The banking licences being granted to private companies in China look set to shake up the country's financial sector, with its 'big four' lenders coming under pressure from tech-savvy newcomers with a strong customer network, such as Alibaba and Tencent.

History, politics, economic plans. These are some of the words that come to mind when thinking of China’s banking sector. Its participants – mostly large state-owned banks – have been pivotal vehicles for government policy, starting from the Qing dynasty, which spanned from the 17th to the 20th century, all the way to Deng Xiaoping’s post-1979 liberalisation drive.

But the China Banking Regulatory Commission's (CBRC's) March 2014 announcement of a pilot programme to establish five privately owned banks in the country marked a momentous change in the largely state-controlled banking sector, in which private banks account for only slightly more than 10% of capital.

This policy move is heavy with meaning. It sends a message to the country's 'big four' lenders (Bank of China, China Construction Bank, ICBC and Agricultural Bank of China) that they cannot let up on their modernisation programmes as the new entrants will be extremely tech-savvy. It also helps tackle shadow banking by bringing private financial institutions inside the regulatory framework. And it encourages financial institutions to service the historically underserved small and medium-sized enterprise (SME) and retail consumer segments.

The reform is unprecedented and is set to change China’s banking sector dramatically. But questions remain as to whether the move will address a broader issue in the Chinese financial market – the proneness to illiquidity and state banks’ skewed balance sheets.

Private ownership on the rise 

Private banks have always played a minor role in China’s banking sector. According to Yang Kaisheng, former president of ICBC, private investment accounted for about 11% to 12% of the Chinese banking industry’s total capital in 2014, with the rest being controlled by the state.

But now five private banks (each comprising of two private co-sponsors) have permission to set up in the cities of Shanghai and Tianjin, and the provinces of Guangdong and Zhejiang. The new banks will only be allowed to operate within their city or province of origin.

Interest from private companies that want to be involved in financial services is huge, largely because the growth potential in the industry is enormous. SMEs and retail consumers are underserved in China, and private companies that have technological prowess and vast customer bases have the means to maximise this potential. It is expected that the new private banks will particularly appeal to China’s tech-savvy younger generation.

Indeed, internet companies Tencent and Alibaba have already acquired banking licences. The former launched WeBank – the first online-only Chinese private bank – in January 2015, and its trial operation will last at least four months. WeBank will focus on mass retail and SME customers by taking advantage of its understanding of the internet and its big data capacities. It also has a registered capital of Rmb3bn ($478.9m), WeBank told The Banker in an e-mail statement.

Alibaba is set to follow Tencent down the banking route. It was granted a banking licence in September 2014 to set up MYbank – which will target SMEs and individual consumers — along with Shanghai Fosun Industrial Technology, a subsidiary of Wanxiang Group, and Ningbo Jinrun Asset Management.

Meanwhile, aviation services and travel company JuneYao Group; finance, property and medical services conglomerate Fosun Group; electronics retailer Suning; air-conditioner manufacturer Gree; low-voltage electrical products manufacturer Chint Electric; and web services firm Baidu are all involved in or are considering launching banking activities.

The services provided by these new banks include lending, money market and wealth management products. Over time, this could expand to insurance and other services, according to market participants.

New applicants

After the first wave of applicants, many more private companies are in line to apply for China's banking licences. Matthew Phillips, financial services leader for China and Hong Kong at PricewaterhouseCoopers (PwC), believes there are about 30 in the offing. “We have seen interest from businesses that have large customer bases, that through their networks have access to retail customers and SMEs, such as vehicle producers and internet platforms,” he says.

Edwina Li, head of financial services assurance at KPMG China, says there could potentially be 100 applicants, but in the short to medium term, she predicts the government will allow one or two private banks to open per province, given China’s gradual approach to reform.

Market participants believe that well-known, trusted companies that are listed will be granted licences first. The market anticipated that a new set of awards would be disclosed after February 2015, but the CBRC has yet to make an announcement on this matter.

Regulating in

The CBRC’s banking reform has won the praise of market observers for being pragmatic and forward-thinking in terms of its approach. “There is a recognition that there are valid alternatives to the traditional bricks-and-mortar banking system in a sector where the 'big four' and joint-stock banks still dominate deposit-taking activities, payments and lending in a traditional sense,” says Tim Pagett, global financial services industry leader at Deloitte China.

Premier Li Keqiang’s launching of WeBank’s first loan at the bank’s opening was interpreted as the ultimate government seal of approval of China’s new private banks, and is widely regarded as a message to China’s state banks to strengthen their technology development and to keep up the pace with their modernisation plans.

“I think the real message is for the [existing] domestic players to get their act together and start developing and innovating,” says Keith Pogson, global assurance leader, banking and capital markets, at EY. “The big four have invested a lot of money in technology but they still have a way to go. Their systems are somewhat legacy systems now.”

With China’s banking sector historically used by authorities as a monetary and fiscal policy vehicle, CBRC’s reform also has a strong policy angle. “A huge amount of post-crisis stimulus was managed through the banking network. Whenever China wants to slow real estate markets, it doesn’t hesitate to change loan-to-value ratios or mortgage lending regulation,” says Mr Pagett.

In this case, the thinking behind CBRC’s regulatory reform may be to find a way to tackle China’s enormous shadow banking problem. Shadow banks have grown in China as a way of intermediating in a market in which deposit rates are capped and lending is often state directed. The new private banks are keen and have the means to target segments – mainly SMEs and retail consumers – that have been less well served by the big four, thus challenging shadow banks in an area in which they have thrived. 

The big state banks have benefited from healthy lending margins as a result of controlled interest rates, and have also been able to focus on the lucrative business of supporting state infrastructure and construction plans and servicing large state-owned enterprises.

“Even if the state has aimed to change China from being a world manufacturing factory to having a consumption focus, there wasn’t a lot of incentive from large banks to change their strategy while enjoying double-digit growth annually with high interest margins,” says William Yung, China financial services partner at PwC.

“[Shadow banking] exists because of the big four. If they had been willing to lend more effectively to SMEs, if they had effectively varied pricing on the upside in the retail space, then shadow banking demand wouldn’t exist. If they had been more flexible in the way they rewarded depositors – there are some restrictions on that but there are things you can do – then the shadow banking market would not be so successful,” adds Mr Pogson. 

Opportunities in the Chinese banking market

A competitive advantage

Technology prowess and significant customer reach thanks to their existing customer bases may put new banks in a strong position to cater to parts of the SME and retail consumer segments that are currently underserved.

For players such as Alibaba, which SME manufacturers already rely upon to sell their goods, it will be relatively easy to reach out to small business owners as a bank. “Alibaba is so deep in the supply chain that it knows where the money is. [And] if SMEs don’t pay Alibaba back, it won’t help them deliver their goods anymore. For [a company] with Alibaba’s retail scale, [that is] a pretty painful threat. With this understanding, you’re going to pay Alibaba first out of all your lenders,” says Mr Pogson.

Thanks to the new banks’ technology skills and the customer information they already have, they can use advanced credit checks and big data to improve credit risk management. In Alibaba’s case, this includes mobile phone records and payment data that go through its platform.

This will also help new banks navigate China’s SME segment, where the risk of non-performing loans (NPLs) is high. “The NPLs in the SME sector are significant and they are an issue. But with the right risk selection there is a huge unbanked market of better quality SME companies that are starved of funding,” says Mr Phillips.

However, Thorsten Beck, professor of banking and finance at Cass Business School, believes that, as with any financial liberalisation, there are considerable risks involved in engaging with SMEs. “I wouldn’t be surprised if some of these new banks will have a crisis a couple of years down the line.” 

The new banks are also free of the political obligations entrenching state banks. There is no divorcing the big four from their political, historic and social obligations, which makes them far less nimble than new entrants. The new private banks’ online focus also avoids the more costly and slow-paced bricks-and-mortar approach, and many believe that this gives them an enormous cost advantage.

Even companies with an inherent physical presence, such as electrical goods retailer Suning, are incorporating online banking in their strategy to minimise costs. Suning has set up a financial services arm to develop money market and wealth management products and distribution online. The arm also helped the company set up a consumer finance business leveraging retail customers through its 1000-plus outlets in China.

“Putting branches in its stores and developing an internet bank is an interesting addition that would allow Suning to connect the online and offline transactions in a low-cost and convenient way,” says Mr Phillips.

Newcomer challenges

Though these private entrants to China's banking sector have significant advantages, their lack of banking experience could be a disadvantage, while building deposits will pose a particularly tough challenge. “When it comes to it, anybody can lend money, but getting deposits is a much harder question,” says Mr Pogson.

New banks may not be capable of building the necessary credit and operational processes such as platforms and middle and back offices. They may also not be savvy in matching tenures and managing liquidity, which could be problematic as internet finance is predominantly depositor-led online, with most of the loans originated offline, according to Mr Phillips. “An outage on a technology platform is not exactly the same as dealing with consequences of a funding mismatch in a bank resulting in a customer unable to withdraw funds and potentially resulting in a run on the bank,” he says.

Trustworthiness is also an issue. “Some customers might be a bit diffident towards new banks at first,” says Mr Pogson.

New banks may also be tempted to offer high interest rates – which helped money market funds such as Alibaba’s Yu’ebao and Tencent’s Licaitong to grow quickly, only to become unsustainable on a larger scale. Strong online service, innovative products and customer experience will then be critical in retaining clients. 

Fast growth

Yu’ebao broke all records in terms of size and speed of growth. It attracted 124 million investors in the year after its launch in June 2013. As of September 2014, Yu’ebao’s outstanding assets under management had risen tenfold from a year earlier to Rmb535bn, according to PwC. Meanwhile, Tencent launched Licaitong in January 2014. Its assets under management had grown to Rmb59bn by September 2014.

Eye-catching yields and a desire among consumers to diversify away from demand deposits have made these funds successful. China’s one-year time deposit rate stands at 3%. Yu’ebao and Licaitong's annual yields in 2014 were a respective 4.72% and 4.22%, according to PwC. They both peaked at about 7% when tightening liquidity boosted interbank lending costs in 2013.

Though Yu’ebao’s performance was unprecedented, the fund’s size has plateaued since as it was impossible to pay these high yields on such a large scale. “When a fund grows considerably, you end up joining the rest of the banks in depositing the money in the interbank market, and the super yields are eroded,” says Mr Pogson.

Notwithstanding these challenges, Yu’ebao and Licaitong illustrate the ability of private companies to sell financial products through a strong understanding and connection to their customer base. “They have already done so with physical goods; why not do that with financial goods?” says Mr Pagett.

This ability could help develop the local corporate bond market. China’s corporate bond market remains underdeveloped since the bulk of market wealth is not mobile. “In developed markets, the institutional market is what pushes wealth around. In emerging markets, particularly in China, the institutional wealth is resident in the big four’s deposit base,” says Mr Pagett.

Chinese corporates’ demand for bond funding is huge, as they are keen to diversify their borrowing away from bank loans. Having access to a more liquid corporate bond market would also lower borrowing costs.

New entrants could provide an alternative to banks as intermediaries between bond issuers and investors. “You’ll start to see a retail-to-retail phenomenon that avoids the growth of institutional funds that we have seen in the past two to three centuries in the developed markets. The power of the individual would be driven back into capital markets via an intermediary that is not running a traditional balance sheet,” says Mr Pagett.

Gloom ahead for foreign banks?

The new private banks will present further competition for foreign lenders that want to enter into and build up their operations in China. CBRC has historically placed a significant number of constraints to stop foreign players growing too rapidly. Overseas banks will now also face new, tech-savvy banks that have stronger name recognition in and knowledge of the local market.

“The dream in retail banking was always to use mobile and the internet to penetrate the 1.3 billion population in China. However, you’ve got these new guys coming along and you think ‘Oh holy crap, someone else has just eaten our breakfast!’,” says Mr Pogson. “I don’t see new entrants making it necessarily any more difficult, but it certainly doesn’t make it any easier,” adds Mr Pagett.

Mr Beck, however, believes foreign banks' difficulties lay elsewhere. “Foreign banks have other problems on their hands and there are other reasons why they might be held back [in China]. I don’t see much of role in China for foreign banks anyway,” he says.

Systemic imbalance

While CBRC’s reform should improve the breadth and scope of China’s banking sector, to some it is seen just as a quick fix for deeper systemic issues in the financial sector and indeed the Chinese economy as a whole. Jan Toporowski, a professor of economics and finance at the University of London's School of Oriental and African Studies, says that the state banking system lacks flexibility and there is a tendency to run out of liquidity if it lends too much.

The market experienced three severe liquidity squeezes in June, October and December 2013. The June crunch briefly sent the overnight interbank rate surging to 30% before the central bank injected additional funds to the market. 

The formation of new private banks could improve this situation in the short term. State banks could shore up their positions by hedging through the interbank market as private banks with spare deposits could lend these out to state banks. The latter would be less reliant on the central bank for liquidity, says Mr Toporowski.

But in the long run, even an effective interbank market alone will not solve all of China’s economic problems. China needs wider reforms that will rebalance the economy away from an overreliance on exports and investment towards consumption. Further liberalisation of interest rates would be part of this journey as it would lead to a better allocation of capital.

In any case, CBRC’s reform is as much about keeping China abreast of the latest banking trends as it is about macroeconomic improvements. In a market the size of China’s, changes such as these can produce dramatic results, hence the development of China’s new private banks is being keenly watched.

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