbo and Bank of Nanjing were

listed on the Stock Exchange successfully. Alone with the fast development of the CCBs and the

introduction of more favorable IPO norms by the government, over 40 CCBs were now on the

waiting list of going public. According to the statistic of CBRC, by the end of 2010, 43% of the

CCBs share was hold by private nonfinancial institutional investors, while only 18.5% of their

22


shares were remained controlled by the local government. In the meantime, the CCBs have alos

developed their own strategic alliance network. For instance, as early as 2001, six CCBs,

Shenzhen, Nanjing, Guiyang, Wuhan, Hangzhou and Dalian have developed a strategic

cooperation framework. And later in May 2004, led by Nanjing City Commercial Bank, another

15 CCBs were aligned to establish two investment centres for inter-banking securities capital. All

these policu stimulated the fast expansion of the CCBs. As shown in Figure 3, total assets of

CCBs have reached RMB 45.638 trillion by the end of 2012, accounting for 9.24% of the whole

sector.

Figure 3 City Commercial Bank Assets from 2004 to 2012

Source: Total Assets and Liability Annual Report in CBRC

2.4 Foreign Banks Entered into Chinese Banking Market

Since China started the economic reform from the late 1970s, the foreign banks were allowed to

enter into the Chinese financial market. Before joining the WTO, the development of the foreign

23


banks went through five stages. In 1979, the Export-Import Bank of Japan was allowed to

establish a representative office in Beijing. After that, some major and more meaningful

developments were carried out mainly focusing on three aspects. At first, starting from 1982, the

foreign banks were approved to open operational branches in Special Economic Zones (SEZs).

Later, the Nangyang Commercial Bank founded the first foreign bank branch in Shenzhen. Then

during the 1990s, the central government expanded the operation scope of the foreign banks to

include more cities. In August 1994, eleven inland cities were opened to the foreign banks,

allowing them to set up representative offices and operational branches. It was 1999 until taht the

geographic restrictions of branches setting on foreign financial institutions were fully cancelled

(Chen, 2000). Finally, the Chinese government further relaxed policies which allowed that allow

eligible foreign banks conducting local currency business in Shanghai and five designated

provinces in 1999. By the end of 1996, foreign banks from 15 countries have established their

branches in China (Leung et al., 2003). The Table 10 shows the total assets and the number of

foreign banking branches during the period of 1985 to 1996.

Table 10 Number of Foreign Banks, Branches and Assets during 1985 to 1996

Source: Leung, Rigby and Young 2003.

Since China joined the WTO in 2001, to supervise the foreign banks more effectively, the central

government started to remove and revise its original banking industry regulations, and

promulgate new rules and policies. For instance, the ‘Content and Time of Chinese Financial

24


Institutions Opening after Entering WTO’ and the ‘People’s Republic of China Ordinance on

Management of Foreign Capital Institutions’ were promulgated by the State Council in 2001.

Furthermore, to fulfill WTO agreement, CBRC raised the ‘Foreign-Funded Financial Institutions

Regulations of the PRC’ in 2004 and relaxed various restrictions imposed on the foreign banks,

such as their business scope and geographical locations (Serrado & Sabadell, 2003). For instance,

in 2001, the foreign banks were only allowed to offer the RMB business to local enterprises in

four coastal cities including Shanghai, Shenzhen, Tianjing and Dalian One year later, the

restriction has been removed in another five cities. Then two-year later, Jinan, Fuzhou, Chengdu

and Chongqi were further opened up. During 2004 and 2005, another seven cities were followed

to implement the opening up policy. And finally in 2006, all the geographic restrictions were

cancelled and the whole Chinese financial market was fully opened for foreign competition. After

deregulation, more and more foreign banks stared to enter into China.

There are four main modes that the foreign banks would choose when they enter the banking

market in China. They were establishing foreign branches, establishing the wholly foreign capital

banks, setting up joint-capital banks or holding share and acting as the strategic investor of the

Chinese domestic banks. Before the Chinese market has been fully opened up, the last mode was

the preferred method. It could be explained by four reasons. First of all, before the 2001 WTO

entry, favorable policies on the Chinese domestic banks helped them in extensive presence and

have made the direct market penetration by the foreign banks hard to achieve (Leigh & Podpiera,

2006). Secondly, cooperate with the domestic banks may help foreign banks obtain interests

protection. Many foreign banks tended to purchase shares in small and medium-size banks to get

a controlling position. Then using such favorable position to get their business expanded further

and to obtain higher yield from China’s fast developed economy. Thirdly, as the strategic

investors, the foreign banks were allowed to participate in the management of the domestic

banks. It provided a platform to help the foreign banks understand the Chinese market, obtain

some local contacts and get ready for further expansion. Last but not least, before 2006, many

restrictions were set up to limit the activities of the foreign banks and this has left them with no

choice but to enter the Chinese market as a strategic investor. It helped them save time and a large

amount of costs for the entering process. According to the CBRC’s regulation on foreign 25


investment, their combined ownership of a Chinese commercial bank was not allowed to exceed

the threshold of 25%. Consequently, all these policies have effectively protected the domestic

financial sector and ruled out the competition.

During the post-WTO period, many foreign banks purchased shares of the domestic banks

successfully and have become their strategic investors. These cases included Citigroup’s purchase

about 5% ownership of Shanghai Pudong Development Bank (PDB) and Hang Seng Bank

Ltd.and IFC etc’s joint purchase of 24.98% share in Industrial Banks in 2003. In December 2005,

the first Chinese commercial bank born with foreign minority stake. China Bohai Bank was

established with 19.99% share owned by Standard Chartered (Berger et al., 2007). By the end of

2004, the foreign investors were found of in owning $ 17 billion shares of the Chinese banking

sector. Table 11 listed all the foreign investment into the Chinese banking sector.

Table 11 Foreign Investors in Chinese Banking Industry

26


Source: Shen et al., 2009

Since 2006, when the foreign banks were allowed provide similar range of services as the

domestic banks, setting up foreign banking branches have became more popular among the

foreign banks. Table 12 illustrates the development trend of the foreign banking institutions in

China. The total assets of the foreign banks presented sustained growth from 2004 to 2011. The

total assets have increased almost four times from the 2004 level in 2011, reaching RMB 2.15

trillion. Meanwhile, they have also obtained sustained increase in profits, mainly a total of RMB

16.7 billion net profits in 2011.

Table 12 Foreign Banks Operations in China 2004-2011

27


Source: CBRC Annual Report 2011

Based on the statistics of CBRC, by of end-2011, there were 181 foreign banks and 209

representative offices from 45 countries were established in China. However, as the Table 12

above demonstrated that although the foreign banks’ total assets and number of institutions have

increased, continuously, their combined assets as a percentage of the total assets of the China

banking industry were actually decreased slightly from 2.38% in 2007 to 1.93% in 2011. Over 40

foreign banks injected additional capital which was equal to RMB 27.1 billion to expand their

business in the Chinese market (CBRC, 2011). The Chinese government adopted a welcomed

attitude for the growth number of foreign banks and their branches. As it is believed by the

central government that they will generate some positive impacts on the Chinese banking

industry, such as forming a healthy competition environment, improving domestic efficiency and

risk management consciousness.

Chapter 3 Literature Review

3.1 Define Efficiency and X-efficiency

Generally, the efficiency is a proportional relationship between the outputs and the inputs of time,

costs or efforts. The concept of X-efficiency was proposed by economist Harbey Leibenstein in

1966. In the banking environment, the X-efficiency could be regarded as the ability of a bank to

28


achieve a maximum of output for a fixed amount of input. There are two ways to achieve highest

efficiency. One is using minimum input to obtain a certain amount of output while the other is

getting the maximum amount of output by a certain amount of input consumed.

There are two main types of X-efficiencies, the cost efficiency (CE) and profit efficiency (PE). In

particular, the cost efficiency is more likely to be use in the banking research as decisions related

to cost control are more likely to be controlled by the management. The CE could then be further

classified into two categories, including the technical efficiency (TE) and the allocative efficiency

(AE). The TE only takes the quantity into account. It was first put forward by Farrell in 1957 and

been improved by Leibenstein in 1966. A bank could be said of achieved full technical efficiency

if it could produce the maximum amount of outputs for a specified amount of inputs, including

labor, capital and technology (Yao et al., 2007). In the AE, Price is the core issues and plays a

guiding role in the allocation of resources. It focuses on whether the banks could make the best

combination of the input resources and output products facing fixed market prices. As a result,

both TE and AE should be considered in the cost efficiency analysis. This is mainly because if

two companies use the same amount of input and obtain same quantity of output, their TE are

identical but their AE may not be the same as the price of the input resources and outputs could

be different. Therefore, the calculation of the cost efficiency of the banks could be represented by

the equation below:

CE = AE * SE (Scale efficiency) * TE

3.2 The Frontier Methods for X-efficiency Study

The efficient frontier analysis is more commonly used in economic and operational research

nowadays. It aims to measure the input-output efficiency of the observations. Compared with

simple ratio analysis, the frontier analysis methods have a series of advantages. For instance, it

allows the use of a variety of indicators and encourages the use of some non-traditional measures.

So the results of the frontier analysis methods can figure out whether a chosen company can be

said of displaying outstanding performance compared with its peers based on a series of different

indicators. The frontier analysis methods mainly consist two main categories, the parametric

29


(econometric) and the nonparametric (mathematical) approach. For the parametric frontier

approach, it mainly includes stochastic frontier approach (SFA), distribution-free approach (DFA)

and thick frontier approach (TFA). The nonparametric frontier approach generally includes two

types of methods, data envelopment analysis (DEA) and free disposal hull (FDH). Parametric

approach and nonparametric approach are two broad classifications of the statistics procedures.

The major differences between the two approaches include the use of data and variables, the

hypothesis about the construction of the efficient frontier and also the assumptions about the

distribution of the error random and managerial inefficiencies. For instance, the data distribution

is significant different between the parametric and the non-parametric procedures. Among these

methods, the SFA and DEA are the most widely used ones.

Although both of the DEA and SFA are frontier methods, they have a series of differences. For

instance, the SFA model is constructed based on a series of strict hypothesis. A production

frontier, such as the Cobb-Douglas functional form or the Translog form needs to be assumed for

the production process and the error term is comprised with two elements. For the random error,

it is assumed to follow a standard normal deviation while for the managerial inefficiencies, since

it is non-negative so it is assumed to follow a half-normal distribution. All these pre-specified

assumptions have made the estimation process more complicated and are criticised of misleading

if they are unable to capture the real picture of the production process or the distribution of the

error terms. Compared with SFA, no the non-parametric approach, DEA has much less

restrictions imposed on the frontier functional forms. The efficient frontier, or the production

frontier of DEA is created based on the observations within the sample and it assumes that there

is no random error. Consequently, all the deviations from the “best practise frontier” are

interpreted as inefficiencies and this has made the estimated DEA efficiency scores lower than the

ones estimated by other methods.

The second difference between the DEA and SFA lies on their use of variables. Due to various

restrictions imposed by the SFA method, the choice of data and variables used for estimation is

difficult. If the distribution of the chosen variables is wrongly assumed, it may lead to biased 30


estimation. Consequently, the DEA model is easier to be expended and transformed into more

advanced models.

Last but not least, the robustness of the estimated results is different between the two methods.

Under the DEA estimation, the “efficiency frontier” is comprised with the DMUs that are more

efficient than other sample DMUs and the efficiency scores of all other DMUs are assigned

accordingly. This has therefore made the estimated efficiency scores relatively subjective. The

DMUs identified as fully efficient are only benchmarks within the sample, making it hard for

cross sample comparisons. In addition, DEA has another major problem, self-identifiers and near-

self-identifiers (Bauer et al., 1998). A bank could be assigned fully efficient not because it is

superior to the other sample DMUs but simply because none of the other DMUs or their linear

combinations is comparable. While for the SFA, its calculated efficiency scores are more

objective and allow the comparison across samples.

Since no consensus view about which method is better than the other has ever been reached in the

academic word, compared the advantages and the limitations of each method and also taking the

need of this research into account, I am planning to adopt the parametric approach, SFA in the

following empirical analysis part.

3.3 Literature Related to X-efficiency Study

Given the importance of the financial sector, numerous studies have been done focusing on

measuring the efficiency of commercial banks across developed countries. This is mainly because

compared with the developing countries, the financial systems in the developed countries tend to

be more mature and their banking systems are also more sophisticated. In addition, due to their

relatively longer history, data of banks in the developed nations are also much easier to get access

to and more reliable. These studies normally adopted both parametric and nonparametric

approaches to measure the overall, technical, allocative, profit and cost efficiency of the banks. In

31


the US, Simper & Drake (2002) adopted input-oriented DEA model to measure the production

efficiency of the US commercial banks during 1984 to 1998. Similarly, many other studies are

also target on the US banking sector, such as Schaeck and Cihak (2008), Allen and Santomero

(2001), and Clark and Siems (2002). In the meantime, there were also many studies focusing on

other developed countries, including Drake (2001) and Webb (2003), Simper and Drake (2003)

for the UK banking industry, Maudos et al., (2002), Kumbhakar et al. (2001), Salas and Saurina

(2003) and Fuentelsaz et al., (2002) for the Spanish banking industry, Girardone et al., (2004) for

the Italian banking industry, Said and Bouri (2013), Weill (2006), Chauveau and Couppey (2000)

for the French banking industry, Kirkwood and Nahm (2006) for the Australia banking industry,

Pasiouras et al., (2008) for the Greece banking industry and Sufian and Majid (2007) for the

Singapore banking industry. In addition, many cross-country researches had also been conducted

to compare the efficiency level of the banking sectors operating in different countries. For

instance, Beccalli et al. (2006) investigated bank efficiencies in five countries, including French,

Germany, Italy, Spain and UK and the study of Liadaki and Gaganis (2008) was based on 15

European countries.

Based on the studies of Loukoianova, E. (2008) and Fu and Heffernan (2007), the average

efficiency scores of the Japanese banks, banks from the European Union (EU), US banks, and

banks from the developed nations were about 69%, between 79%, 91% and 85% respectively. In

general, these studies were focused on following four aspects: the influences of ownership

structure on the efficiency of the banks (Levine, 1996; Weill, 2003; Havrylchyk, 2006; Grigorian

& Manole, 2006; Kraft et al., 2006; Lensink et al., 2008). For instance, they are trying to

investigate whether the private ownership could improve a banks efficiency level; or whether the

foreign banks are more efficient than that of the domestic banks. The second area attracted wide

research interest mainly related to the impacts of financial deregulation on the efficiency of the

banks (Hubbard & Palia, 1995; Lozano-Vivas, 1998; Black & Strahan, 2002; Wright, 2002;

Abbott, 2009; Kerr & Nanda, 2009). The formation of the European Union was expected to

improve economic harmonization across the European region. However, how this would impact

on the financial system and the efficiency of the individual banks? The third research area is

related to the influence of acquisition and mergers (Rhoades, 1996; Berger & Humphrey, 1992; 32

http://www.sciencedirect.com/science/article/pii/S0148619503000262#BIB42





DeYoung, 1997; Panetta & Salleo, 2002; Ashton & Pham, 2007). Whether the efficiency of the

banks could be improved via alliance with a bigger and stronger competitor? Last but not least,

many studies having also been done to compare the different efficiency measures based on data

from different countries (Hasan & Hunter, 1996; Bauer et al., 1997; Eisenbeis et al., 1999; Weill,

2004).

For the first research area, it is expected that privatization would increase the efficiency level of

the banks effectively. This is mainly because by transferring the state-ownership to private

ownership, it may help the banks to improve their corporate governance practice and risk-

management behaviors, pushing them to change the operational mode to become more profit-

oriented and also assisting them to allocate the limited financial resources more effectively.

Among different types of private ownership structure, a special case is the foreign ownership. For

most of the emerging economies, they welcome such foreign investment as it may generate a

series of positive impact to the domestic banking sectors. For example, they may bring in more

advanced technologies, management expertise and may also intensify the competition within the

domestic banking sector. This may in turn to push the local banks to improve their own

operational efficiency to become more competitive (Levine, 1996).

For the empirical studies, Weill (2003), Havrylchyk (2006), Hasan and Marton (2003), Jemric

and Vujcic (2002), Isik and Hassan (2002) all supported the above argument, concluding that

privatisation was indeed an effective way to enhance a bank’s efficiency, in particular among

countries during transition such as Czech Republic, Poland, Hungarian, Croatia and Turkey.

Similar conclusion has also been reached by Fries and Taci (2005) based on their study of 15 East

European transition countries. Compared with the SOBs, the operational efficiency and the cost

efficiency of the private banks are higher (Grigorian & Manole, 2006). On the other hand, when

the foreign banks were included into the sample, it has been found that they tend to be the most

efficient banks within the sample (Bonin et al, 2005). It was followed by the domestic private

banks while the SOBs were among the least efficient ones. The reason was explained by the more

advanced skills, employees and technologies processed by the foreign banks. However, Karas et 33


al. (2008) argued that in Russia, the SOBs were actually more efficient than the private banks and

the foreign banks and similar conclusion have also been reached by Lensink et al. (2008) and

Kraft et al. (2006) in their studies of European transition countries and Croatian. The inferior

performance of the private banks might because of the government’s protection over the state

sector. While for the foreign banks, their difficulties were mainly comes from the inability of

coping local environment. Different cultural background, institutional arrangement and

regulatory system made the foreign banks hard to replicate their success in their home countries.

In addition, when the cost and profit efficiency were considered separately, the results would

become even more complicated. In Yildirim and Philippatos’s (2007) study, they adopted SFA

approach to estimate the bank efficiency of 12 central and Eastern European countries during the

period of 1993 to 2000. Their results showed that although the private banks were more cost

efficient than the SOBs, their profit efficiency was poorer than that of the SBOs. This may again

indicate that due to their relatively small size, the private banks have not got enough power to

compete with the SOBs effectively over the market. Therefore, to improve their own

performance, they tend to focus more on internal costs control rather than expanding income

generation sources.

For the studies base on the banking sector of developed nations, such as the US, UK, France,

Germany and Spain, they generally found that the foreign ownership could not improve the

efficiency of the private banks significantly (DeYong & Nole, 1996; Altunbas & Molyneux,

2001; Borovicka, 2007). The domestic banks were found to have better performance on both cost

efficiency and profit efficiency than the domestic private banks and the foreign banks. This

argument was supported by many researchers such as DeYoung and Nolle (1996), Chang et al.,

(1998), Berger et al., (2000) and Borovicka (2007). In Austria, Otchere and Chan (2003)

concluded that when the Commonwealth Bank of Australia (CBA) tried to privatize the domestic

Australian banks, they received substantial resistance. Therefore, based on the existing studies, it

could be concluded that the overall banking efficiency of the domestic private banks is higher

than that of the SOBs in transitional countries, whereas the same conclusion does not hold for the

developed countries.

34


In terms of bank efficiency and deregulation, a positive relationship between them had been

concluded in general. They believed that the financial liberalisation would increase the flexibility

in banks’ operation and enhance the efficiency of the financial system. In Jayaratne and Strahan’s

study (1998) of the US banks during the deregulation period of 1970s to 1994, they found that the

lower entry barriers had attracted more private and foreign investors into the banking industry

and hence enhanced the competition, efficiency and effectiveness of credit allocation. The result

also have been proved by Hubbard and Palia (1995), Black and Strahan (2002), Kerr and Nanda

(2009) in their studies. Deregulation has led to a more competitive financial system and

consequently contributes to higher levels of productivity and efficiency (Wright, 2002; Abbott,

2009). However, Humphrey and Pulley (1997) argues that during the post-deregulation period,

the efficiency of the small-size banks may not be improved due to fierce competition. Since 2002,

the establishment of the European Union (EU) has led to financial liberalisation and the

subsequent establishment of a modernized financial institution system among the new EU

members. This has therefore triggered many scholars trying to investigate whether the efficiency

of the banks have also been influenced by such significant policy changes. However, the results

were quite mixed (Lozano-Vivas, 1998; Caus and Girardone, 2004).

For the studies analysing the impact of merger and acquisition (M&As) on banks’ efficiency,

most of them believed the performance of bank will be enhance by M&As. The M&As action

may lead to the deduction of overlapping, allowing wider geographic access, helping the banks to

realize economic of scale and enhancing their risk resistance ability (Rhoades, 1996). During the

period from 1980 to 1994, there was a big wave of merger activities in the US banking industry.

Many studies showed that, the profit efficiency of the U.S. banking sectors had been enhanced by

such M&As due to the risks diversification effect (Berger, 1998; Akhavein, Berger & Humphrey,

1997). In the meantime, their cost efficiencies have not been changed significantly, only up by

5% in average (Berger & Humphrey, 1992; DeYoung 1997; Peristiani, 1997). However, if the

1990s data were employed, the positive impact generated by M&As on cost efficiency would be

greater, as high as 10% (Akhavein et al., 1997). Similar studies have also been conducted in other

35


developed countries and the conclusions were also mixed. Using M&A data of UK banks during

1998 to 2004, the study of Ashton & Pham (2007) demonstrated that after consolidation, the cost

efficiency of the merged banks had experienced significant improvement. They explained the

reason as after M&A, the banks were able to control a bigger market share and hence allowed

them to enjoy a certain degree of monopoly power. In Vander Vennet’s study (1996) of 500

European banks, he concluded that if the merge was conducted between banks with similar sizes

or between domestic bank and foreign banks, the subsequent cost efficiency gain would be much

more significant. Such result was also supported by the studies of Resti (1998), Focarelli, Panetta

and Salleo (2002) in Italian banking industry during the period of 1985-1996 and Haynes &

Thompson’s (1999) study of the UK banks. This might because for the consolidation between

extremely big and small banks, it may take some time for both of the sides to integrate with each

other to archive some efficiency gain in the end.

Recently, some other studies shifted their focus, started to test the consistency of different

efficiency measurement methods (Berger & Mester, 1997; Hasan & Hunter, 1996). In general,

they found that the tested results between the parametric method and the non-parametric methods,

the DEA and SFA methods in particular do share some similarities (Drake & Weyman-Jones;

1996; Resti, 1997). Based on the Italian banking sector, Eisenbeis et al., (1999) found that both of

the DEA and SFA method tend to rank the same observation in the similar order. While on the

other hand, some other studies failed to find evidence to support this argument. Bauer et al.,

(1997) employed four methods to test efficiency of the US banks. They concluded that consistent

results have been provided by parametric approaches. However, the results which measured by

DEA and SFA has significant differences. Similar conclusion has also been found by Ferrier &

Lovell (1990). They concluded that the rank order correlation between the DEA and SFA methods

was quite low, at just about 0.2. Recently, Furthermore, Weill (2004) employed three methods to

investigate the efficiency in banking of 12 European countries. He concluded that a positive

relationship has been identified using the parametric approaches across all sample countries

whereas the results measured by DEA failed to show any significant relationship with any other

parametric approaches.

36


In recent years, the fast economic development of the emerging economies has attracted wide

attention. This has therefore triggered the researches focusing on those countries. Due to data

limitation, only few researches were focused on China in the early period. Nevertheless, along

with China’s accession to the WTO and the fully opening up of its financial sector in 2006,

research focusing on China surged. In general, efficiency studies in China were concentrated on

three areas, including the influence of ownership reform on banking efficiency (Fries & Taci,

2005; Fu & Heffernan, 2007; Ferri, 2009; Yao & Jiang, 2010) the impact of stock listing on banks

efficiency and lastly (Lin & Zhang, 2009; Yao & Luo, 2010), the influences of foreign entry to

the performance Chinese banking sector (Lin, 2005; Lochel & Pecher, 2008; Shen et al., 2009;

Xiong & Hou, 2009; Berger et al., 2009).

As mentioned in the background chapter, historically, China has only got four SOBs. Their close

relationships with the government has allowed them to enjoy substantial monopoly power but

were also forced to be engaged into various policy lending activities. This has directly resulted in

their low efficiency in operation and decision making. This has also been confirmed by many

previous studies that over centralization were negatively related to bank efficiency. In average,

the efficiency of the Chinese banks was ranged between 41% and 52% during the period of 1985

to 2002 (Fu & Heffernan, 2007). Among the various banking types, efficiency of the SOBs was

the lowest, followed by the CCBs while the JECBs were found of having the highest level of

efficiency level (Bonin et al., 2005). Nevertheless, after a series of ownership reform and

privatisation, the efficiency of Chinese banking sector has been improved significantly over the

past decade. According to the study of Yao & Jiang (2010), the average profit and cost efficiency

of the Chinese banks have been improved to 63% and 74% respectively. Compared with the

JECBs and CCBs, the SOBs were still the least efficiency banks. However, if eliminate the

negative impact of scale efficiency, the actual technical efficiency of the SOBs has actually

surpassed that of the JECBs (Luo and Yao, 2010). This was mainly because of the relative large

size of the SOBs. To get access to the widest range of customers, they have established extensive

networks and employed a large number of employees. This has directly dragged down their

37


overall efficiency level. On the other hand, the superior performance of JECBs might also result

from their geographical location (Ferri, 2009). Instead of spreading their operation across all the

regions, they tend to concentrate more on those prosperous East-coastal provinces. Since the

economic performance of those provinces was far better than the national average, this has

consequently led the JECBs to enjoy a higher than average profit.

In terms of the impact of stock listing on the Chinese commercial banks’ efficiency, since most of

them were only listed on the market since the 2006, the study was quite limited. It was expected

that once the banks were listed on the stock market, they would subject to increased public

supervision and could get access to wider funding opportunities and consequently, their efficiency

could be improved. The early study has been done by Liu and Song’s based on a sample of

JECBs. They concluded that the two listed banks, CMB and PDB were indeed display a higher

than average efficiency level. Later, a study conducted by Lin and Zhang (2009) based on a panel

of Chinese banks over the period of 1997 to 2004 concluded that banks that went through foreign

acquisition or public listing had recorded better pre-event performance. However, soon after the

IPO, the positive impact diminished and this was explained as the “selection effect” Lin and

Zhang (2009). A more recent study had been done by Yao and Luo (2010) is based on a sample of

14 listed Chinese commercial banks. They applied both of the DEA and SAF method and

concluded that the average efficiency of the banks has been improved by 5% after IPO. Similarly,

they also found that over 50% of the sample banks’ efficiency had deteriorated immediately after

the IPO year. Therefore, although it is believed that there should be positive link between stock

listing and bank performance, such conclusion still needs to be interpreted with caution.

Lastly, regarding the influences of foreign entry on the performance of Chinese commercial

banks, it was since the 2001 WTO entry that China has gradually opened its market for foreign

competition. It was until 2006 that the country’s financial market has fully opened for foreign

competition. Many foreign banks entered the market seeking for better business opportunities. In

general, when the foreign banks come to China, they would either acting as a strategic investor,

acquiring a minority stake in the Chinese banks or establishing its own branches (Xu, 2011). As 38


suggested by Berger et al., (2009) that the enrollment of foreign banks on board would help their

Chinese partners to improve their efficiency level, especially for those smaller banks. Garcia-

Herrero and Santabarbara (2008) added that it was more likely for the Chinese banks to achieve

an efficiency gain if their foreign partner was acted as a strategic investor rather than a pure

financial provider. They believed the foreign strategic investor would bring in advanced

technologies for risk control, promoted business diversification and enhanced reputation in local

and global capital markets (Lochel & Pecher, 2008). Similar conclusion has also been reached by

(Ling and Lu, 2004; Lin, 2005; and Liu, 2005). In addition, it has been argued that the increased

foreign penetration would instill addition completion into the Chinese financial market and hence

force the local banks to improve their own operational efficiency (Xiong and Hou, 2009; Zhang

and Wu, 2010). Facing greater competition, the profit margin of the Chinese banks would be

squeezed. Therefore, they were forced to diversify their income sources, and to be more

innovative in product and service design. Nevertheless, despite all these reforms, the big four

SOBs remain dominate the market. Their profit was unlikely to be influenced by the grater

foreign entry (Shen et al., 2009).

Within all these researches focusing on China, few of them compared the efficiency of the

Chinese commercial banks with other foreign banks operating within the same territory. This is

one of the gaps this research aims to fill. In addition, the world financial sector was hit badly by

the recent US financial crisis. How the Chinese commercial banks have been influenced by the

financial crisis is another area left under-researched. In summary, this study aims to investigate

the following research questions:

How the recent financial crisis has impact on the efficiency of the Chinese commercial

banks?

Whether the ownership structure of the banks is still able to influence their efficiency?

Whether the foreign banks could maintain a higher efficiency than the Chinese domestic

banks once they entered into the country?

What is the change of efficiency level of the Chinese banks over recent years? 39


Chapter 4 Methodology and Data

4.1 Methodology

In this study, the parametric approach, SFA is going to be employed. It was developed by Aigner

et al. (1977), Battese and Corra (1977) and Meeusen and Van den Broek (1977) independently

but was proposed simultaneously. The original model could be expressed as the following:

Y j=x j β+v j−u j i=1,2… N

Where x irepresents an input vector for the jth bank; v j denotes the random error and it takes

account of all the measurement error and other random factors that may affect the output variable.

It can be positive and negative so normally it is assumed to follow a normal distribution. For u j, it

represents the inefficiency term and it is assumed to be non-negative, or following the half-

normal distribution. This method is believed to be better than the DEA approach as it

differentiates the random error from the technical inefficiencies.

In the early studies, most of the researches tend to adopt a two-step approach when analysing the

factors that may impact on the efficiency of the banks. They use either DEA or SFA to estimate

the efficiency level of the observations in the first place. Then in the second step, a series of

variables would be chosen to test their influence on the estimated efficiency level. However, such

estimation method suffers a major problem. This is because in the first step, the random errors are

expected to be randomly distributed whereas in the second step, they are assumed to follow

certain functional form. To overcome this problem, Battese and Coelli proposed an extended one-

step model in 1995 and also allowed the use of unbalanced panel data. In this paper, I am also

planning to adopt this method.

To apply the SFA estimation, we need to specify a functional form first. Since the bank is a

financial intermediary with multiple input and outputs, the traditional production function does

not fit for the purpose. Therefore, we decided to choose the Translog function form. Assuming

40


that the total costs of bank j in year t equals to TCjt and it could be expressed as the following:

TC j= f (Y r , j , Pi , j )+ϑ jt+μ jt

If replace the above equation with the Translog function form, it could be changed into:

lnC j=α 0+∑rj

βr ln yrj+∑ij

β i ln c ij+12∑i

∑k

βik ln y ij ln ykj+12∑i

∑z

β iz ln c ij ln czj+∑r∑

iβ i ln yr ln c i+ϑ jt+μ jt

Where Y r , j represents the r-th output of bank j and Pi , jrepresents the price of i-th input. The error

term is comprised with the random error ϑ jt and the technical and allocative inefficiencies μ jt.

Following other literatures, we also impose the homogeneity restrictions (Yao et al., 2007):

∑r

βr=1 ,∑i , z

βiz=0 ,∑i

β i=0

Then the bank specific efficiency scores could then be estimated as expE [−μ|ε ] . It takes the value

between 0 and 1. The higher score, the more efficient the bank is. If an observation has achieved

1, it means that it is fully efficient.

4.2 Data and Variables

In terms of the variables chosen for the test, it could be summarised into two groups, the input

and output variables. However, the classification criteria of the chosen of variables, no consensus

has been reached. This is mainly because of the nature of the bank’s operations. Unlike

manufacturing firms which use raw materials for the production of finished goods, the operation

of the banks is more complicated. The banks are more like a financial intermediately, channeling

funds from the depositors to the borrowers. Therefore, there is no definite input or output of the

banks. For example, for deposit, it could be classified as an output because the banks need to

incur substantial costs, such as human capital and fixed assets to collect the deposit from the

customers. However, on the other hand, it could also be regarded as an input because without

deposit, the banks would have no financial resources to lend out as loans. Consequently, in the

previous studies, two approaches, the production approach and the intermediation approach were

41


commonly employed to define the banks’ input and output variables.

Regarding the production approach, it treats the banks the same as a manufacturing firm, using

labour and capital to produce finished products. The key objective of the banks is profit

maximization. Under such assumption, the inputs of the banks could hence be restricted to the

cost of human capital and capital expenses. While for the outputs, it could be defined as the

number transactions carried out, the new accounts opened or the documents issued within certain

period (Luo and Yao, 2010). On the other hand, the intermediation approach focuses on the

financial intermediary function played by the banks. Although the banks would incur substantial

costs in collecting the deposits, the primary function of the deposits is to be used for lending and

other investments. Therefore, under the assumption of the intermediately approach, apart from

the costs of human capital and assets, the deposit could also be classified as an input variable. On

the other hand, for the output variables, they may include the amount of loans, other earning

assets, or the new profits generated by the banks within certain period. In practice, since neither

of these two approaches could reflect the full picture of the banks operation, they have been used

as complementary to each other. In this research, when determining the input and output

variables, I will use the intermediary approach.

For the data used in this study, they were mainly subtracted from Bankscope. In addition, the

annual statement of the individual banks, the China Statistical Yearbook and the official website

of China Banking Regulatory Committee (CBRC) were also used as supplementary. In total, data

of 39 banks were employed. It includes four SOBs, twelve JECBs, 15 CCBs and eight foreign

banks. The total observation of the sample is 277, covering the period of 2005 to 2012. Due to

data limitation, the data is comprised with an unbalance panel with the smallest 24 banks being

included in 2005 and the largest number of 39 banks being included during 2009 to 2011, as

shown in Table 13 below. For the variables, two price variables were calculated, they are the

interest expense to total deposits and the non-interest expense divided by total assets while the

amount of loans and total earning assets generated were treated as the output variables. To

eliminate the influence of inflation, all these variables are divided by the related GDP Deflator for 42


each year. Another variable, the number of employees was originally chosen as an input variable

as well. However, since for all the eight foreign banks, they did not disclose this information in

the Bankscope, I therefore dropped this variable due to inaccessibility. Table 14 summarises the

correlation coefficient of the input and output variables. It is clear that two output variables are

correlated closely with the input variables, suggesting that the change of input variables would

influence the output level significantly.

Table 13 Number of Banks in Each Year

Table 14 Correlation Coefficient of the Input and Output Variables

In addition to the input and output variables, I have also included a series of explanatory variables

to investigate the factors that may impact on the efficiency of the banks. The first one is the

43


ownership structure. It is measured by a dummy variable. It takes the value of 1 in turn for state-

ownership, joint ownership, city commercial banks and the foreign banks. The second variable is

the return on average assets employed, or ROA. This ratio is a commonly used ratio measuring a

company’s profitability. A higher ratio means that the company could generate more profits with

the assets under control. Hence, banks with a higher ROA ratio are expected to be more efficient

as they could use the resources more efficiently. The third ratio is equity to assets ratio (E/A) and

it could be regarded as a measurement of a company’s exposure to financial risks. A higher E/A

ratio indicate that within the banks’ asset portfolio, the equity finance accounts for a bigger

percentage and the hence made the banks less likely to suffer a financial distress. Moreover, the

E/A ratio could also be interpreted with the budget constraint theory (Luo and Yao, 2010). If the

bank has a higher E/A ratio, it suggests that it may subject to a harder budget constraint. This is

mainly because that due to the residual claim nature of the equity ownership, the shareholders

tend to be more risk averse, prudent and accountable than the debt holders. A lager proportion of

equity finance means that the operation of the banks might be subject to tighter control and

supervision. In addition, the ratio, loan loss reserve to total loans, or LLR/TLs is also expected to

be included for analysis. It measures the credit risks faced by the banks. A higher ratio means that

the bank is more likely to suffer a loss due to the default of the customers. Therefore, a negative

relationship between the LLR/TL ratio and efficiency level of the bank is expected. On the other

hand, this ratio could also be regarded as a proxy for the bank’s risk appetite. If the bank is

willing to take higher risk, it is not surprise that it would have a higher than average LLR/TL

ratio. In theory, a higher risk tends to be related with higher profits. It is thereby hard to say

whether a higher LLR/TL ratio would lead to a higher or a lower level of efficiency. Moreover,

the ratio of loan to deposit, L/D is also used. It measures how much loans have been lent out by

the banks as a percentage of the total deposit collected. A higher level may indicate that the

operation of the bank is highly risky as a shortage of deposits fund may put the bank into

liquidity difficulties. While on the other hand, banks’ lending is expected to generate higher

return for them, so a high ratio may also indicate that the bank uses its funds more effectively. For

each of these variables, they may influence the efficiency of the banks in different ways and the

Table 15 and Table 16 below present the summary statistic and the correlation coefficient matrix

of the variables used for the SFA test. None of the independent variables used for the test is

highly correlated. This ensures that the tested result is not biased. 44


Table 15 Summary Statistics of the Variables

Table 16 Correlation Coefficient of the Independent Variables

Chapter 5 Results of the Empirical Analysis

To test the efficiency level of the chosen banks, the computer software, Frontier 4.1 used and the

result is summarises in Table 17. The average efficiency score of the sample banks is 0.71, in line

with the previous studies. In terms of the six explanatory variables, four of them were found of

being able to influence the efficiency level of the banks significantly.

Table 17 Results of the Stochastic Input Distance Function

45


Notes: *** means that the variable is significant at 1% level; ** means that the variable is significant at 5% level and * means that

the variable is significant at 10% level; ROA, return on asset; LLR/TL, loan loss reserve to total loans; E/A, equity to assets.

It is quite surprised to find that ROA influences the efficiency level of the banks negatively.

Theoretically, highly profitable banks tend to have a higher efficiency as the resources have been

used more efficiently. The negative relationship between ROA and bank efficiency could be

explained by China specific reasons. In China, despite all the reforms, the banking system

remains dominated by the SOBs. The central bank has also set up strict requirements about the

minimum lending rate and the highest deposit, effectively ruling out market competitions.

Consequently, with extensive network distributed across the country and the monopoly power

over the market, the four SOBs could generate extremely high profit although their operational

efficiency is lower than other types of banks. The second variable, E/A has been found of having

positive relationship with the bank efficiency. This is in line with expectations. Banks with a

tighter budget control tend to have a higher efficiency as they need to convince the shareholders

that the resources have been used effectively. For the variable, Loan / deposit ratio, it has been

found of having a negative relationship with the bank’s efficiency level. This may indicate that

banks which are less risk averse tend to have a lower efficiency and it could be linked with

China’s specific situation directly. The financial market in China is quite immature and there is no

established credit rating system. Therefore, for the banks’ lending a relatively bigger percentage

of their deposits, there is also a higher possibility that these lending may go bad. This explains

why banks with a higher Loan/deposit ratio tend to have a lower efficiency level. Lastly, the

variable, IPO has also been found of having a positive relationship with the banks’ efficiency but

it is only significant at the 5% level. Such result proved the effectiveness of the strategy adopted

by the Chinese government to reform its SOBs. After the banks having been listed on the stock

exchanges, their operations would subject to increased public scrutiny and hence giving them

more pressure to enhance their efficiency.

46


On the other hand, two variables, the GDP growth rate and the ownership structure are found of

unable to influence the efficiency level of the banks significantly. This might because of the

sample period employed in this study. It ranged from 2005 to 2012 during which the economic

development in China has been maintained at a relatively stable rate. Without substantial

expansion, business opportunities provided to the banks are also limited and therefore the model

failed to detect a statistically significant relationship between GDP growth and banks’ efficiency

level. The insignificant relationship found between bank ownership structure and efficiency level

is in contrast to many of the previous studies. This is again could be explained by the unique

sample period employed in this study. Since 2006, the four SOBs were listed on the stock

exchanges successfully. In the past, the state ownership is expected to influence the efficiency of

the banks negatively. However, once they have been listed and become shareholding

corporations, they are also expected to be transferred into real commercial banks with profit

maximization being set as the ultimate target. Consequently, the influence of the bank ownership

is diminished. For the foreign banks, although they are expected to have a higher level of

efficiency compared with the domestic banks, the different culture and institutional background

in China may impede their display of full potential. As a result, in China nowadays, ownership

structure is found of having no significant impact on the efficiency of the banks.

In terms of the efficiency of the banks, in average, the efficiency level of all 277 observations is

0.71 and the average efficiency level of the SOBs, JECBs, CCBs and FBs are 0.72, 0.78, 0.74 and

0.73 respectively during the sample period. Although the JECBs seem to be the most efficient

type of bank within the sample, it does not different significantly with the rest three banking

types. This is consistent with the previous statistical analysis. The highest efficiency score is

achieved by a foreign bank, BNP in 2005 at 0.99 while the lowest efficiency score among the

sample banks has been achieved by a city commercial bank, Xiamen Bank in 2012 at just about

0.34. The average efficiency level of all banks over 2005 to 2012 is decreasing gradually from

0.82 to 0.67. This could be explained by the unfavorable economic environment in China, the

unstable financial system triggered by the US financial crisis and the broken out of European debt

47


crisis over the past few years. In 2005, the average efficiency level of the sample banks is 0.82

and it was further improved to 0.82 in 2006. This might because that it was in 2006 that most of

the SOBs obtained stock listing and they were pushed to present better than normal performance

before listing. However, once listed on the market successfully and accompanied by the worsened

international environment, performance of the banks deteriorated.

Figure 4 and Table 18 present the average efficiency score of different banking types over 2005 to

2012. For the SOBs, although their efficiency score was lower than the sample average during

2005 to 2009, they managed to surpass the average efficiency level in 2010. It is worth noting

that actually since 2010, decouple from the general downward trend, the average efficiency levels

of the SOBs have increased steadily from 0.72 to 0.75. This may indicate that first of all, the past

reforms implemented by the Chinese government focusing on the SOBs were proved to be

successful, helping them to become more and more efficient over years. On the other hand, it also

suggests that operations of the SOBs were less affected by the worsened external environment.

Due to their big size and the dominate position over the Chinese financial system, a slowing

down economy would not dampen their profit significantly. In addition, their prudent nature also

determined that they had only got limited exposure of the US securities. This might be another

reason that explains why they could achieve a steadily growth while the rest of the sector was

undergoing a difficult time. For the JECBs, at 2005, their average efficiency score is the highest

among all types of banks at about 0.81 but it fluctuates up and down during the sample period. In

2011, their average efficiency was even surpassed by the SOBs and this may directly result from

the slowdown of the Chinese economy over the past two years. Unlike the SOBs which have an

extensive network and a close relationship with the big enterprises, operations of the JECBs are

more closely related to the local smaller businesses. Consequently, a drop in economic growth

may damage the income sources of the JECBs and hence making them less efficient in general. In

addition, the decline in efficiency of the JECBs may also because of the increased competition.

The fast growth of the CCBs and foreign banks could hardly violate the market position of the

SOBs, but could pose direct pressure to the JECBs. To compete with other types of banks, the

JECBs may incur addition costs in recruiting highly skilled employees and purchasing advanced

technologies and this might be the reason contributing to the declined efficiency of the JECBs. 48


For the foreign banks, at beginning, they are the most efficient banks in China with an average

efficiency score of 0.92 in 2005. However, the broken out of the US financial crisis has made

their efficiency declined continuously to become the least efficient banking type in 2011.

Nevertheless, in 2012, their efficiency level started to recover rapidly. With sophisticated

technology, advanced management expertise, matured management system and less regulatory

constraints, it is expected that these foreign banks would impasse substantial pressure to the

Chinese domestic banks in the near future.

Figure 4 Efficiency Level of All Banks by Different Types: 2005-2012

Table 18 Average Efficiency Score of Different Banking Types: 2005-2012

Chapter 6 Conclusion

49

2005 2006 2007 2008 2009 2010 2011 20120.0000

0.1000

0.2000

0.3000

0.4000

0.5000

0.6000

0.7000

0.8000

0.9000

1.0000

SOBs JECBs CCBs FBs Average efficiency


Starting from the late 1970s, China has also initiated a series of reforms trying to transform its

mono-banking system to a decentralised, market oriented and competitive system. The reforms

implemented by the Chinese government included the introduction of a three tier banking system,

the diversification of the ownership structure of the banks, the listing of commercial banks onto

the stock exchanges and the gradual opening up of domestic financial sector for foreign

competition. Up to the end of 2010, 17 Chinese commercial banks have been listed on the stock

exchanged successfully. They include four SOBs, 10 joint equity commercial banks and three city

commercial banks. Over the past five years, influenced by the US financial crisis, many world

baking giants have experienced serious financial difficulties. Their shares have plummeted and

some of them have even been transformed into state-ownership. However, the Chinese

commercial banks seemed decoupling from the rest of the world, managing to achieve superior

performances consistently.

After all these reforms, China can be said of in processing of one of the biggest banking sectors

in the world. By the end of 2012, among the world’s biggest 10 banks measured by market

capitalization, China accounts for four of them. In particular for the Industrial and Commercial

Bank of China (ICBC), it also has the largest customer base, number of employees and deposit

stocks. In addition, Chinese banking sector has also reported high growth in its profitability in

recent years. In 2010 and 2011, total profits were up by 34.5% and 14.6% respectively year-on-

year (Xinhua, 2012). For the ICBC alone, its recorded net profit in 2011 was 208.4 billion yuan,

up by 25.6% from a year earlier, ranking the highest among all the banks across the world.

However, facing an unfavourable international financial environment in general and a slowdown

of Chinese economy in particular, how these banks could maintain such rapid increase in profit

would be a real challenge. With increased foreign entry, the operational environment of the

domestic banks would become even more complicated. With more experiences and advanced

technology and management expertise, it is no doubt they would impose additional pressures to

the Chinese commercial banks. Therefore, in this paper, five questions were investigated with the

data of 39 banks during the period of 2005 to 2012. In particular, I am trying to find out the 50


change of efficiency of the Chinese commercial banks over recent years; how their efficiency has

been influenced by their ownership structure, their stock listing status, their attitude towards risks

and recent US financial crisis. In addition, the performance of the foreign banks in China will

also be addressed.

For the previous studies on the Chinese banking sector, normally they concluded that the

efficiency of the Chinese commercial have been improved continuously over the past decades.

Among the different banking types, the state-owned banks were the least efficient group. Their

close relationship with the government has led to substantial policy oriented lending and

consequently accumulated large amount of non-perforating loans. For the JECBs, since they tend

to adopt a mixed ownership structure and concentrate their operations in the economic developed

regions, their performance are normally higher than other types of banks in China. Regarding

increased foreign entry, they general concluded that they have brought in increased competition

to the Chinese banking sector. To compete with their foreign counterparts, many Chinese

commercial banks were forced to reduce their interest margin and incur additional costs in staff

recruitment, new product and service design and purchasing of advanced technologies. However,

it has also been said that due to different culture background and the tight government control, it

is hard for the foreign banks to replicate their success story in China as their home country.

Therefore, in this paper, 8 foreign banks were also included in the study. I am trying to track their

change of efficiency once they come into the China.

This study employed the parametric method SFA for the analysis. The data are mainly subtracted

from Bankscope. In addition, the annual statement of the individual banks, the China Statistical

Yearbook and the official website of China Banking Regulatory Committee (CBRC) were also

used for cross-checking. In total, data of 39 banks were employed. It includes four SOBs, twelve

JECBs, 15 CCBs and eight foreign banks. The total observation of the sample is 277, covering

the period of 2005 to 2012. For the variables, the input variables include two price variables, the

interest expense to total deposits and the non-interest expense divided by total assets while the

amount of loans and total earning assets generated are chosen as the output variables. To 51


eliminate the influence of inflation, all these variables are divided by the related GDP Deflator for

each of the separate years. In addition, six explanatory variables are also included to test their

influence to the efficiency of the banks. They are the ownership structure of the banks, the stock

listing status of the banks, ROA, Loan to deposit ratio, Equity to assets ratio and the GDP growth

rate.

In general, we found that among the six independent variables, four of them could influence the

efficiency of the banks significantly. It is quite surprised to find that ROA influences the

efficiency level of the banks negatively and this might because of the dominate position of the

four SOBs in the Chinese banking industry. The second variable, E/A has been found of having

positive relationship with the bank efficiency and it is in line with expectations. Banks with a

tighter budget control tend to have a higher efficiency as they need to convince the shareholders

that the resources have been used effectively. For the variable, Loan / deposit ratio, it has been

found of having a negative relationship with the bank’s efficiency level. This may indicate that

banks which are less risk averse tend to have a lower efficiency. Lastly, the variable, IPO has also

been found of having a positive relationship with the banks’ efficiency. This proved the

effectiveness of the strategy adopted by the Chinese government to reform its SOBs. After the

banks having been listed on the stock exchanges, their operations would subject to increased

public scrutiny and hence giving them more pressure to enhance their efficiency. On the other

hand, two variables, the GDP growth rate and the ownership structure are found of unable to

influence the efficiency level of the banks significantly. This might because of the sample period

employed in this study. It ranged from 2005 to 2012 during which the economic development in

China has been maintained at a relatively stable rate. Without substantial expansion, business

opportunities provided to the banks are also limited and therefore the model failed to detect a

statistically significant relationship between GDP growth and banks’ efficiency level. Regarding

ownership, since most of the reforms were finished by 2005 and the SOBs were listed on the

stock exchange and being transformed into shareholding corporations, the influence of the bank

ownership has therefore diminished. For the foreign banks, although they are expected to have a

higher level of efficiency compared with the domestic banks, the different culture and

institutional background in China may impede their display of full potential. As a result, in China

nowadays, ownership structure is found of having no significant impact on the efficiency of the

52


banks.

In terms of the efficiency of the banks, in average, the efficiency level of all 277 observations is

0.71 and the average efficiency level is deteriorated year-after-year. This could be explained by

the unfavorable economic environment in China, the unstable financial system triggered by the

US financial crisis and the broken out of European debt crisis over the past few years. For the

SOBs, although their efficiency score was lower than the sample average during 2005 to 2009,

they managed to surpass the average efficiency level in 2010 and become the most efficient

banking type in 2012. This may indicate that the past reforms implemented by the Chinese

government focusing on the SOBs were proved to be successful, and it also suggests that

operations of the SOBs were less affected by the worsened external environment due to their

bigger size and monopoly power over the market. For the JECBs, at 2005, their average

efficiency score is the highest among all types of banks at about 0.81 but it fluctuates up and

down during the sample period. This may because the operations of the JECBs are more closely

related to the local smaller businesses and are more likely to be influenced by the increased

market competition. Therefore, for the JECSB, they need to develop new income sources to

improve their existing operations to maintain competitive in the market. For the foreign banks, at

beginning, they are the most efficient banks in China with an average efficiency score of 0.92 in

2005. However, the broken out of the US financial crisis has made their efficiency declined

continuously to become the least efficient banking type in 2011. Nevertheless, it is believed that

with once the economic condition recovered, these banks would growth up quickly and impose

substantial pressure to the local banks in the near future.

Lastly, in terms of the limitation of this research, first of all is the choice of variables. If data

related to the salary payment to the employees and the number of employees could be found,

another price variable could therefore be calculated and used in the analysis. Secondly, it is the

relatively small size of the sample. If time allowed, more data about different types of banks

could be collected so as to reach a more solid conclusion.

53


54


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