Chinese Finacial System may Face Great Reform

Chinese Finacial System may Face Great Reform

Shanghai : China | Apr 24, 2012 at 10:23 PM PDT
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Limited competition has made China's big banks profitable but lazy. That may be about to change.

Speaking Tuesday, Chinese Premier Wen Jiabao criticized the 'monopoly' profits of state-owned banks. He has a point. Industrial & Commercial Bank of China, 1398.HK +2.00%China's biggest by assets, grew its net profit by 26% in 2011, despite a slowing economy and a credit squeeze for small business.

On average, the four biggest Chinese banks generate a return on equity of about 25% and a return on assets of between 1% and 1.6%. By comparison, U.S. banks with more than $10 billion in assets generated an average return on equity over the past 10 years of 9.2% and an average return on assets of 0.9%, according to Federal Deposit Insurance Corp. data. Even J.P. Morgan Chase, JPM -2.22%the biggest U.S. bank by assets, posted a return on equity for 2011 of just 11%.

While U.S. banks operate in a competitive market for funding and have been hamstrung by super-low interest rates, the biggest Chinese banks benefit from government-set deposit and lending rates. That results in a decent spread for the banks: With the one-year deposit rate set at 3.5% and the loan rate at 6.56%, banks can generate a net interest margin of 3.06 percentage points.

While not spectacular, the margin is pretty much guaranteed. Big U.S. banks posted a net interest margin of 3.5 percentage points in last year's fourth quarter, according to the FDIC, but this spread can fluctuate depending on lending and funding conditions.

And big Chinese banks tend to reap more of their profit from interest income. At Agricultural Bank of China, 1288.HK +2.40% net interest incomes accounted for 80% of operating income in 2011; at J.P. Morgan, 2011 net interest income was about 50% of total net revenue.

But changes in China's financial system, along with the possible upheaval signaled by Premier Wen's remarks, mean big Chinese banks may face a more uncertain and less-profitable future.

Most important is the explosive growth of wealth-management products─investment instruments that offer savers higher returns than a conventional deposit. These products aren't subject to government quotas, unlike traditional lending, so they can grow faster. Citigroup estimates assets in these products almost doubled in 2011 and are now equivalent to about 7% of deposits in the banking system.

The margin on a wealth-management product is about one percentage point, Citigroup estimates. The more the sector grows, the more it eats into banks' fat profits.

There could be worse to come. In March, central-bank Governor Zhou Xiaochuan said the time was 'basically ripe' for interest-rate overhaul. If the regulatory ceiling on deposit rates is lifted, banks could see margins come under even more pressure rotary kiln. Mr. Wen also appears more eager to see private capital play a bigger role in the financial system─increasing competition.

Last month, former central bank adviser Li Daokui said China's state-run banks were like dinosaurs cone crusher. Extinction isn't on the cards, but these latter-day T-Rex's will have to evolve, fast.

rotary kiln:

cone crusher:

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Barack Obama delivers remarks on finacial reform
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