EUCHINABMTWORKINGPAPERSERIES No.

010

Chinas Changing Business Model of Banking

Prof. Dr. Horst Loechel China Europe International Business School, Frankfurt School of Finance & Management German Centre of Banking and Finance at CEIBS 699 Hongfeng Road, Pudong, Shanghai 201206, P. R. China hloechel@ceibs.edu, h.loechel@frankfurt-school.de
Helena Xiang Li (Corresponding author) Frankfurt School of Finance & Management Sonnemannstrasse 9-11, D-60314 Frankfurt am Main, Germany h.x.li@frankfurt-school.de

Chinas Changing Business Model of Banking

Prof. Dr. Horst Loechel China Europe International Business School, Frankfurt School of Finance & Management German Centre of Banking and Finance at CEIBS 699 Hongfeng Road, Pudong, Shanghai 201206, P. R. China hloechel@ceibs.edu, h.loechel@frankfurt-school.de

Helena Xiang Li (Corresponding author) Frankfurt School of Finance & Management Sonnemannstrasse 9-11, D-60314 Frankfurt am Main, Germany h.x.li@frankfurt-school.de

Working Paper, January 2010

Acknowledgements: The authors are very grateful for extensive discussions with Prof. Chang Chun and Dr. Zhu Honghui of China Europe International Business School. The authors would like to express deepest thanks also to Ludwig Fella (Commerzbank AG, Shanghai Branch), Dr. Stephan Popp (Nord/LB, Shanghai Branch), Constantino Riviello (Citibank N.A., Regional Office Asia Pacific Banking Institute), Dr. Hans Schniewind (Helaba, Shanghai), Marcus Wassmuth (LBBW, Shanghai), Julia Wu (Deutsche Bank AG, Shanghai) and Prof. Zhao Xiaoju (Shanghai University of Finance and Economics) for providing valuable insight into the development of Chinas banking industry. This research is part of the EU-China Research Fellowship Program, a co-operation between China Europe International Business School and Frankfurt School of Finance & Management in the framework of the EU-China Business Management Training Program, which is generously sponsored by the European Union.
2

Abstract
The recent turmoil of the global financial system urges both academics and professionals to rethink the fundamental question of the appropriate banking business model. The recent suggestion of President Obama to separate investment banking from commercial banking recalls the come back of the Glass-Steagall Act, i. e. the return to the separate banking business model similar to the reaction after the word economic depression in 1930s. This turn around is particularly of interest for China due to the fact that Chinese banks just moving the other way around after a track record of more than thirty years reform policy. Surprisingly enough, academic research about the gradual change of the banking business model in China towards a specific type of universal banking system is still rare especially in an international context. The current paper aims to shed some light in this regard by conducting a comparative study based on data of banks from China, Europe, the UK and the USA. The analysis reveals that that the profitability of Chinese banks is mainly bolstered by the still guaranteed interest margin set by the central bank. Moreover, the risk pricing mechanism in loan business as evident in Western peer banks is not yet established well in Chinas banking sector. Therefore, the diversification in fee and commission income is most important for Chinese banks to leverage their competitiveness. The high concentration of the current revenue sources on lending in Chinese banks can not sustain if the interest margin narrows in a more liberalized interest and exchange rate environment. The equity participating of Chinese banks in asset management companies shows already first results in generating synergies in terms of scale and scope. However, it will be shown that this transformation is so far not accompanied with an inappropriate leverage of risks due to a prudent regulatory environment, which limits non-interest income business of Chinese banks to service fees and provisions from customers instead of trade for own account. Given the momentum of stricter bank regulation on an international level as well, a system convergence between Western and Chinese banking business model could be expected in a foreseeable time.

Keywords: Banking business models, financial crisis, universal banking, China financial system JEL classification: G01, G20, G21, G28

I. Introduction
In the disastrous crisis year of decades for the global banking industry, Chinese banks celebrated their stunning advances in the global banking league. The state-owned commercial bank giants ICBC, CCB and BOC1 were ranked as the world largest banks by assets with the most valuable brands and were the three most profitable banks over the world in 20082. The market capitalization of those three banks also took over the first three places of global ranking by the end of June 2009, regardless of the fact, that the whole banking industry was deemed as insolvent with non-performing loan (NPL) ratio of over 20% only five years ago. China has done its home work of banking reform with gradual but persistent and caution steps: from separating policy lending from state-owned commercial banks (SOCBs), to the hundred billion dollar bail-out of the whole banking system by transferring NPLs to separate asset management companies, followed by establishing modern corporate governance structure and introduction of foreign strategic participation as well as bringing banks to capital markets step by step.3 Despite the long lasting discussion of severe problems including operational inefficiency, lack of risk management skill, policy lending and so on, the fact can not be neglected that the vanilla business model and strict regulation guarded Chinas banking sector in most instances from the spill-over of the recent financial turmoil.4 The belief that Western banking model was regarded as sample model for banking reform in emerging markets was severely shaken after the financial crisis. Lessons are learned that escalating bank return by inflating risks, a popular model which the success of some Western banks were thanks to before the crisis, is proved to be not sustainable. A new round of debates broke out among academics and banking managers on banking business model after the crisis time.5 One stream of opinion claims the radical way back to narrow banking in which banking business is mainly limited to deposits, lending and settlement. Another stream points out the fact that a limitation of the business scope is unrealistic in modern banking, as disintermediation and global competition fundamentally undermines the foundation of utility banking with high reliance on interest rate margin and credit expansion. Market demand for more individual and diversified financial products to meet long-term financial needs in line with demographic changes and to manage risk complexity requires variety in financial products, markets and channels. The crisis has however shown that revenue enhancement through high-leveraged capital market speculation deviates from the core concept of universal banking. The implications of this turnaround is of special value for Chinese banks which saved the disruption phase of system shake caused by banks extensive risk taking in trading and leveraging by creating paper gains through financial innovation far beyond the needs of the real economy. The narrow business model in Chinas separated banking system and strict foreign capital control prevented the infection of the global financial turmoil. Based on the experiences of the transformation of a separated to a universal banking model6 in Western banking, Lv Suiqi, Deputy Chair of the department of finance at the Peking University, stressed however that Chinese banks could no longer rely on the old business model based on interest rate spread which is determined by Chinas central bank. Instead, it is essential to explore other revenue sources such as asset management products to increase the core competitiveness of commercial banks.7 However, Chinese banks face the dilemma to adapt their business models on a more and more liberalizing environment in terms of currency, interest rates and capital markets, without a convincing paradigm of international universal banking standards. Due to the financial crisis, further deregulation of Chinas banking sector towards an integrated banking business model was even slowed down upon to the results of reconsideration of the benefits and risks of the Western style of banking. Liu Mingkang, for instance, Chairman of CBRC8, stated at the Luijiazui Forum in May of 2009 in Shanghai: We dont discuss universal banking.9
1 2

ICBC: Industrial and Commercial Bank of China, CCB: China Construction Bank, BOC: Bank of China See Financial Times Asia, April 29th, 2009, p. 3. 3 See for instance Neftci and Xu (2007), Loechel and Zhao (2006), Wu (2005) and Garca-Herrero, Gavil and Santabrbara (2006) for an overview of the reform process. 4 Backed with the strong performance of Chinese banks in the crisis, Liu, Mingkang, Chairman of CBRC, expressed his full convince in Chinas banking regulation concept in his newly published article Basic rules helped China sidestep financial crisis in Financial Times Asia. See Financial Times Asia, June 29th, 2009, p. 7. 5 For competing opinions on banking business model after the crisis, see for instance Dobbs and Kuehner-Hebert (2008) and Rizzi (2009). 6 In this paper, we define universal banking as the combination of commercial banking, investment banking, asset management and other related financial services in contrast to the separated banking business model, which focuses banks on commercial banking activities alone. The universal banking model can be extended to an integrated financial services provider model by adding insurance to the service scope. 7 See 21st Century Business Herald, May 14th, 2009, p. 10. 8 CBRC: China Banking Regulatory Commission, the regulatory and supervisory body for banking in China 9 See The Wall Street Journal Asia, May 18th, 2009, p. M2. 4

Against this background, the current paper reflects the revenue diversification process in Chinese banks in comparison with the business scope in European and Anglo-Saxon peer banks. To our best knowledge, this paper has the unique value to first address the business model transformation in Chinas banking sector in an international context.10 The main hypothesis is that Chinas banking business model is gradually moving from a segregated towards a universal banking system, forced by interest rate liberalization, capital market development and further opening of domestic financial markets. In detail we prove that the profitability of Chinese banks is so far mainly driven by an interest margin above the level in Western peer banks. As the interest margin is artificially held high in China through an administrated interest rate regime, this business model can not sustain. Moreover, we discover that the risk pricing mechanism is still not well established in Chinese banks lending practice. The guaranteed interest margin and stable loan growth provide little incentive to diversify revenue sources through non-interest income products. Compared to Western peers with high investigation in proprietary trading, we notice that fees and commissions instead of trading income dominate the non-interest income in Chinese banks. We also identify that synergies in Chinas first trial of universal banks in the form of banks majority share holding in asset management companies are realized through economies of scale since bank related funds are larger in size and provide favorable management and custody fee condition. As the internationalization of the Chinese currency quickens the pace as demonstrated with the ambitious appeal of Chinese Central Bank governor Zhou Xiaochuan to rebuild the global currency system,10 the liberalization of the domestic interest rate system of China to a more market orientation is simultaneously foreseeable. At the same time, promotion of direct financing through capital markets to reduce the current high risk concentration in financing of over 80% through banking will fuel the capital market development in China and therefore disintermediation. Chinese banks face the unique challenge and opportunity of business model transformation to more engagement in non-interest income business with balanced fees and commissions, high portion of investment in high-graded government, financial and corporate bonds, limited trading for risk hedging and restricted exposure in equity and derivative products. There is no reason to believe that this controlled as well as highly regulated extension of the commercial banking business model of Chinese banks will be accelerated towards a Western style high-leveraged trading and asset business model. The paper is organized as follows: After a short review of current discussions on banking business scope in section II, the evolution of Chinas banking sector from the separated to the universal banking system are introduced in section III. Section IV analyzes the return and risk impact of interest income and non-interest income in Chinese banks in comparison with their peers from Europe, the UK and the USA. Section V evaluates the first trial of universal banking model in China banks majority holding in asset management companies and identifies the synergy sources in Chinese universal banks. A conclusion in section VI summarizes the results and provides outlook for future development of banking business model in China.

II. Business Scope in Banking A Post-Crisis View

The exacerbation of the crisis was triggered with the bankruptcy of Lehman Brothers on September 14th, 2008.11 The domino effect through interlinks among financial institutions and the large-scale engagement in speculative subprime real state sector allowed the fast spread-out of the pandemic to almost all universal banks, which ended up with global dry-up of credit and market liquidity and a recession in global economy. Voices became louder to bring banks back to the basic roots: deposit and loans, the narrow function of a utility bank model, as risky financial innovation in investment banking was deemed as cause of the crisis. President Obama proposed a plan to limit proprietary trading of commercial banks12. At the same time, the crisis showed evidence that stand-alone investment banks without stable financing source from deposits are vulnerable to market disrupts and bankruptcy risks.13 Leading stand-alone investment banks Bear Stears, Merrill Lynch were sold to universal banks JP Morgan Chase, Bank of America respectively; Lehman Brothers went bankrupt; both Goldman Sachs and Morgan Stanley were converted to bank holding companies under the cover of FDIC, conducting commercial deposit taking and lending services. The current crisis renewed the long-lasting academic interest engaging with the expansion of banks business scope in non-interest income businesses and its impact on risk and return profile of diversified
10 10

For a comprehensive overview of Chinas financial sector in general see Zhu, Cai, and Avery (2009). See Zhou (2009). 11 For a judgment of the crisis in historical comparison see Reinhart and Rogoff (2009). 12 See Obama beschneidet Freiheit der Banken, Handelsblatt, Jan. 22nd, 2010. 13 For discussions about banking business model after the crisis, see for example Schildbach (2009). 5

banks. The discussion about the justification of the introduction of Glass-Steagall Act in 1933, the legal establishment of the segregated banking system in the US as a consequence of the financial crisis at that time, has not reached conclusive results14. In regard to the permissible scope in banking, we first consider functions of banking in the economy. Banks basically act as settlement agent for money transfer and intermediation in financial markets, enabling transformation of amounts, risks and maturities of financial assets. The variety of activities include deposit taking, corporate and retail lending, mortgages, leasing, clearance & settlement, credit cards, custody, sales agency for funds and insurance products, financial advisory for corporate and private clients, underwriting of debt and equity instruments, M&A advisory, securities broking and trading etc. Those business lines bear differentiated return and risk patterns. There are basically two systems to organize the service bundles: the segregated banking system and the universal banking system15. The former separates investment banking activities from commercial lending, deposits and settlement services, the latter unifies commercial and investment banking, either under one roof as the case in European-style universal banks, or through holding structure in financial holding companies as the case in the US and the UK. With the expansion of business scope of banking into insurance services in the sense of bancassurance 16 , the concept of universal banking is further extended to integrated financial services providers/financial conglomerates. The emergence of cross-sector services in the financial industry urged studies on the return and risk pattern of combination of different business lines in banking. However, academic debates have still not yet brought conclusive results for our insight in this research area. Previous studies 17 generally believe the revenue enhancement and risk diversification gain from expansion in non-interest income businesses, this view has been however not yet conclusively proven on the basis of empirical results. Allen and Jagtiani (2000) find that combining banking with securities services and insurance activities reduces the overall risk. DeYoung and Rice (2004) futher reveal persistent outperformance in term of higher sharp ratio of diversified, non-traditional banking compared to traditional banking. Ebrahim and Hasan (2004) evaluate the gains from the view of the capital market and find out that banks with heavier involvement in non-interest income business are credited with more growth potential and consequently with higher market valuation. Contradictorily, Stiroh (2004) points out that the volatility in trading revenue largely diminishes the risk reduction through diversification in non-interest income businesses and the interest and non-interest income became more correlated over time. Laeven and Levine (2007) investigate the diversification discount of financial conglomerates and show that the benefit gains from economies of scale and scope can not compensate the costs from agency problem in financial conglomerate, which leads to a trade discount of financial conglomerates on the capital market. Similar results are found by Schmid and Walter (2008). They reveal comprehensively the existence of conglomerate discount in the financial services industry and conclude that the total balance of functional diversification is value-destroying. However, with more differentiated analysis, they show that the combination of commercial banking with insurance and the combination of commercial banking with investment banking produces significant premium. Kwan and Ladermann (2009) review the portfolio effects of business divergence in banking and conclude that both securities and insurance services are more profitable and more risky than banking. They emphasize however the necessity to differentiate sub-activities in securities and insurance and point out that securities underwriting and insurance agency businesses for instance can reduce the overall risk of bank holding companies. De Jonghe (2009) explicitly examines the impact of bank diversification on financial system stability and concludes that interest income is less risky than non-interest income in crisis time. The above ambiguous empirical results induce a more differentiated view on banks non-interest income. We divide non-interest income in fees and commissions and trading income. Revenue sources for fees and commissions include both traditional commercial banking services like settlement, credit lines, credit cards, foreign exchanges and investment banking services like brokerage and advisory fees. In recent years, commission fees from sales agency services for insurance and mutual funds products have gained importance. Trading income primarily refers to the net gains/losses from banks trading of foreign exchange, fixed-income, equity and derivative products on its own account proprietary trading. Fees and commissions income of banks for providing brokerage, agency and advisory services remains in most times profits, whereas trading income is
See for instance Kroszner and Rajan (1994). Saunders and Walter (1994) provide good theoretical and empirical foundation for the universal banking system. 16 Nurullah and Staikouras (2008) show the predominant role of banks as life insurance sales agent in European countries like Spain, Italy, France and Belgium, 17 For an overview of discussions on benefits and costs in integrated financial services providers, see for instance Loechel, Brost and Li (2008). 6
15 14

highly volatile subject to capital markets mood and can turn to be huge losses. Due to the high volatility and loss potential in non-interest income, especially in trading income, voices are louder to limit the business scope of commercial banks to loans and deposits. We emphasize however that the limitation of the business scope is unrealistic in modern banking as the operating environment has gone fundamental changes in last years: Innovation in information and communication technology has changed the fundamentals in banking. Modern information and communication technology challenges banks role as information producer. International convergence in disclosure requirements enables higher transparency and comparability about lending firms and the internet facilitates seamless communications between investors and lenders. Large firms, the core corporate clients for most internationally operating banks, turn directly to capital markets by issuing commercial papers and bonds for short-term and long-term financing. Calculations of Royal Bank of Scotland show that direct financing through bonds already accounts for 64% of external financing of large firms, compared to (syndicated) loans.18 Global competition has depressed interest rate spread in banking. Not only the loss of large corporate lenders due to disintermediation, but also the pressure on interest margin due to fierce international competition as a result of financial markets deregulation and information transparency shakes the dominance of interest income as revenue source in banking. Banks are facing more substituting products and service providers. Alternative investment in money markets, investment funds and insurance products has channeled deposits directly into capital markets or to insurers. Lower cost structure through large-scale data processing in internet banking and on-line brokerage firms further challenges banks market position as sole financial intermediators. The settlement function of banks has been more and more outsourced to external IT-specialists. Rating agencies and financial information providers have been increasingly replacing banks role as credit monitor; Financial advisory services for corporate clients have become more sophisticated. Capital market knowledge and risk management expertise of banks are increasingly demanded by internationally operating large corporations with decreased needs for bank loans. Demographic changes generate demand for individualized products for long-term private wealth accumulation. Asset management, insurance and pension have gained weight in financial markets. As a consequence, global operating banks have adjusted their business model, expanding the business scope more in investment banking, asset management or even insurance and non-interest income has gained weight as revenue source. Backed by an upward trend of business circle in overall economy and capital markets, the diversification in Western banking especially in proprietary trading granted years of double-digit capital return and induced the radical transformation of banks role from lenders to traders. The excessive engagement in profit making from speculative asset bubbles beyond the needs in real economy uncovered the risk side of the business model and is blamed as one of the main causes of the financial crisis. Some banks went too far, moving from capital market trade facilitator to risk taker19, which brought the whole financial system in fragility. We believe that lessons are learned that there will be a return from the capital-market focused universal banking model to the customer-centric universal model in banking with a balance of commercial and investment banking activities determined by the needs of the real economy instead by greed for short-term profits. Regulatory reforms are of necessity in the post-crisis time. The radical cut-off of proprietary trading from commercial banks is however subject to closer look, since proprietary trading is actively engaged in banks asset-liability and risk management. The exclusion of commercial banks as market makers would have undesirable consequence of the overall liquidity on capital markets. Barth, Caprio and Levine (2008) even prove empirically that activities restriction in banking increases the probability of banking crisis. If activities restriction is unrealistic or expensive in the time of disintermediation, global convergence of regulation on integrated financial services providers has become an urgent task. Research in this field is already under way: Blundell-Wignall, Atkinson and Lee (2008) propose to bundle diversified services in banking only under non-operating financial holding to prevent risk transfer. Change of paradigm to integrated risk management urges, with emphasize on interactions of various risks from interest and non-interest income within a financial
18 19

See Hennes and Metzger (2010). See BCG Creating Value in Banking 2009. 7

conglomerate group.20 Compulsory disclosure of non-interest income business lines has become necessary to evaluate the aggregated risk profile of a universal bank. The above discussions are of special value for Chinas banking reform, since China is on trace of the transformation from the segregated to the universal banking system. Chinese scholars are increasingly analyzing lessons of Western universal banks to develop a universal banking model suitable for the Chinese reality. Chen (2009), Professor for economics at Renmin University of China, recently points out that the restriction of permissible services in banking leads to banks concentration on lending business, which in turn causes pro-cyclical credit expansion. Mao (2008) addresses that the high risks from proprietary trading diminished the diversification benefit of universal banking in the crisis and emphasizes that the non-interest income business in universal banking should concentrate in fees and commissions services. The transformation of Chinas banking sector towards the universal banking model has become an urgent task in recent years, as: Foreign competition and integration of China in global financial markets put pressure on traditional banking business model. After Chinas accession to WTO, foreign banks were granted to full license of local currency also to retail clients after December 200621. Over the world, functional separation of commercial and investment banking were lifted, in 1986 in the UK, 1987 in Canada, 1992 in Japan and in 1999 in the USA for example. Foreign competitors in China are not only involved in deposits and lending with strong position in foreign currency lending and trade financing, but also are active in high value-added investment banking business like derivatives trading, M&A advisory and asset management. With the entry of foreign universal banks, Chinese banks bear risk of the loss of business opportunities in cross-sector services to foreign competitors, if Chinese banks miss the chance to build up capacities for cross-sector services due to strict activities permission in a separated banking system. Currency and interest rate liberalization in next years is anticipated in line with the State Councils plan to build up Shanghai to an international finance centre till 202022. The business model of concentration of revenue source on lending of the current over 80% on average in Chinas banking sector can not sustain in the more liberalized operating environment with lower margin. Bolstering revenue through loan expansion bears the risk of excess market liquidity and asset bubble.23 Chinese banks face the challenge to change the quantity-based competition to quality-based competition with diversified products, markets and channels24. Leveraging banks transformation provides the key solution for solving the co-existence of high excess liquidity in the banking sector and limited financing access of private SME companies. As in figure 1 depicted, over 80% of financial assets in China are concentrated in the banking sector, which bears high concentration risk for the entire financial system. Extending banks scope to securities services, asset management and insurance can broaden financing access for corporates and build up social securities for private households.

20 21

See for instance the recent research results of BIS on interaction of market and credit risk, BIS (2009). Till the end of 2008, seven local incorporated foreign banks were granted license for RMB retail business; 51 banks were granted license for derivatives trading, see CBRC (2008), p. 44. 22 For details of the plan to build Shanghai as an international finance centre, see Loechel/Boeing (2010). 23 Foos, Norden and Weber (2009) show that abnormal loan growth leads to higher credit losses, lower bank profitability and higher bank insolvency risk. 24 Jamie Dimon, CEO of JPMorgan Chase, observes the need for diversification in Chinese banks and puts the evolution of JPMorgan as an example for Chinese banks expansion into fee business, see Dimon (2009). 8

Figure 1. Distribution of Savings in China

Despite the relevance and urgency of the topic on banks non-interest income business, relevant research in this field, especially for the Chinese case, is rare.25 The current paper aims to fill this gap by evaluating the business model of Chinese banks in an international context and to contribute to the general debate on banking business model after the financial crisis.

III. Transformation of Segregated to Universal Banking System in China

As if by a miracle, Chinese banks escaped almost unaffected from the crisis year, in greater extent as a result of the lucky fact that Chinese banks still follow the narrow banking model with strict restriction in engagement of investment banking and the strict foreign currency control policy in China prevents the risk transfer from international capital markets. This segregated banking system was established in 1993 with the issuance of Resolution on Financial System Reform of the State Council and legally established with Article 43 of the Law of Peoples Republic China on Commercial Banks issued in 1995: Commercial banks are not allowed to make trust investment, trade in shares or make investment in fixed assets of non-self use within the People's Republic of China. Commercial banks are not allowed to make investment in non-banking institutions and enterprises within the People's Republic of China. Correspondently, the separation of securities from banking is regulated through Article 6 of the Securities Law of the Peoples Republic of China enforced in 1998: Securities business shall be engaged in and administered as a business separate from the banking business, trust business and insurance business. Securities companies shall be established separately from banks, trust companies and insurance companies. The integration of banking in insurance institutions is restricted according to Article 104 of the Insurance Law of the Peoples Republic of China issued in 1995: : The use of fund of the insurance company is restricted only to bank deposit, trading of government bonds and financial bonds and other forms of fund utilization stipulated by the State Council. The fund of the insurance company may not be used to set up securities operation organizations or to invest in enterprises. According to the above articles, combination of banking with securities services, real estate and insurance, which are usually included under one roof in European style integrated financial services providers, are prohibited by law in China. Even in international comparison with developing countries, China still belongs to the 10% minority of countries with the most strict activity restriction in the banking sector26. Furthermore, the Provisional Rules Governing Money Brokerage Firms issued in 2005 grants only non-bank institutions permission to set up money brokerage firms. Chinas choice for the segregated banking model is all other than accidental. Chinese Academy
25 26

Sauders and Walter (1996) are among the first to address the development of universal banking in the Asia Pacific context. See IIB Global Survey (2009) and Barth, Caprio and Levine (2001). 9

of Social Science (2001) argues that this decision made in the 1980s was in accordance with the acknowledgement of the draw-back of conflicts of interests in universal banks and the lacked skill in managing risks in diversifying institutions in the immature stage of Chinas financial institutions, after thorough comparative studies on the America style separated banking system and the European style universal banking system. With the pace of global deregulation of activities restriction in banking and market demand for diversified services, financial conglomerates with holding subsidiaries in banking, securities and insurance emerged in China27 and some banks like BOC actually by-passed the restriction by setting up subsidiary for cross-sector services in securities and insurance abroad like in Hong Kong. In 2004, an opening clause...with the exception stipulated by the State was introduced to Article 43 of the commercial bank law and article 6 of the securities law regarding business restriction, which marked the first step of the loosening of activities restriction. Banks should leverage their dominant position in the financial system to foster diversified financing sources and channel funds to capital markets through providing products and services in securities and asset management. With the overall market enthusiasm for banks diversification in other revenue sources than lending and to promote capital market development, PBC28, CBRC and CSRC jointly issued in February 2005 Administrative Rules for Pilot Incorporation of Fund Management Companies by Commercial Banks, which established the legal permission for SOCB and JSCB as primary shareholder in equity-holding of fund management companies. Banks are permitted to sell fund products of affiliated fund management companies on the commission basis, however only under third-party condition. The aim was to channel the high liquidity in bank deposits to capital market investment, to increase competition between fund management companies, as well as to diversify banks revenue resources. This step was regarded as a significant step to transfer Chinas banking system from the segregated to the universal banking model with a holding structure. Pilot permissions were granted to three of the big five SOCBs: ICBC, CCB and BOCom29. Already before this deregulation, BOC circumvented the sector separation by setting up its majority holding fund management company through its holding subsidiaries in Hong Kong in 2004. After the liberalization, the shares were transferred to BOC in 2008. As the last SOCB, ABC got the license in 2008 and founded its own fund management company. All five SOCB-held fund management companies were established as joint ventures with foreign financial institutions. The permission to cross-sector bank holding in fund management companies granted to five SOCBs was expanded to two JSCBs - SPDB30 and China Min Sheng Bank, setting up joint venture fund management companies in 2007 and 2008 respectively. As depicted in figure 2 and figure 3, the liberalization of banks participating in fund management companies triggered an expansion in market share of bank related asset managers in the form of bank subsidiary, bank affiliation and financial conglomerate affiliation31. The fifteen fund management companies with bank-linkage occupied 38.70% of total market share in total assets under management among total sixty fund management companies only three years after the liberalization in 2005.
Figure 2. No. of Fund Management Companies
50 45 40 35 30 25 20 15 10 5 0 45 8.16% 6.41%

Figure 3. Market Share of Fund Management Companies per Total Assets 2008

24.14% 7 2 Bank subsidiary Bank affiliation Financial conglom erate affilation Stand alone Bank subsidiary Financial conglom erate affilation Bank affiliation Stand alone 6 61.30%

Source: Wind
27 28

For the development of financial conglomerates in China, see for instance Lin (2003). The Peoples Bank of China (PBC) is the Central Bank in China. The regulation and supervision of financial institutions is carried out through the central bank plus three commissions (Yi Hang San Hui) system in China. Three commissions include the sector supervisory bodies CBRC, CSRC and CIRC. 29 BoCom: Bank of Communications 30 SPDB: Shanghai Pudong Development Bank 31 Bank subsidiary is defined in this paper as a fund management or securities company majority-held by a bank, bank affiliation is a fund management or securities company minority held by a bank and financial conglomerate affiliation is a fund management or securities company with a financial conglomerate as major shareholder which also has equity participation in banking within the group. 10

Moreover, the equity link of banks with fund management companies promotes the agent and custody services in banking. Although banks with fund management affiliates are only allowed to conduct business contracts with their affiliates under the same condition as with third party, the business cooperation with affiliated parties is more intensified and the scope of cooperation is broader and deeper, especially that bank as sales agent may favorably choose affiliated funds, securities and insurance companies as partner. The cooperation with affiliated companies is however restricted through Article 8 of the Law of Peoples Republic of China on Securities Investment Fund issued enforced in June 2004, A fund trustee and a fund manager should not be the same party, and should not make capital contribution to or hold the shares of each other. Since eleven of the total fourteen banks with a custody license are listed on the exchange, the above Article is in current discussion to be removed in order to enable fund management companies to optimize their investment portfolios including shares of their custody banks. The manifold possibility of cooperation of banks with their affiliates can be illustrated with the following example: Industrial Bank Co. Ltd., Industrial Securities Co. Ltd. and Industrial Fund Management Co. Ltd., for instance, signed a MoU for strategic alliance in 2007 to share client base, distribution channel, product information and training capacities. The lifting of the separation of banking from fund management in 2005 changed dramatically the landscape of the distribution model in fund products. As shown in figure 4, bank gained significant ground in fund distribution and took over almost 80% of the market share within two years after the policy liberalization.
Figure 4. Fund Sales Channel
90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2004 2005 Fund
Source: Securities Association of China

2006 Bank Security

2007

This policy change opened new revenue resources with high growth potential alongside with the booming capital market. Total bank custody fee skyrocketed in 2007 and almost reached the mark of five billion CNY (see figure 5). With the vast branch network, broad customer base and capital strength, the big five SOCBs dominate the fund custody market and took over 90% the market share, as illustrated in figure 6.
Figure 5. Bank Custody Fee
60 50 in 100m CNY 40 30 20 10 0 1998 1999 2000 2001 Fee 2002 2003 2004 2005 2006 2007 500 450 400 350 300 250 200 150 100 50 0

SH Com posit Index

Source: Almanac of China's Securities Investment Funds, wind

Rebased 1998=100

11

Figure 6. Market Share of Fund Custody 2007

Other banks, 9% BoCom , 8% ABC, 14% ICBC, 31%

BOC, 16%

CCB, 22%

Source: Securities Association of China

Compared to the rapid rise of banks in the fund management market, banks equity holding in securities firms is limited. There is only one securities subsidiary of a bank in China BOC International (China) Ltd. founded as a subsidiary in 2002 by Bank of China International Holdings, a Hong Kong-based wholly-owned subsidiary of Bank of China Ltd. Securities affiliates of financial conglomerates have long track record in securities services and hold 13.86% of total market share. However, 96 stand-alone securities companies still dominate the market, with 77.47% of total assets in the securities market, as shown in figure 7 and figure 8. From the policy side, it is not expected to see a rapid liberalization and the consequent expansion of banks market share in securities services in the near term, as what happened in the fund management market with a strong supporting policy favoring banks engagement. The cautious approach of the Chinese government in dealing with securities services demonstrates its great concern about the transfer of volatile capital market risks to the banking system.
Figure 7. No. of Securities Companies
120 100 80 60 40 20 0 Bank subsidiary Bank affiliation Financial conglom erate affilation Insurance subsidiary Stand alone 1 3 5 1 77.47% Bank subsidiary Financial conglom erate affilation Stand alone Bank affiliation Insurance subsidiary 96

Figure 8. Market Share per Total Assets 2007

1.25% 6.08%

13.86% 1.35%

Source: Securities Association of China, China Securities Yearbook

The financial crisis seems not to distract China from its cautious plan of gradual loosening of activities restriction in banking. In November 2009, CBRC issued Provisional Rules on Commercial Banks Share Holding in Insurance Companies, granting banks equity participation in insurance companies. Over years, especially the big five SOCBs and JSCBs have build up financial holding emporia with business lines covering banking, securities, asset management, leasing, insurance etc. with subsidiaries at home and abroad. As shown in Figure 9 as an example, the financial group BOC Ltd. covered financial services in banking, insurance, investment and leasing. Similar to the situation in many of its domestic peers, Hong Kong SAR32, with its liberate regulatory boundary in business diversification for financial institutions, is a preferred location for Chinese banks to explore the expansion in cross-sector services. The investment-banking arm of BOC Bank of China International (China) Ltd. was founded as a subsidiary of BOCs wholly owned Hong Kong subsidiary BOC International Holdings Ltd. to enable the best knowledge and personnel transfer in securities services from Hong Kong to Mainland China.

32

SAR: Special Administrative Region 12

Figure 9. Group Structure of BOC

Source: Bank of China Annual Report 2008

China has chosen a gradual and cautious pace in relaxing activities restriction in banking. Compared to European-style universal banking with commercial and investment banking under one roof, China follows the Anglo-Saxon approach of financial holding company. The most remarkable difference compared to universal banks in Western style is the limited scale in proprietary trading. Trading products are in majority less risky fixed-income products as well as interest rate and foreign exchange derivatives for risk hedging. For each category of trading instruments, a separated license should be applied. The licenses are linked with strict capital and human resource requirement. For instance, the Rules on Proprietary Trading in Foreign Currency of Financial Institutions issued in 1993 set US$20 million as the minimum capital for foreign currency trading. The management and trader should have gained working experiences in trading for five and three years respectively. With the belief that banks have gained knowledge over time, the scope of trading securities is gradually expanded to stocks, commodities and derivatives. Permissions are however predominantly granted to preferential SOCBs and advanced JSCBs which can meet the strict requirements in capital strength, risk management capacity and specialist know-how. The overall result shows a rapid expansion of Chinese banks into non-interest income sector since the policy change in 2005. Universal banks in China benefited from the capital boom from 2005 to 2007 and gained considerable market shares in fund distribution, custody and insurance agent services. With the trend of the internalization of the Chinese currency and the subsequent liberalization of interest rates as well as the development of Chinas capital markets and disintermediation to more direct financing, the move of Chinese banks from the narrow banking model to the universal model seems to be irreversible. The meltdown of the Western banking model with excessive leveraged trading is seen as a confirmation for Chinas caution in liberating Chinese banks engagement in proprietary securities trading. In the following section, we compare the current business model of Chinese banks with banking models of Western peer banks, try to understand the return and risk impact of revenue diversification in non-interest income in Chinese, European and Anglo-Saxon banks and to prognosticate the further pace of this transformation.

13

IV. Chinas Banking Business Model in International Comparison 4.1. Data description
In this section, we compare the business models of Chinese banks with their European, UK and US peers, using data both for top banks defined as the top five banks per total assets in respective regions/countries and panel data of bank annual financial reports over the time frame from 2003 to 2008.33 We try to understand how differently Chinese banks operate compared to their Western peers and evaluate the sustainability of the current model. Data are drawn for commercial banks from the database Bankscope34. In order to capture the whole business rage in universal banking, we choose the consolidated financial statements of the selected commercial banks.35 Figure 10 provides a comparison of the development in total assets in top banks. As shown in figure 10, the largest banks are concentrated in the Euro area. In Europe, seven banks passed the total assets threshold of one trillion USD (Deutsche Bank, BNP Paribas, Socit Gnrale, Banco Santander, UniCredit, ING Bank and Calyon) at the end of 2008. All big four Chinese SOCBs (ICBC, CCB, ABC and BOC) reached the level of their international peers with over one trillion USD total assets. Barclay, RBS, HSBC from the UK and Bank of America, Citibank from the US play in the same league of large banks with over one trillion assets. With the increasing financial depth in China (currently 278% of GDP, 314% for the Euro zone, 326% for the UK and 385% for the US)36, a further expansion of assets in Chinese banks in next years is expected. Backed with similar operating scale as internationally operating banks, Chinas SOCBs have the potential to upgrade theirs business model to compete with their international peers.
Figure 10 . Average Total Assets - Top 5
2,500,000 in million USD 2,000,000 1,500,000 1,000,000 500,000 0 2003 2004 China
Source: Bankscope

2005 Europe

2006 UK US

2007

2008

The overall statistics of the sample are provided in appendix B. For the whole banking sector, Chinese banks with the average asset return of 0.68% still lie behind the level of European, UK and US banks with asset return of 0.89%, 0.85% and 0.97% respectively. On the aggregated level, Chinese banks are still weak in equity strength (with average equity ratio of 4.98% compared to 9.63%, 11.85% and 11.10% in Europe, the UK and the USA respectively) and asset quality (with average NPL ratio of 5.05% compared to 3.22%, 2.20% and 0.88% in Europe, the UK and the USA respectively). Regarding the business scope, revenue resources are highly concentrated in interest income with non-interest income as percentage of gross revenue of average 14.25%, compared to 45.22%, 36.14% and 27.99% in European, UK and US banks respectively. Chinese banks benefit from stable savings deposit as main financing source with 80.78% of assets from customer deposits (compared to 40.87%m 55.57% and 70.89% in European, UK and US banks respectively) and enjoy high asset growth with average growth rate of 26.21% (compared to 15.33%, 14.11% and 16.26% in Europe, the UK and the USA respectively). Remarkable is the very limited involvement of Chinese banks in trading with trading asset ratio as percentage of total assets of
33 The total sample size is summarized in appendix A. The short time frame is chosen since the development of universal banking is a relatively new phenomenon in line with the recent loosening of activities restriction in China, and data availability is limited for Chinas banking sector before 2003. Over the sample years, Chinese banks underwent fundamental restructurings. Both factors could limit the explanatory power of the results. 34 Bankscope universal format is applied to mitigate the deviation in term definitions. 35 Consolidated reports are only available for 17 Chinese banks. For the rest of Chinese sample banks, unconsolidated bank reports are applied. Since the majority banks with unconsolidated reports do not have subsidiary entities, the results will not be altered with this limitation. 36 See McKinsey Global Capital Markets: Entering a New Era (2009). 14

1.97% (compared to 8.54%, 8.70% in European and UK banks respectively). The composition of interest and non-interest income of Chinese banks in comparison with their Western peers as well as the return and risk impact of the differences in business scope are of our special interest in the analyses in this section.

4.2. Business model comparison Revenue pattern - interest income

In the following, we explore the pattern of revenue resources in banking. We first take a look at the composition of revenue sources in top five banks. Figure 11 manifests the high reliance on lending business in top Chinese banks. The average portion of non-interest income in gross revenue of 14.8% lies far below the level of peer banks in Europe with 51.8%, in the UK with 46.5% and 41.0% in the US. The figure clearly indicates that Western commercial banks have more balanced revenue sources between interest income and non-interest income businesses to cope with disintermediation in their operating environment, while Chinese banks still struggle for a break-through in creating value with high value-added financial services beyond the lending business. Based on this observation of top banks, we assume: Hypothesis 1: Compared to Western banks with balanced portfolio of loans and high value-added non-interest income products, asset return in Chinese banks depends highly on lending business with net interest margin and asset quality as profitability determinates.
Figure 11. Non-interest Income / Gross Revenue - Top 5
70 60 50

Percentage

40 30 20 10 0 2003 2004 B5 2005 EURO UK 2006 USA 2007 2008

Source: Bankscope

To test hypothesis 1, we conduct in the following regression analyses for the testing fields based on panel data37. The OLS model is used for the following regression equation (Basic model: China, Europe, UK and USA model 1): ROAAit = + 1 * [Ln (total assets)] it + 2 * [equity/total assets] it + 3 * [net interest margin] it + 4 * [cost income ratio] it + 5 * [growth of total assets] it + 6 * [impaired loans/gross loans] it + 7 * [non-interest income/gross revenue] it + it

With the above equation, we try to test the influence of seven explanatory variables for i bank at time t on profitability measured with ROAA 38 . We choose asset return ROAA instead of equity return ROAE as profitability indicator, because Chinese banks experienced higher fluctuation in equity through asset injection and IPO in last years, and some banks even had negative equity in early sample years before the capital injection. The seven explanatory variables include the natural logarithms of total assets, equity ratio, net interest margin, cost income ratio, asset growth, impaired loan ratio and non-interest income ratio. The total regression results are
37

We conduct separated regressions for the four countries/regions instead use pooling data with country/region dummy variables, with the belief that the profitability of banks in those countries/regions follow different patterns. 38 ROAA: return on average assets, ROAE: return on average equity. 15

summarized in appendix C. The seven variables in the basic models jointly explain 43%, 24%, 51% and 51% (adjusted R) for the return pattern in China, Europe, the UK and the USA respectively. Comparing the results of regression constants, the insignificance of the constant factor in China reveals the high heterogeneity of asset return among diverse types of commercial banks in China, whereas the asset return of Western banks converges to a level of over 1% at 10% significance level (1.0107, 1.0660 and 1.8608 for European, UK and US banks respectively). In China model 2 where the sample concentrates on the biggest commercial banks in China, the regression constant with 1.5896 at the 1% significance level shows that the profitability in strongest Chinese banks, including five SOCBs and listed JSCBs, lies on an international comparative level. Across the research fields, banks with equity strength (with significantly positive regression coefficients of equity ration of 0.0197, 0.0747, 0.0364 and 0.0256 for China, Europe, the UK and the USA respectively) and favorable cost income structure (with significantly negative regression coefficients of cost income ratio of -0.0178, -0.0123, -0.0073 and -0.0233 in China, Europe, the UK and the US respectively) have significantly higher asset return. The increase of 1% in net interest margin in China contributes to 0.01882% higher asset return, compared to 0.0748% in the UK and 0.01689% in the USA. Margin increase in Europe has however no significant impact on asset return. In comparison, the increase in 1% of non-interest income ratio as percentage of gross revenue leads to significantly higher asset return of 0.0144% in Europe, compared to 0.00795 in China and 0.0100 in the USA. Summarizing the balance of interest income and non-interest income as revenue sources, European banks exhibit the highest level of disintermediation. Valverde and Fernndez (2007) explain that European universal banks charge low net interest margin for client access and create value through bundling and cross-sell high value-added non-interest income businesses. Asset expansion in both Chinese and UK banks contributes to higher return (with regression coefficients of 0.0026 in China and 0.0241 in the UK). In China, larger banks demonstrate significantly higher asset return (with the regression coefficient for the natural logarithms of total assets of 0.0293), whereas the size affect is not significant in Western peers. In Western banks, asset quality predominantly determines the rate of asset return. The regression coefficients of impaired loan ratio are -0.0626, -0.2049 and -0.2884 in Europe, the UK and the USA respectively. In contrast, the regression shows no significance of the impact of impaired loan ratio in China. This could be explained by the fact that there were structural changes of NPLs in Chinese banks due to restructuring programs in last years. For example, the impaired loan ratio in top five banks dropped dramatically from the average of 17.6% in 2003 to 2.6% in 2008, as shown in figure 12. In the subsequent years, banks were forced to take tremendous efforts to improve lending practice by replacing policy lending, establishing more market oriented lending mechanism and better risk management39.
Figure 12. NPLs / Gross Loans - Top 5
20 18 16 14 12 10 8 6 4 2 0 2003 2004 B5 2005 EURO 2006 UK 2007 USA 2008 Percentage
39

Source: Bankscope

We future examine the level and impact factors of net interest margin, another determinant in lending business beside asset quality. Ho and Saunders (1981) reveal that various factors have impact on net interest margin: banks risk perception, size of banks transactions, banking market structure and market interest rate variance. Saunders and Schumacher (2000) further recover that regulatory components like restrictions on deposits, reserve requirement, capital ratio etc. also have influence on banks net interest margin. As exhibited in figure 13, Chinese
For an overview of the restructuring programs in Chinas banking reform, see for instance Wang (2009) 16

top five banks enjoyed an average interest margin of 2.6%, compared to the European average of 1.1% and 1.3% in the UK. The low margin in continental Europe and in the UK of large banks can be partially explained by the fierce competition for large European banks and the dominant universal banking model in which interest margin is kept low to maintain long-term client relationship and revenues from cross-selling non-interest income products and services to those clients play an important role. Only in the US, large banks achieved a slightly higher average margin of 2.8% in last years. For the whole banking sector, the average net interest margin of Chinese banks with 2.78% is relatively low compared to 3.38% in Europe, 2.98% in the UK and 3.53% in the USA (see attachment B). However, the extreme low standard deviation of 0.94% in Chinas banking sector (compared to 16.92%, 4.00% and 1.30% in Europe, the UK and the USA respectively) reveals in some extent a more differentiated pricing policy in Western banks with broader client scope of diverse risk profiles.
Figure 13. Net Interest Margin - Top 5
4.0 3.5 3.0 Percentage 2.5 2.0 1.5 1.0 0.5 0.0 2003 2004 B5 2005 EURO 2006 UK 2007 USA 2008

Source: Bankscope

In China, policy component PBC could play a significant role in explaining the magnitude and variance of banks interest margin. Under the current interest rate regime, the central bank of China PBC sets a ceiling of deposit rate and a floor of lending rate, which for example guarantees an official net interest margin of current 3.06% for one-year loan in local currency, as illustrated in figure 14. This guided interest rate system was established through Interim Measures of the Administration of RMB Interest Rates in 1990 and the revised version Administrative Provisions on RMB Interest Rates issued in 1999, which granted the central bank PBC the authority to set the ceiling deposit rates and floor lending rates. The interest rates on the inter-bank markets and repo rates are allowed to be negotiated among institutional market participants. A floating of the lending rate within the range of 0.9 and 2.0 is permitted from 2004 on, the ceiling deposit rate is however obligatory. The goal is to use guided interest rate as macro-prudential measure for monetary control as well as to prevent banks from losses in fierce competition through high interest rate promise and dumping lending rates40. For foreign currency depositing and lending, the price mechanism is more market oriented since only the interest rate for deposits under the limit of 3 million USD is ceiled with a guided interest rate issued by PBC. However, the strict capital control in flows of foreign currency diminishes the freedom in market pricing. The guaranteed profit margin in RMB lending keeps Chinese banks away from the level playing field with international peers which price loans solely on market condition. The artificial higher profit partially conceals the hiding inefficiency in pricing and risk management and impedes innovation in new products and services in Chinas banking sector. The higher official-set margin can only be held with the current system of capital control for foreign currency capital account. With the internalization of the Chinese currency and more openness of its financial market in the foreseen decade, it is expected that the interest rate regime will be reformed in the direction of more market orientation. Till then, Chinese banks, which fail to build up risk pricing capacity and balanced revenue portfolio, will risk their ability in standing the competition with international peer on a level playing field.

40

Saunders and Schumacher (2000) also argue that policy settings in interest rate is used as instruments to balance the trade-off of bank solvency (high equity ratio, high margin for example) with lower financing costs (lower margin). 17

Figure 14. Net Interest Margin from Guided Interest Rates 1991-2008
14 12 Percentage 10 8 6 4 2 0
19 91 .0 19 4 .2 93 1 .0 19 5 .1 5 93 .0 19 7 .1 95 1 .0 19 1 .0 1 95 .0 19 7 .0 96 1 .0 19 5 .0 1 96 .0 19 8 .2 97 3 .1 19 0 .2 3 98 .0 19 3 .2 98 5 .0 19 7 .0 1 98 .1 19 2 .0 99 7 .0 20 6 .1 0 02 .0 20 2 .2 04 1 .1 20 0 .2 06 9 .0 20 4 .2 8 06 .0 20 8 .1 07 9 .0 20 3 .1 8 07 .0 20 5 .1 07 9 .0 20 7 .2 1 07 .0 20 8 .2 07 2 .0 20 9 .1 5 07 .1 20 2 .2 08 1 .0 20 9 .1 6 08 .1 20 0 .0 08 9 .1 20 0 .3 0 08 .1 20 1 .2 08 7 .1 2. 23

Date of PBC Interest Rate Adjustment

Deposit
Source: PBC

Loan

Margin

Based on the above observation of interest rate setting, we assume: Hypothesis 2: Due to the administrated interest rate regime, the risk pricing mechanism in lending is distorted in Chinese banks. We test the risk pricing mechanism in banking by exploring the correlation of various profitability determinates with net interest margin. The results are summarized in appendix D. The striking observation is the negative sign of the correlation between impaired loan ratio and net interest margin for Chinese banks compared the positive correlations in Western banking. While the risk pricing rule lower asset quality in terms of higher NPL ratio, higher margin functions well in Europe and in the UK (with correlations of 0.2403 and 0.5388 respectively), the negative correlation in China with -0.1997 is statistically significant at the 1% level. This observation manifests partially that the government administrated interest rates distort risk pricing mechanism in lending practice of Chinese banks. Furthermore, the close relationship between cost income ratio and net interest margin in China with -0.4608 confirms that the high interest margin instead of operational efficiency explains partially the lower cost income ratio in China. The consistent negative correlation between non-interest income ratio and net interest margin in all testing fields (-0.6316, -0.1025, -0.1662 and -0.3229 in China, Europe, the UK and the USA respectively) documents that the decline in net interest margin forces banks to expand the business scope in non-interest income business. The highest correlation between net interest margin and non-interest income ratio in China (-0.6316) demonstrates that the administrative guaranteed high net interest margin reduces in large extent the incentive of revenue diversification in Chinese banks. The high negative correlations between trading securities ratios with net interest margin (-0.1570, -0.5239 and -0.1136 in Europe, the UK and the USA respectively) reveal that the thin margin in lending business further drives Western banks to diversify securities trading. In respect of the size effect, the negative sign of correlation with total assets shows that large banks in all testing fields are not able to use the market power to push through higher margin, which dilutes the concern of the monopoly power of current large size banks. To summarize the results from the above analysis of interest income as revenue source, the profitability pattern in Chinese banks has the highest dependence on net interest margin. Especially in European universal banks, the correlation of non-interest income ratio with between net interest margin is statistically not significant, which shows the highest disintermediation rate in European universal banks. Furthermore, the risk pricing mechanism is still not well established in Chinese banks due to the administrated interest rate regime. Western peer banks demonstrate in comparison consistent risk pricing pattern: lower loan quality, higher net interest margin. The guaranteed high margin diminishes partially the incentive of Chinese banks to expand the business scope in non-interest income businesses. Facing margin pressure, Western banks are diversifying in trading business. The findings from the comparison cause much concern about the sustainability of the current business model in the Chinese banking sector: At the latest when big SOEs turn directly to capital markets for fund raising and the interest rate is liberalized and adjusted to an international conventional level, Chinese banks which fail to build up capacities for risk pricing in lending business and to balance interest income and non-interest income business will
18

suffer from a sharp decrease in profitability.

Revenue pattern - non-interest income

Having recognized the backlog in revenue diversification, Chinese banks took tremendous efforts to develop non-interest income businesses, backed by supporting policy and taking advantage of the capital market boom for insurance and funds agency and custody services in the last upward cycle. In absolute term, the scale of net income from fees and commissions lies however half to two-third of the level of comparable peers from the UK or Europe, as shown in table 1. And the potential in bancassurance products is not fully explored in China. It is remarkable that the revenue scale of securities trading in Western top banks almost reached or even surpassed the level in fee and commission business, whereas the scale in trading of Chinese large banks amounted to only a small fraction of net income from fees and commissions. Measured by the fraction of trading assets in total assets, the limitation of Chinese banks trading activities is evident, with an average rate of 1.1% (20.1% in Europe, 13.8% in the UK and 9.3% in the US), as illustrated in figure 15. The immature stage of revenue diversification in Chinese banks results on the one side from the fact that the loan business generates sufficient profit thanks to high interest spread and loan growth rate, on the other side from the underdeveloped stage of capital markets as well as limited experience and resources in cross-sector services. Another remarkable fact is that only a small fraction of investment securities (BOC for example 5.3% in 2008) belongs to the active trading securities designated as the asset class financial assets at fair value through profit and loss and the majority of the investment securities are high-graded bond securities of the public sector (BOC for example with 66.7% in government and public sector bonds, 27.1% in bonds of financial institutions, 5.5% in corporate bonds and 0.8% in equity and other securities in 2008). Trading securities in Chinese banks are mainly fixed-income products of lower risk class and in some extent foreign currency and interest rate derivatives for risk hedging. When we compare the results from 2008 with those of 2007 shown in table 2, it is noticeable that the high volatility in trading income is in great contradiction to the stable income flows from the most positive fees and commissions income. In crisis time, losses from trading can even diminish the total net fee and commission income, as the case of Deutsche Bank in 2008. Fees and commissions remain as stable and positive revenue sources, since banks act mostly as value creator through providing financial market related services. The composition of non-interest income in fees and commissions as well as in trading of each bank shows the extent of a banks transformation from a capital market service provider and advisor to capital market risk taker.
Table 1. Overview of Non-interest Income Business in Top 5 Banks in 2008
Net G/L on Trading and Derivatives Net G/L on Securities Other Net G/L on Assets at FV through Income Sub-total Statement Net Insurance Income Net Fees and Commissions

in million USD

China ICBC CCB ABC BOC BoCom Europe Deutsche Bank BNP Paribas Socit Gnrale Banco Santander UniCredit UK Barclays Bank Royal Bank of Scotland HSBC Bank Bank of Scotland Lloyds TSB Bank USA Bank of America Citibank HSBC Bank USA Sallie Mae-SLM Corporation RBS Citizens Source: Bankscope (346) (4,058) n.a. n.a. 79 (1,671) (1,900) n.a. (186) 78 n.a. n.a. n.a. n.a. n.a. (2,017) (5,958) n.a. (186) 158 n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. 461 n.a. 2,327 (10,312) 5,480 (5,473) (17,095) 392 n.a. 151 n.a. 35 61 n.a. (2,026) n.a. n.a. 2,780 (10,312) 3,606 (5,473) (17,060) 1,576 n.a. 1,951 392 15,277 15,528 10,621 7,309 3,373 4,686 (49,756) (16,146) 6,750 1,764 (3,710) (969) (478) (249) 1,557 n.a. 34,530 19,028 (410) 893 (773) (16,195) 2,403 6,091 4,215 (4,482) n.a. 4,604 775 370 61 14,339 8,617 10,906 12,429 13,364 271 352 (647) (1,017) 224 (65) (324) 71 289 33 (101) 110 n.a. 164 n.a. 106 138 (576) (564) 257 n.a. n.a. n.a. 1,010 n.a. 6,330 5,531 3,424 5,747 1,271

19

Figure 15. Trading Securities / Total Assets - Top 5

30% 25% 20% 15% 10% 5% 0% 2003 2004 B5
Source: Bankscope

2005 EURO

2006 UK USA

2007

2008

Table 2. Overview of Non-interest Income Business in Top 5 Banks in 2007

Net G/L on Trading and Derivatives Net G/L on Other Securities Net G/L on Assets at FV through Income Sub-total Statement Net Insurance Income Net Fees and Commissions

in million USD

China ICBC CCB ABC BOC BoCom Europe Deutsche Bank BNP Paribas Socit Gnrale Banco Santander UniCredit UK Barclays Bank Royal Bank of Scotland HSBC Bank Bank of Scotland Lloyds TSB Bank USA Bank of America Citibank HSBC Bank USA Sallie Mae-SLM Corporation RBS Citizens Source: Bankscope (3,183) (2,804) n.a. n.a. 54 236 468 n.a. (96) 82 n.a. n.a. n.a. n.a. n.a. (2,947) (2,336) n.a. (96) 137 n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. 492 n.a. 7,528 2,287 6,983 370 6,280 1,121 n.a. 1,105 n.a. 10 587 n.a. 252 n.a. n.a. 9,236 2,287 8,341 370 6,290 1,039 n.a. 495 298 (4,190) 15,445 12,062 8,379 5,261 5,261 5,370 8,984 13,143 3,182 772 1,087 1,173 22 n.a. 1,762 4,438 1,765 (388) n.a. (5) 10,894 11,922 12,777 3,182 2,530 n.a. 3,942 1,035 438 45 16,842 8,664 10,317 11,019 12,924 178 111 227 406 33 56 171 5 (429) 86 (186) 47 n.a. (368) n.a. 47 328 231 (392) 119 n.a. n.a. n.a. 1,206 n.a. 5,046 4,119 3,025 4,675 933

To test the impact of securities trading on asset return, we extent the above regression analyses by adding three regression variables trading securities ratio and available for sale securities ratio as well as customer deposits ratio to the regression equation (China, Europe, UK and USA model 2). The results are summarized in appendix C. The surprising finding is that proprietary trading, either classified as trading securities or available for sale securities, does not generate significant higher asset return over the testing period in all testing fields, as indicated by the insignificant coefficients of securities ratio.41 This could result from the fact that the high volatile trading results from one year to another are only averaged out over years and do not generate constant higher asset return. The coefficients of net interest margin in extended models reconfirm that the profitability in Chinese banks is mainly driven by higher interest margin (0.1328 in China model 2), whereas the effect of margin in large Western
We replicate the extended model regression by excluding data sets from 2008 for the four testing fields to factor out the impact of the extreme market scenario in the crisis. Neither the coefficients of trading securities ratio nor those of available securities ratio are statistically significant at 10%. 20
41

banks42 is not significant. Non-interest income contributes constantly to higher asset return in European and UK banks with coefficients of 0.0109 and 0.0122 respectively.

Risk pattern
In the following, we investigate the risk reduction effect through diversification in non-interest income. To realize risk reduction through diversification, it is expected that: Hypothesis 3: The volatilities of interest income and non-interest income are not or negatively correlated. Regarding non-interest income (NII), we further separate the effects of fees and commissions (FC) and trading income, since we believe fees and commissions business and trading business have different risk pattern. We determine the risk term as the standard deviation of the outcome, nominated with the respective average value43. The risk factor for interest income (II) of i bank is calculated with the standard deviation of the banks outcome of interest income for the sample years, nominated with the average interest income of the bank: Risk IIi = Standard deviation ( IIi t ) / Average IIi

The same method is applied to calculate the risk factor for fees and commissions as well as for total non-interest income. We tried to determine the risk factor also for trading income, came however to only a few data sets, since the average income for the sample years usually turned to be negative. We test the correlations of the risk factors in the three business lines. As shown in table 3, fees and commissions income is significantly correlated with non-interest income in China, the UK and the USA with correlations of 0.2362, 0.4501 and 0.4823 respectively, which indicates that fees and commissions are driving forces of non-interest income in those countries. In all testing fields, the correlations between interest income and non-interest income are statistically not significant, which implies the potential of risk reduction through combining interest income with non-interest income. Noticeable, fees and commissions income is positively correlated with interest income in UK and US banks (with correlations of 0.2877 and 0.4834 respectively), but not significant in China and in Europe. In the UK and the USA, both interest income and fees and commissions could be more influenced by movement of macroeconomic determinants like interest rate level or general capital market mood, whereas fees and commissions in Chinese and European banks could more stem from stable sources like credit card fees, custody fees which are less sensible to determinants of interest income.
Table 3. Risk Correlation
China
II II p-value obs. FC p-value obs. NII p-value 0.0846 0.4078 98 -0.1257 0.2174 0.2362 ** 0.0192 -0.0041 0.9435 305 -0.0091 0.8734 0.0316 0.5831 305 0.2877 ** 0.0450 49 0.0247 0.8608 53 0.4501 *** 0.0012 49 0.4834 ** 0.0226 22 0.1208 0.2515 92 0.4823 ** 0.0230 22 FC NII II -

Europe
FC NII II -

UK
FC NII II -

USA
FC NII

obs. 98 98 311 II: interest income; FC: fees and commissions income; NII: non-interest income. *** / ** / * Statistically significant at 1% / 5% / 10% Source: Bankscope

We further compare the risk factors for interest income, fees and commissions income and non-interest income separately44 for the sample period to compare the magnitude of the risks. As shown in table 4, the fluctuation of revenues from fees and commissions as well as from total non-interest income business in Chinese and UK banks is statistically significant higher that that in traditional interest income business (0.3068, 0.5387 and 0.2917, 0.3417 higher for China and the UK respectively). Non-interest income in US banks also has a higher volatility than interest income (0.2030 higher). However, the variation of fees and commissions business in Europe and in
42 By adding two variables trading securities ratio and available for sale securities ratio, the sample size is reduced. We believe the remaining sample banks in regression model 2 are mainly large banks, since the financial reporting are more detailed. 43 In case the average value turns to be negative, the risk term is not included in the analysis, with the assumption that long-term average return should not be negative. 44 The risk factor for trading income is not used here since most mean values in trading income turn to be negative as the result of sharp down-ward movement in capital markets in the financial crisis. 21

the USA and that of total non-interest income in Europe are statistically not significantly higher than that of interest income. The overall results show that especially European banks have build up stable non-interest income sources.
Table 4. Risk Comparison
Variable Mean obs./p value Variable II 0.3928 98 FC 0.6996 98 China NII 0.9316 98 UK *** II 0.2699 92 FC 0.1670 22 II<FC (0.3068) 0.0000 *** II<NII (0.5387) 0.0285 ** II 0.8860 311 FC 0.3953 305 Europe NII 0.6739 311 USA NII 0.4729 92 II<FC 0.0185 0.7508 II<NII (0.2030) 0.0028 *** II<FC 0.4789 0.7979 II<NII 0.2121 0.6448

II FC NII II<FC II<NII Mean 0.2291 0.5153 0.5708 (0.2917) ** (0.3417) obs./p value 53 49 53 0.0149 0.0046 II: interest income; FC: fees and commissions income; NII: non-interest income. *** / ** / * Statistically significant at 1% / 5% / 10% Source: Bankscope

V. Synergies in Chinese Universal Banks: The Example of Asset Management Companies

The analyses above show the necessity and in part the direction of developing universal banking model in Chinas banking sector. In practice, reform is under way. The first trial of universal banking model in China - banks equity participation in asset management companies was introduced in the liberalization in 2005 and achieved great market success. We use this unique transformation as template to explore the benefits of allowing banks engagement in asset management. By matching the current 539 Chinese asset management funds with their respective asset management companies, we differentiate the funds between bank-majority holding funds (bank funds), bank-minority holding funds (affiliate funds), funds held by a financial conglomerate (conglomerate funds) and stand-alone funds (stand-alone funds). We analyze the characteristics and performance differences of these funds using data from 2007 to 200845. Data are draw from the database wind. As illustrated in table 5, bank funds emerged after the liberalization of banks majority holding in asset management companies in 2005. However, over 70% of asset management funds in number are still held by stand-alone fund management companies.
Table 5. Founding Year of Asset Management Funds
Bank (No.) 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 0 0 0 0 0 0 0 4 7 5 17 17 Affiliate (No.) 1 1 0 1 1 1 2 2 4 3 4 5 Conglomerate (No.) 2 4 1 1 4 8 8 6 14 12 14 11 Stand-alone (No.) 2 9 0 3 14 31 31 31 52 42 82 82

However, the test of asset size shows that bank funds, affiliate funds as well as conglomerate funds are significantly larger in size measured both with total assets and net assets under management at the end of 2008, as summarized in table 6. Bank majority held funds are in average 1.8748 billion CNY and 1.2007 billion CNY larger in total and net assets respectively than other types of funds. Funds minority held by banks also enjoy larger funds volume with 1.3057 billion CNY and 1.3226 billion CNY more total and net assets respectively. Conglomerate funds, which were established in early years competing along side with stand-alone funds, demonstrate the highest asset volume, with in average 2.1151 billion CNY and 2.0230 billion CNY more total and net assets than other funds. This result demonstrates that bank-related funds are able to draw investors attention and to attract more financial resources. The comparative advantage of banks could be related with the strong fund
45

This time frame is chosen for reason of better funds data availability from 2007 on. 22

distribution ability due to reputation of established brand and vast distribution network in bank branches.
Table 6. Fund Total Assets Comparison
Mean Variable Bank Total assets 2008 in bn CNY obs. Net assets 2008 in bn CNY obs. *** / ** / * Statistically significant at 1% / 5% / 10% Source: wind 5.8746 29 4.9928 33 Affiliate 5.3785 19 5.1457 20 Conglomerate 5.8679 73 5.5560 74 Stand-alone 3.4274 284 3.2632 298 Bank > Other 1.8748 405 1.2007 425 ** 0.0437 *** P value 0.0080 Difference Affiliate > Other 1.3057 405 1.3226 425 * 0.0683 * P value 0.0849 Conglomerate > Other 2.1151 405 2.0230 425 *** 0.0000 *** P value 0.0000

The favorable fee condition could be another explanation for the attractiveness of bank related funds. Thanks to the larger size of assets managed by a single fund and synergies with banks own asset management operation, especially bank funds are able to offer fund products with favorable condition by lowering management and custody fee, which in turn attracts more assets and aggravates the economic of scale. In average, bank funds require 0.12% and 0.01% lower management and custody fee respectively, as results in table 7 show.
Table 7. Fees Comparison
Mean Variable Bank Management fee in % obs. Custody fee in % obs. *** / ** / * Statistically significant at 1% / 5% / 10% Source: wind 1.1340 50 0.2220 50 Affiliate 1.2820 25 0.2300 25 Conglomerate 1.2092 85 0.2289 85 Stand-alone 1.2559 379 0.2326 379 Bank < Other (0.1151) 539 (0.0098) 539 ** 0.0349 ** P value 0.0245 Difference Affiliate < Other 0.0457 539 (0.0010) 539 0.4493 P value 0.7144 Conglomerate < Other (0.0347) 539 (0.0023) 539 0.2942 P value 0.2282

Regarding the portfolio structure, we identify that funds with bank linkage invest in average 6% to 8% more in fixed-income products and 4% to 8% less in equity securities, as depicted in table 8. This result can be interpreted with the fact that Chinese banks have longer tradition and gained expertise and market presence in bond market, especially through inter-banking markets and can extend this expertise in their fund subsidiaries.
Table 8. Fund Portfolio Comparison
Mean Variable Bank Stock% obs. Bond% obs. Other% obs. 58.43 9,012 32.55 9,012 8.55 8,966 Affiliate 54.26 7,781 35.20 7,781 10.20 7,752 Conglomerate 58.61 28,925 32.63 28,925 8.72 28,913 Stand-alone 63.49 107,945 24.70 107,945 11.61 107,710 Bank = Other (3.5888) 153,663 5.6921 153,663 (2.4001) 153,341 *** 0.0000 *** 0.0000 *** P value 0.0000 Difference Affiliate = Other (7.9489) 153,663 8.4399 153,663 (0.6466) 153,341 *** 0.0000 *** 0.0000 *** P value 0.0000 Conglomerate = Other (3.9399) 153,663 6.7082 153,663 (2.5858) 153,341 *** 0.0000 *** 0.0000 *** P value 0.0000

*** / ** / * Statistically significant at 1% / 5% / 10% Source: wind

We further explore the question if the larger funds size of bank related funds results from superior performance in the sense that banks are better asset managers. We compare the performance of bank related and stand-alone funds using daily return of net asset value of funds during the years from 2007 to 2008. We evaluate both the absolute daily return and the abnormal daily return defined as the return over the benchmark with the same portfolio structure. The second measurement should take into account the different portfolio structure of bank-related and stand-alone funds as identified above. For stock investment, daily return of Shanghai Composite Index is chosen as benchmark; for bond investment, daily return of China Composite Bond Index is chosen; and we assume the investment of the rest of the assets in the portfolio in short-term and liquid market and choose the daily return of Shanghai Interbank Overnight Rate (SHIBOR) as benchmark for the rest portion of assets. As summarized in table 9, the performance of bank-related funds do not differ much from that of stand-alone funds, both in terms of absolute return and abnormal return compared to benchmark. This result indicates that banks are not the surely better asset manager on the Chinese capital market. The reputation of big Chinese banks is still not the sufficient condition to attract over performing asset managers to deliver better performance than fund managers in stand-alone funds.

23

Table 9. Fund Performance Comparison

Mean Variable Bank Fund NAV daily return obs. Fund NAV daily abnormal return # obs. (0.0644) 8,990 (0.0298) 5,812 Affiliate (0.0505) 7,774 (0.0117) 1,952 Conglomerate (0.0435) 28,898 (0.0436) 18,344 Stand-alone (0.0654) 107,821 (0.0389) 61,245 Bank = Other (0.0041) 153,483 0.0095 87,353 0.7414 P value 0.8874 Difference Affiliate = Other 0.0104 153,483 0.0275 87,353 0.5715 P value 0.7393 Conglomerate = Other 0.0209 153,483 (0.0063) 87,353 0.7209 P value 0.2358

*** / ** / * Statistically significant at 1% / 5% / 10% # Abnormal return = fund daily return - portfolio daily return, portfolio daily return = stock% * SH composite index daily return + bond% * China composite bond index daily return + other% * SHIBOR daily return Source: wind

Consolidating the above findings, we conclude that potential synergies of banks equity participation in asset management companies are realized through reputation and distribution network of banks to attract funds flows as well as lower management and custody fee condition through economies of scale. Chinese banks especially apply their expertise in fixed assets investment in their funds products, generating economies of scope.

VI. Conclusion and Outlook

The overall results of the above analyses confirm our suspicion of Chinese banks high dependence on net interest margin compared to international peers. Due to the rigid interest rate regime, the risk pricing mechanism is still not established in the lending practice of Chinese banks. However, in China, Europe, the UK and the USA, volatilities of interest income and non-interest income are not correlated, which provides potential diversification benefits in revenue diversification in non-interest income, especially fees and commissions businesses. Having recognized that the current narrow banking model can not sustain after the interest rate liberalization and with the aim of participating in returns from rapid development of capital markets, Chinese banks gradually diversify in non-interest income businesses with fees and commissions in dominance and limited securities trading. Over a short time of four years, Chinas major banks have successfully leveraged the strong brand and distribution network to build up presence in fund, insurance agency and custody services. Economies of scale in bank related funds are transferred to investors through lower management and custody fee. Economies of scope are achieved by sharing expertise in investment in fixed-income products. The cautious liberation of banks engagement in proprietary trading especially in trading equity and derivative products as well as of banks participation in securities companies reveals that China learned the lesson of Western banks with over-leveraged trading and over-risked universal banking model of pre-crisis time. A downscale of trading in Western universal banks could bring about the convergence of a post-crisis universal banking model with more stable and moderate return and balanced interest, fees and commissions and trading income. The transformation towards the universal banking model in China even today already goes further by including insurance services as well. This development opens-up the way for the establishment of the third banking business model in China despite of the separated and the universal, which is the integrated financial service provider. Just recently, in November 2009, Chinas banking regulator, CBRC, issued Provisional Rules on Commercial Banks Share Holding in Insurance Companies, which permit banks equity participation in one insurance company. After the failure of the banc assurance model in different European countries, perhaps China could become the new frontrunner with regards to integrated financial service provider. A lot of research is still needed to understand the full variety of the transformation of Chinas banking sector in an international context.

24

Appendix

A. Total Sample Description

China SOCB JSCB CCB RCB Total 5 12 79 6 102 Euro Area Austria Belgium Finland France Germany Greece Ireland Italy UK Total 55 Luxembourg The Netherlands Portugal Slovakia USA Total 101 Spain Total 21 14 7 81 43 15 16 39 11 31 11 10 35 334

B. Summary Statistics
mean
ROAA (%) Total assets (million USD) Equity/total assets (%) Net interest margin (%) Cost income ratio (%) Total securities/total assets (%) Trading securities/total assets (%) Available for sale securities/total assets (%) Customer deposits/total assets (%) Growth of total assets (%) Impaired loans/gross loans (%) Non-interest income/gross revenue (%) Source: Bankscope 0.68 63,612 4.98 2.78 43.16 22.35 1.97 15.31 80.78 26.12 5.05 14.25

China std.
0.45 184,423 3.13 0.94 13.18 10.09 3.11 9.50 9.46 18.27 9.05 13.50

obs.
373 382 382 371 371 380 97 372 382 313 303 371

mean
0.89 90,022 9.63 3.38 68.53 21.48 8.54 10.88 40.87 15.33 3.22 45.22

Europe std.
2.79 263,554 11.90 16.92 37.76 18.74 12.18 12.98 25.68 37.52 3.31 41.85

obs.
1,351 1,359 1,359 1,348 1,339 1,292 838 996 1,277 1,077 573 1,291

mean
0.85 174,327 11.85 2.98 58.65 14.07 8.70 12.05 55.57 14.11 2.20 36.14

UK std.
1.64 479,566 15.24 4.00 23.99 16.76 8.21 16.41 28.20 30.18 3.19 35.47

obs.
239 239 239 236 235 188 72 102 204 191 100 225

mean
0.97 35,955 11.10 3.53 62.44 20.96 0.78 15.81 70.89 16.26 0.88 27.99

USA std.
2.86 163,305 7.76 1.30 33.14 16.85 2.85 13.83 19.89 45.52 1.31 27.13

obs.
472 477 477 472 469 472 399 87 455 460 449 471

25

C. ROAA Regression Results

Variable China (1) Ln total assets 0.0293 t value 2.6500 p value 0.0090 Equity/total assets 0.0197 t value 2.5300 p value 0.0120 Net interest margin 0.1882 t value 6.1400 p value 0.0000 Cost income ratio -0.0178 t value -7.3400 p value 0.0000 Trading securities/total assets t value p value Available for sale securities/total assets t value p value Customer deposits/total assets t value p value Growth of total assets 0.0026 t value 2.2000 p value 0.0280 Impaired loans/gross loans -0.0037 t value -1.2000 p value 0.2330 Non-interest income/gross revenue 0.0079 t value 3.6900 p value 0.0000 Constant 0.3569 t value 1.5300 p value 0.1270 F value 29.4300 R-squared 0.4498 Adjusted R 0.4345 Obs. 260 *** / ** / * Statistically significant at 1% / 5% / 10% Source: Bankscope *** China (2) 0.0183 0.8600 0.3910 0.0338 2.1700 0.0330 0.1328 2.0100 0.0480 -0.0288 -6.1100 0.0000 0.7468 0.7100 0.4790 0.1421 0.3000 0.7660 -0.4198 -0.8800 0.3800 -0.0009 -0.4500 0.6570 -0.0058 -0.4200 0.6790 0.0003 0.0500 0.9570 1.5896 2.8300 0.0060 10.6400 0.5833 0.5284 87 Europe (1) -0.0450 -1.2200 0.2250 0.0747 4.7900 0.0000 0.0450 0.6000 0.5490 -0.0123 -5.6800 0.0000 Europe (2) -0.0744 -1.4600 0.1460 0.0706 3.7200 0.0000 -0.0703 -0.6500 0.5170 -0.0182 -5.6100 0.0000 1.1087 1.1400 0.2560 -1.1059 -1.2000 0.2310 0.6326 1.2000 0.2290 0.0011 0.4900 0.6250 -0.0694 -2.5500 0.0110 0.0109 2.5100 0.0120 1.8818 2.4100 0.0160 13.2700 0.2609 0.2412 387 UK (1) -0.0499 -1.0700 0.2890 0.0364 1.9600 0.0530 0.0748 2.8700 0.0050 -0.0073 -2.4200 0.0180 UK (2) -0.0089 -0.1100 0.9120 0.0705 1.8500 0.0770 -0.0215 -0.0900 0.9290 -0.0086 -1.9000 0.0690 -1.2107 -0.6400 0.5270 -0.8173 -0.7800 0.4410 0.1926 0.2700 0.7910 0.0043 0.9500 0.3540 -0.0028 -0.0800 0.9370 0.0122 2.0100 0.0560 0.3927 0.2800 0.7850 3.6500 0.6133 0.4452 34 USA (1) -0.0312 -1.1700 0.2450 0.0256 2.5700 0.0110 0.1689 3.7200 0.0000 -0.0233 -15.9300 0.0000 USA (2) -0.0125 -0.0700 0.9480 -0.0811 -2.2600 0.0860 0.5821 0.7300 0.5060 -0.0383 -2.6700 0.0560 1.8285 0.4100 0.7010 -0.7226 -0.3300 0.7550 -2.5608 -1.5600 0.1930 0.0038 0.4600 0.6700 -0.3460 -2.7100 0.0540 0.0178 0.7300 0.5050 3.9156 0.9800 0.3850 42.1500 0.9906 0.9671 15

**

**

***

***

**

***

**

***

***

***

***

***

***

**

***

**

***

***

0.0006 0.3300 0.7420 -0.0626 -2.8800 0.0040 0.0144 4.6200 0.0000 1.0107 1.9300 0.0540 22.9200 0.2513 0.2403 486

***

**

***

**

**

0.0241 5.9400 0.0000 -0.2049 -6.3600 0.0000 0.0034 0.8500 0.3960 1.0660 1.8700 0.0650 13.1300 0.5506 0.5087 83

***

***

-0.0011 -1.0700 0.2830 -0.2884 -7.1500 0.0000 0.0100 4.4900 0.0000 1.8608 5.0900 0.0000 63.8800 0.5145 0.5064 430

***

***

***

26

D. Impact on Margin - Pairwise Correlations with Net Interest Margin

China Ln(Total Assets) p-value obs. Equity/Total Assets p-value obs. Cost Income Ratio p-value obs. Net loans/Total Assets p-value obs. Trading Securities/Total Assets p-value obs. Available for Sale Securities/Total Assets p-value obs. Customer Deposits/Total Assets p-value obs. Growth of Total Assets p-value obs. Impaired Loans/Gross Loans p-value obs. Non-Interest Income/Gross Revenue p-value obs. *** / ** / * Statistically significant at 1% / 5% / 10% Source: Bankscope -0.1350 *** 0.0082 383 0.1847 *** 0.0003 383 -0.4608 *** 0.0000 383 0.4035 *** 0.0000 383 0.1019 0.3107 101 -0.5066 *** 0.0000 373 0.1665 *** 0.0011 383 0.0600 0.2840 321 -0.1997 *** 0.0004 310 -0.6316 *** 0.0000 371 Europe -0.1176 *** 0.0000 1,348 0.0450 * 0.0983 1,348 0.0503 * 0.0658 1,339 -0.0290 0.2890 1,335 -0.1570 *** 0.0000 833 -0.1748 *** 0.0000 990 -0.0800 *** 0.0044 1,267 0.0033 0.9129 1,073 0.2403 *** 0.0000 571 -0.1025 *** 0.0002 1,291 UK -0.3503 *** 0.0000 236 0.4854 *** 0.0000 236 0.0115 0.8614 235 0.3781 *** 0.0000 234 -0.5239 *** 0.0000 72 -0.0431 0.6670 102 -0.1197 * 0.0905 201 -0.1000 0.1711 189 0.5388 *** 0.0000 100 -0.1662 ** 0.0126 225 USA -0.3398 *** 0.0000 472 -0.0404 0.3810 472 -0.0223 0.6304 469 0.3614 *** 0.0000 469 -0.1136 ** 0.0241 394 0.2620 ** 0.0174 82 0.2637 *** 0.0000 450 0.1358 *** 0.0037 456 -0.0272 0.5672 445 -0.3229 *** 0.0000 471

27

References
Allen, Linda/Jagtiani, Julapa (2000): ''The Risk Effect of Combination Banking, Securities and Insurance Activities'', Journal of Economics and Business, Vol. 52 Barth, James R./Caprio, Gerard, Jr./Levine, Ross (2008): ''Bank Regulations Are Changing: For Better or Worse?'', The World Bank, working paper Barth, James R./Caprio, Gerard, Jr./Levine, Ross (2001): ''The Regulation and Supervision of Banks Around the World - A New Database'', World Bank, working paper BCG (2009): ''Creating Value in Banking 2009: Living with New Realities'' BIS (2009): ''Findings on the Interaction of Market and Credit Risk'', working paper Blundell-Wignall, Adrian/Atkinson, Paul/Lee, Se Hoon (2008): ''The Current Financial Crisis: Causes and Policy Issues'', OECD Financial Market Trends Chen, Yulu (2009): ''Generating Growth without Financial Crisis'' (Shi Xian Wu Jin Rong Wei Ji De Zeng Zhang), Study Times (Xue Xi Shi Bao), April 7th, 2009 Chinese Academy of Social Sciences (2001): ''Universal Banking: Historical Retrospect and Realistic Options for China at the Present Stage'', World Economy and China De Jonghe/Olivier (2009): ''Back to the Basics in Banking? A Micro-Analysis of Banking System Stability'', European Banking Centre, discussion paper DeYoung, Robert/Rice, Tara (2004): ''How Do Banks Make Money? A Variety of Business Strategies'', Economic Perspectives Dimon, Jamie (2009): ''Prospects for Chinese Banks: Why Global Banks are Drawn to China'', in ''Chinas Emerging Financial Markets'', Zhu/Cai/Avery (editors), John Wiley & Sons (Asia), Singapore Dobbs, Kevin/Kuehner-Hebert, Katie (2008): ''Old Banking Models Gain Prominence in Crisis'', American Banker, Dec. 15th, 2008 Ebrahim, Ahmed/Hasan, Iftekar (2004): ''Market Evaluation of Banks Expansion into Non-Traditional Banking Activities'', State University of New York, working paper Farrell, Diana/Lund, Susan/Rosenfeld, Jaeson et al. (2006): ''Putting Chinas Capital to Work: the Value of Financial System Reform'', McKinsey Global Institute Foos, Daniel/Norden, Lars/Weber, Martin (2009): ''Loan Growth and Riskiness of Banks, University of Mannheim, working paper Garca-Herrero, Alicia/Gavil, Sergio/Santabrbara, Daniel (2006): ''China's Banking Reform: An Assessment of its Evolution and Possible Impact'', CESifo Economic Studies, Vol. 52 Gorton, Gary/Winton, Andrew (2002): "Financial Intermediation", Wharton School Center for Financial Institutions, University of Pennsylvania, working paper 02-28 Hennes, Markus/Susanne Metzger (2010): "Konzerne nabeln sich von banken ab", 22.01.2010, p. 23 Handelsblatt,

Ho, Thomas S. Y./Saunders, Anthony (1981) : "The Determinants of Bank Interest Margins: Theory and Empirical Evidence", The Journal of Financial and Quantitative Analysis, Vol. 16 Institute of International Bankers (2009): ''Regulatory and Market Developments, Banking - Securities Insurance Covering 33 Countries and the EU'' Kroszner, R.S./Rajan, R.G. (1994): "Is the Glass-Steagall Act Justified? A Study of the U.S. Experience with Universal Banking Before 1933", The American Economic Review, Vol. 84 Kwan, Simon H./Ladermann, Elizabeth S. (1999): On the Portfolio Effects of Financial Convergence - A Review of the Literature, FRBSF Economic Review Laeven, Luc/Levine, Ross (2007): ''Is There a Diversification Discount in Financial Conglomerates?'', Journal of Financial Economics, Vol. 85

Lin, Changyuan (2003): ''Financial Conglomerates in China'', Chinese Academy of Social Sciences, working paper Loechel, Horst/Boeing, Philipp (2010): ''The Present State of Shanghai as an International Financial Centre a Comparison with London and Frankfurt'', EU-China BMT working paper series No. 011 Loechel, Horst/Brost, Heike/Li, Helena Xiang (2008): ''Benefits and Costs of Integrated Financial Services Providers State-of-the-Art in Research, EU-China BMT working paper series No. 006 Loechel, Horst/Zhao, Xiaoju (2006): ''The Future of Banking in China'', Frankfurt Lund, Susan/Roxburgh, Charles (2009): ''Global Capital Markets: Entering a New Era'', McKinsey Global Institute Mao, Xiaoyun (2008): ''Implications of Financial Crisis for Development of Universal Banking and the Strategic Choice of China Development Bank'' (Cong Jin Rong Wei Ji Kan Hun Ye Jing Ying De Fa Zhan Qu Shi Ji Kai Hang De Ce Lue Xuan Ze), Financing Research (Rong Zi Yan Jiu) Neftci, Salih N./Mnager-Xu, Michelle Yuan (2007): ''Chinas Financial Markets: an Insiders Guide to How the Markets Work'', Amsterdam Nurullah, Mohamed/Sotiris K. Staikouras (2008): ''The separation of banking from insurance: Evidence from Europe, Multinational Finance Journal, Vol. 12 Reinhart, Carmen M./Rogoff, Kenneth S., This Time is Different, Eight Centuries of Financial Folly, Princeton and Oxford Rizzi, Joseph (2009): ''Universal, Originate-to-Distribute Models Failed'', American Banker, Jan. 2nd, 2009 Saunders, Anthony/Schumacher, Liliana: ''The Determinants of Bank Interest Rate Margins: an International Study'', Journal of International Money and Finance, Vol. 19 Saunders, Anthony/Walter, Ingo (1994): ''Universal Banking in the United States'', Oxford University Press Sauders, Anthony/Walter, Ingo (2006): ''Financial System Design in the Asia Pacific Context: Costs and Benefits of Universal Banking, Management Decision, Vol. 34 Schildbach, Jan (2009): ''Global Banking Trends after the Crisis'', Deutsche Bank Research Schmid, Markus M./Walter, Ingo (2008): ''Do Financial Conglomerates Create or Destroy Economic Value?'', New York University, working paper Stiroh, Kevin J. (2004): ''Diversification in Banking: Is Noninterest Income the Answer?'', Journal of Money, Credit and Banking, Vol. 36 Valverde, Santiago Carb/Fernndez, Francisco Rodrguez (2007): ''The Determinants of Bank Margins in European Banking'', Journal of Banking and Finance, Vol. 31 Wang, Jianxi (2009): ''Commercial Banking Reform'', in ''Chinas Emerging Financial Markets'', Zhu/Cai/Avery (editors), John Wiley & Sons (Asia), Singapore Wu, Jinglian (2005): ''Understanding and Interpreting Chinese Economic Reform'', Mason, Ohio Zhou, Xiaochuan (2009): ''Reform the International Monetary System'', Peoples Bank of China, March 23th, 2009 Zhu, Min/Cai, Jinqing/Avery, Marha (2009), Chinas Emerging Financial Marktes Challenges and Global Impact, Singapore

31