Foreign strategic investment in Chinese bank, corporate governance and performance
Master Thesis
Master of International Finance Amsterdam Business School
University of Amsterdam
Author: Xie xiaojuan
Thesis Supervisor: Prof. Stefan Arping September 2014
Abstract
This study investigates the effects of foreign strategic investors on bank corporate governance and performance in China. Using data of stated- owned and major national joint stock banks in China from 2001 to 2013, we first exam the governance structure changes and the entry of foreign strategic investors and find that the shareholder and board structure changed dramatically after the entry of foreign strategic investment. From the descriptive and empirical results, the study demonstrates that bank performance, including profitability, capital ratio, ratio of nonperforming loan and operating efficiency were considerably improved. But few of the improvements can be contributed to foreign strategic investment. Change of bank profitability is even negatively related to foreign strategic investment.
Table of contents
1 Introduction ………,…. 4
2 Chinese bank reform and foreign strategic investor ………... 7
2.1 Chinese bank reform………..….… 7
2.2 Foreign strategic investor ………. 10
3 Literature Review ………...……….... 15
4 Impact on corporate governance ……….... 17
4.1 Sample and data ………... 17
4.2 Variables description ………... 18
4.3 Descriptive statistics ……… 21
5 Impact on bank performance ………. 23
5.1 Descriptive statistics on bank performance ……….… 23
5.1.1 Performance index selection ………..… 23
5.1.2 Descriptive statistics ……….. 25
5.2 Empirical analysis on bank performance ………. 27
6 Conclusions ……….. 32
References ……… 34
1. Introduction
Corporate governance, ownership structure and performance have been the topic of an ongoing debate for many years. It is not always easy to reach consensus on optimal ownership and management structure as mixed results often are reported by empirical literature. Corporate governance practices in the banking industry are more complex compared with other industries due to the importance of banking industry in modern society, the level and quality of bank regulation and supervision, the opaque nature of banks assets, the state of market development and the institutional environment (Levine 2004).
When it comes to Chinese banks, it’s even more complicated due to historical reasons and huge volume of bank assets. The bank system in China has been undergoing
transition from single government oriented to multitier market based since 1978 in order to create a more open and competitive system to support economy growth and
stabilization. During the process of privatization of big state- owned banks, especially after China joined WTO in 2001, foreign strategic investors are encouraged by Chinese government with the intention to get more capital injected and employ better corporate governance system. It is generally believed that foreign strategic investors will bring new concepts and skills on management and risk control system and improve the
competitiveness of Chinese banks. While controversial results are found by previous studies. And more criticism can be heard in China from scholars to government officers on the efficiency of foreign investors when some of them sold out the shares of Chinese banks during financial crisis in 2008 and 2009. Critical questions are raised under this 4
circumstance: What kind of changes happened to corporate governance practices among Chinese banks after entry of foreign strategic investors? What’s the relationship between these changes and bank performances? This paper tries to add insights on these questions.
In this paper, both qualitative and quantitative analysis are adopted on whether and how corporate governance affected the performance of listed banks in China. The study investigates in particular the effectiveness of foreign strategic investors. The descriptive statistic investigation is conducted by using a unique dataset of corporate governance, mainly ownership structure and board composition 3-year before and after foreign investment in listed banks in China. Lower state ownership is found after foreign strategic investment, but the change isn’t significant. The percent of top 1 shareholder increased dramatically on the contrary, which is inconsistent with the assumption of decreased largest shareholding after foreign strategic investment. These facts suggest that ownership structure of investigated banks wasn’t changed much with foreign strategic investment. A possible explanation is that the largest shareholder, especially the state wants control over domestic banks, and foreign investors are subjected to strict
limitations on shareholding. The percentage of top 3 shareholders increased dramatically as expected. Board independence and external supervisory system are also reinforced.
From the descriptive statistics, we find that except for innovation capability (measured by the ratio of non-interest income to gross revenues), other indicators of bank performance, including profitability, capital ratio, ratio of nonperforming loan and operating efficiency were strengthened. In order to measure the relation between bank performance and foreign strategic investment, the study sets up regression with data of 13 listed banks 5
from 2007 to 2009. The performance of bank is reflected through bank's capital ratio, NPL ratio, and profitability, operating efficiency and innovation ability. Foreign strategic investment related variables are investment ratio of foreign strategic investors, ratio of foreign strategic investors at board and if foreign strategic investor is in management committee. Three control variables are included, namely asset volume, GDP growth rate and customer deposit increase rate. Empirical study proves that few of bank performance improvements came from foreign strategic investment. Foreign strategic investment did not contribute as much as expected. And bank profitability increase is even negatively related to rate of foreign strategic investment. The results also suggest that macro-economic environment and policy position had great influence on bank innovation progress while no obvious contribution to bank profitability.
Due to the availability of the data, only the listed banks are selected as research subjects. National joint-stock banks were listed later and some of the pre-listing data is missing. All of these may affect the regression results of the models and the credibility and applicability of the conclusions accordingly.
The rest of the study is organized as follows: Part two gives an introduction into Chinese bank system and reform. Part three is literature review. Part four investigates the changes of governance structure with foreign strategic investor involvement by gathering of all listed banks on Bank governance indicators from 2001 to 2013. Part five exams the impact of foreign strategic investment on performance of 13 listed commercial banks in China. Part six includes a brief summary and outlook.
2. Chinese bank reform and foreign strategic investor
2.1 Chinese bank reform
The entry of foreign strategic investors is closely related to the process of Chinese bank reform. And it’s critical to know Chinese bank system and its evolution process in order to understand the complexity and problems inherent in Chinese banks. China used to follow a mono-bank model, with the People's Bank of China (PBC), also the central bank, as the main entity authorized to conduct operations in the country before 1978. In the late 1970s, banking reform was put on the agenda with the goal of creating a multi-ownership, competitive and market-oriented banking system. There are four steps of China's Banking Reform.
First, a two-tier banking system was established by bank restructuring. the commercial banking operations were gradually deprived from People's Bank of China (PBC) and taken over by four specialized state-owned banks (known as the ‘Big Four’): the
Agricultural Bank of China (ABC); the Industrial and Commercial Bank of China (ICBC); China Construction Bank Corporation( CCBC); and the Bank of China (BOC)
The second stage followed from 1985 to 1994 to deepen bank ownership restructuring. Foreign banks and national joint-stock banks were allowed to enter into the market. Most nationwide or regional joint stock commercial banks (JSCBs) were formed under
shareholding ownership structures. However, the ‘Big Four’ still dominated the banking system and played a strong role in promoting economic growth and maintaining stability.
The third stage of banking reform was the commercialization of banks during1995–2002. In 1995, the Central Bank Law and the Commercial Bank Law were enacted. The ‘Big Four’ were legally defined as state-owned commercial banks and their policy lending functions were taken away by the three newly established policy banks, the Agricultural Development Bank of China (ADBC), China Development Bank (CDB), and the Export– Import Bank of China (Chexim). In the mid-1990s, City Commercial Banks (CCBs) were created through restructuring and consolidating former urban credit cooperatives. Capital was provided mainly by local enterprises and governments. At first these City
Commercial Banks were operated limited to local geological sites. Since early 2000, City Commercial Banks flourished and were allowed case by case to expand into other regions. However, the ‘Big Four’ had huge amount of NPLs due to weak corporate governance and large policy loan under frequent intervention from Central and local governments. At the same time, the Chinese economy experienced overheating; NPLs (non-performing loans) became even worse while bank capital adequacy ratios declined further. The banking system became rather vulnerable. Confronted with criticism at home and alerted by the South East Asian Financial Crisis in 1997, the central government started the first round of SOCBs bailouts in 1998–1999. RMB 270 billion was injected into SOCBs in 1998 and RMB 1.4 trillion of NPLs from the SOCBs was offloaded. However, the reform did not address the corporate governance issue or improve bank performance as expected.
The fourth stage started from 2003 till now. After the failure of the first trail, the central government accelerated the pace of bank reform since 2003 and took more radical and
comprehensive banking reforms to optimize bank ownership structure, improve corporate governance, enhance internal control and risk management systems in response to
China’s WTO entry in 2001. The central government aimed to remove NPLs and prepared the banks for the entry of strategic investors prior to WTO membership. Under this circumstance, Central Huijin Investment, a fully state-owned investment bank was established. Using the huge foreign exchange reserves, the government injected capital through China Investment Corporation to trip off NPLs from major commercial banks, including BOC, CCBC, CBC, ABC and Bank of Communication. The procedure of bank reform at this stage was first financial restructuring, after that, these banks were partially privatized to attract foreign strategic investors and eventually went public on the
Shanghai and Hong Kong Stock Exchanges. Both foreign investors and the capital market reacted quite positively. Foreign investors have invested in all types of domestic banks and stock price of some listed banks increased dramatically in the capital market. ICBC became the largest bank in the world with a market capitalization of $246 billion in July 2007.
These reforms have brought in tremendous changes to banking industry in China. Now a multi-layered banking system has been built, consisting the central bank (PBC), the regulatory and supervisory body, China Banking Regulatory Commission (CBRC), Four state-owned commercial banks (SOCBs), 23 joint stock commercial banks (JSCBs) and 141 city commercial banks ,rural commercial banks, urban credit cooperatives (UCCs), rural credit cooperatives (RCCs), postal savings, foreign banks and non-bank financial institutions (NBFIs). The total assets and liabilities of banking institutions reached RMB
160 trillion and RMB 149 trillion respectively by the first quarter of 2014 (http://www.cbrc.gov.cn).
2.2 Foreign strategic investor
The various types of investors are generally segregated into two specific classes. One is known as a financial investor and the other is strategic investor. Financial investor is interested in the cash flow generation from a business and the future exit opportunities from the business. Most financial investors are looking for a well-managed company with consistent earnings and growth rate. Strategic investor goes beyond simply investing capital into a business. This type of investors are often actively involved in some aspects of the business operation, and contribute time and experience to help grow the business. Strategic investors are interested in a business’s fit into their own long-term plans and focus heavily on synergies and integration capabilities. Strategic investors could be domestic investors or foreign investors. But the Chinese banks emphasize the importance of foreign financial institutions when considering attracting strategic investors. Domestic strategic investor as the shareholders of commercial banks can hardly implement
substantial reform as they can’t avoid intervention from central and local governments. Therefore, the study focuses on foreign strategic investor as well.
According to China Banking Regulatory Commission (CBRC), five principles are
applied to the entry of foreign strategic investor: First, a minimum 5% for a single foreign investor. Otherwise foreign strategic investor would be lack of incentive to engage in the management and improvement. Second, a lock-up period of three years to ensure that strategic investor would stay long enough to make positive changes happen. Third, 10
foreign strategic investors are encouraged to have board members and experienced management expertise in Chinese banks invested. Fourth, foreign strategic investors should have sound background and experience in financial industry with no less than $ 0.5 billion oversea assets under management and be willing to provide management and technical support during cooperation. Fifth, a single foreign bank should not invest in more than 2 state-owned commercial banks in China to avoid interest conflicts and monopoly. And above all, the basic rule is investment at 20% for a single strategic foreign investor and 25% for foreign investors in total in one Chinese bank.
The paper has discussed the intention of Chinese government and banks on the entry of foreign strategic investor, as the other side of the coin, why do foreign strategic investors also responded positively on this matter especially after 2003? There’re two ways for foreign banks to enter into Chinese banking market. One is setting up branches directly. The other is taking shares of Chinese banks. Some foreign banks have already opened their branches in China mainly in cities like Beijing, Shanghai and Shenzhen, but there are strict regulations and limitations on their operation in China as foreign bank. Most of foreign banks take the approach as minority shareholders in Chinese banks. Their interest in acquiring may include: (1) Potential upside of substantial financial return. Strategic can get considerable return in capital market during IPO of commercial banks in China. And foreign strategic can make use of their advanced management and risk control practices to improve corporate governance and profitability of Chinese banks and get more dividends. (2) Find a way around rigid regulations from Chinese government and explore expansion opportunity into new geographic markets, product lines and customers,
eliminating competition and enhancing some of its own key weaknesses (distribution, customer base, etc.).(3) Diversify operation risk. Including Chinese banks in the whole network of operation worldwide will help mitigate the risk of big foreign banks. And even Chinese banks have some historical issues and weak in corporate governance, they’re determined to reform and supported by Chinese government, hence, there are more opportunities than risks.
Foreign strategic investment started in China in 2001, when the International Financial Corporation (IFC), the private sector of the World Bank Group, first took 7 percent in the Bank of Shanghai, a city commercial bank in China. From 2003 to 2007,
there was a boom in foreign bank investments in China. 20 foreign investments happened during that period. By the end of 2013, twenty-three Chinese banks, including three of the Big Four state-owned banks, twelve joint stock commercial banks, and eight city commercial banks had introduced foreign strategic investors. Table 2-1 shows the details of the 23 Chinese banks:
Table 2-1 Chinese banks with foreign strategic investors Type of
bank Chinese bank Foreign investor Percent Year Contract Listed
State-Owned
Banks
Bank of China
RBS 10 2005 3-year lock-up period;
Central Huijin Investment guarantee that net price per share will not go below that of 2004
Yes Asia Financial holding 5 2005
UBS 1.61 2005
Asian Development Bank 0.24 2005
China Construction Bank
Bank of America 9.00 2005
3-year lock-up period; preemptive right; no competition with CCBC in
retail banking Yes
Asia Financial Holding 5.10 2005
3-year lock-up period; buy another $1 billion new shares at issuing price
Industrial and Commercial Bank of China
Goldman Sachs 5.75 2006 3-year lock-up period; no shareholding increase after IPO Yes Allianz 2.25 2006 American Express 0.44 2006 Bank of Communications HSBC 19.9 2004 Yes Joint Stock Commercial Banks China Everbright
Bank Asian Development Bank 3.29 1996 Yes
Bank of Shanghai HSBC 8 2001 No IFC 7 2001 Shanghai Pudong Development Bank Citigroup 5.00 2003
5-year lock-up period; Call option, can increase shareholding to 24.9% at most by 04/30/2008 Yes Industrial Bank Co Ltd HangSeng Bank 15.98 2004 Anti-dilution provisions in
case of private offering Yes GIC Special Investments 5 2004
IFC 4 2004
Shenzhen Development Bank
New Bridge Capital 17.89 2004 5-year lock-up period Yes
Minsheng Bank Asia Financial Holding 4.55 2004 Yes
IFC 1.08 2004
Bank of Beijing
ING 19.90 2005 5-year lock-up period; preemptive right; anti-dilution provisions; no competition
Yes
IFC 5.00 2005
Hua Xia Bank
Deutsche Bank 7.02 2005
5-year lock-up period; right of first refusal; anti-dilution provisions
Yes Sal Oppenheim 4.08 2005
Deutsche Bank
Luxembourg 2.88 2005
Bank of Nanjing BNP Paribas 19.2 2005 cooperation on credit Yes
IFC 5 2001 management and risk control China CITIC
Bank BBVA 5 2006
3-year lock-up period; cooperation on private banking area
Yes Bank of Ningbo OCBC (Singapore) 12.2 2006 10-year lock-up period;
preemptive right Yes
City Commercial
Banks
China Bohai
Bank Standard Chartered Bank 19.9 2006 No
Xi’an City Commercial Bank IFC 2.5 2002 No Scotia Bank 2.5 2002 Jinan City Commercial Bank Commonwealth Bank of Australia 11 2004 No Hangzhou City Commercial Bank Commonwealth Bank of Australia 19.9 2005 No Tianjin City Commercial Bank
Australia and New
Zealand Banking Group 20 2005 No
NanChong City Commercial Bank DEG 10 2005 No SBFIC 3 2005 Bank of DaLian
Asia Development Bank 4.99 2006 No
Scotia Bank 20 2007 No Bank of ChongQing DahSing Bank 17 2007 Yes Carlyle Group 7.99 2007
Source: Open resources from internet
3. Literature Review
The relationship between ownership structure, corporate governance and performance has been the subject of a long and ongoing debate in corporate finance literature. Ownership structure lies in two respects: the degree of ownership concentration and the nature of the owners (Iannotta, Nocera, and Sironi 2007). Jensen and Meckling (1976) argue that when ownership becomes more dispersed, agency costs increase accordingly. Iannotta, Nocera, and Sironi (2007) find that ownership concentration has no significant effects on banks’ profitability while it is related to more qualified loan and lower asset and insolvency risks. Technically speaking, state ownership implies ownership of all citizens, who in practice have little power and incentive to influence and monitor the management practice of state organizations and government is left to act as the only effective representative agent (Huibers 2005). At the same time, state-owned firms are considered to be inefficient due to insufficient market discipline and inadequate punishment for wrong decisions caused by managing bureaucrats. The lack of supervision and pressure for better performance leads to huge agency costs, including losses associated with corruption (Li et al. 2008, Peng 2001).
When it comes to the banking industry, the issue of corporate governance and
performance becomes more complicated than other industries for a couple of reasons, including the level and quality of bank regulation and supervision, the opaque nature of banks assets, the state of market development and the institutional environment (Levine 2004). Empirical study in general reports that compared with private banks, state-owned banks tend to underperform (Bonin, Hasan, and Wachtel 2005a; Fries and Taci 2005;
Yao, Jiang, and Feng 2007). And the entry of foreign banks would increase the
efficiency and improve the corporate governance of the banking industry in developing economies (Arun and Turner 2004). Such positive attitude was also reflected in Chinese government’s the approach toward bank reforms. Hope and Hu (2006) argue that foreign investment in China’s banking sector has the potential to dramatically improve the performance of Chinese banks with fewer government interventions. But mixed outcomes are found. Lin and Zhang (2009) investigated the impact of bank ownership reform on bank performance and found no performance improvement after ownership changes, Jiang, Yao, and Zhang (2009) observed some bank performance improvements by changes in corporate governance.
Moreover, the global financial crisis in 2008 put the prevailing opinion on optimal corporate governance practice in banking under challenge. In the end of 2008, UBS sold its holding on Bank of China the second of lock-up period ended. Two weeks later, RBS also sold out its holding on Bank of China and got $2.4 billion. The similar thing also happened to China Construction Bank and Industrial and Commercial Bank of China. Foreign strategic investors were pushed into the center of the national debate. While, big financial institutions experienced heavy losses during financial crisis, it’s understandable for them to dump shares to get through the crisis. But one undeniable lesson from
financial crisis was that banking sector was extremely vulnerable to immoral behavior and contagion due to its complexity and homogeneity (Haldane 2009). It also indicated that banks in countries with more instead of fewer restrictions outperformed during the crisis (Beltratti and Stultz 2010).
4. Impact on corporate governance
Foreign strategic investors are introduced to add new blood to the board, diversify
ownership and improve the weak supervision system of Chinese banks. Adopting a Board of Directors structure and diversified ownership composition was considered to be crucial for improving governance because it can help balance management and shareholder interests and reduce agency cost. All of the foreign strategic investors assigned 1-2 directors in the board, e.g. there were 2 in the Bank of Beijing, 5 in Shenzhen
Development Bank. Some of these foreign directors took responsibilities in management team, but most of them were non-executive directors. Foreign strategic investor assisted Chinese banks in the area of corporate governance, credit rating, risk management, human resource and offered a series of training programs.
4.1 Sample and data
By the end of 2013, there are 16 listed Chinese banks. But Agricultural Bank of China and China Merchants Bank haven’t introduced foreign strategic investment yet; Even though China Everbright Bank had introduced foreign strategic investor,Asian
Development Bank in 1996, foreign financial institutions were not allowed to take shares in Chinese commercial banks before 2001, Asian Development Bank was an exception at that time. But there was no real cooperation afterwards; it had more political implication instead. We first exclude these three banks. As to Bank of China, China Construction Bank and Industrial and Commercial Bank of China, three big state-owned banks, there is no related data before going public. Plus the effect of divest of foreign strategic investors 17
during financial crisis in 2009, the three banks will not be included in the analysis either. Bank of ChongQing employed foreign strategic investor, but it was listed in November 2013, there’s no adequate data available. There are 9 listed banks left exclude these 7 banks. As China joined WTO officially in 2001 and financial reform speeded up after that, we will choose data of these 9 banks from 2001 to 2013 considering the availability of data. All the observations are divided into two groups by the entry year of foreign strategic investor; the data for the entry year will not be taken into consideration. There are 492 observations in total, 60 of these are before the entry of foreign strategic investor and 332 are observations after that. All the data is collected manually from the annual report of these 9 banks from 2001-2013.
4.2 Variable description
We choose 7 indexes in four respects of corporate governance, namely shareholder structure, board of director, supervisory board, management team to compare the changes before and after foreign strategic investor.
(1) State ownership
Traditional ownership theory demonstrates that optimal ownership structure plays a vital role in maximizing firm value and reducing agency cost. A higher state ownership of banks is considered to be related with lower efficiency (La Porta et al. 2002) as state ownership in banks will restrain the monitoring and supervising function of secondary market or other shareholders. State ownership, literally means everyone has an ownership, it’s not far away for no one taking responsibility. The management team may not be fully
motivated or threatened to act efficiently. And the board members appointed by the state normally are members of Communist party of China. They can be very influential but they are not always motivated to act commercially efficient. They may put too much weight on politically correct, which is important to their career success. It’s expected that state ownership will decrease after foreign strategic investment.
(2) Top 1 shareholder
In single ownership structure, big shareholder has the right to influence important decision making process and may choose favorable management team to . Therefore, single shareholder structure may lead to abuse of right and misbehave of agent. In this context, percentage of top 1 shareholder is estimated to decrease after entry of foreign strategic investment.
(3) Top 3 shareholders
When residual claim right and control right fall on few shareholders, these few shareholders are more motivated to collect information and monitor the management team. Organization with more concentrated ownership is likely to have better profitability and market performance. Here, ownership concentration is reflected through the percent of top 3 shareholders and expected to increase after foreign strategic investment. (4) Size of the board
Although more information and expertise is available within bigger board size, decision-making costs may increase as well. And large boards are more likely to have free-riding problems among directors and increased decision-making circle. Communication and coordination cost may also increase within a large board size. And in a large board, most directors won’t directly go against or judge the decision made by the management. This
is partly because of the culture that “face” is of great importance especially among old and respected people in China. For these reasons, small boards are better from a shareholder’s perspective. Therefore, board size is expected to decrease with foreign strategic investment.
(5) Board independence
Board independence is measured by the percentage of independent directors, those who are non-executive directors. In order to enhance the efficiency of the board, independent board is introduced to Chinese banks. Independent directors are believed to have a better position to do the due diligence and discipline management. Hence, independent directors are considered to be more effective in stopping opportunistic behavior and reducing potential agency conflicts. A higher percent of independent directors is assumed since the involvement of foreign strategic investor.
(6) External supervisor
The superiority of supervisory committees system is that there is no interest connection between external supervisor and the management team. External supervisors are expected to monitor the board and the management team independently and objectively. More external supervisors are expected to be seen in the supervisory committee since the introduction of foreign strategic investor. Table 4-1 shows the definition of corporate governance indexes discussed above:
Table 4-1 Corporate Governance Indexes
Index Definition
State ownership Shares hold by state / Total shares
Top 1 shareholder Shares hold by Top 1 shareholder / Total shares Top 3 shareholders Shares hold by Top 3 shareholders / Total shares Size of the board LN( the number of the directors )
Board
independence Number of Independent director / Total number of the directors External
supervisor
Number of external supervisor / Total number of supervisory committee
4.3 Descriptive statistics
Table 4-2 displays the results of descriptive statistics of corporate governance indexes before and after foreign strategic investment with t-Test.
Table 4-2 Result of Descriptive Statistics
This table compares the changes of corporate governance variables, namely State ownership, Top 1 shareholder, Top 3 shareholders, Size of the board, Board independence and External
supervisor. The time horizon is 3-year before and 3-year after foreign strategic investment. The data of the entry year is excluded. The table also reports the t-statistic and p-value (in bracket) showing whether the difference is significant at 10%, 5%, 0r 1% level (***, **, and * indicate significance at 10%, 5%, and 1%, respectively)
Variable Mean SD Median Min Max Sample
State ownership Before 28.31% 0.167 23.87% 8.10% 55.72% 10 After 26.52% 0.195 28.95% 0.00% 68.39% 72 t-Stat 0.296 (0.3859) Top 1 shareholder Before 9.16% 0.026 8.12% 7.08% 14.29% 10 After 21.47% 0.154 16.39% 5.90% 66.95% 72 t-Stat -6.075 (0.0000***) Top 3 shareholders Before 23.47% 0.065 21.79% 16.67% 35.72% 10 After 38.51% 0.193 34.17% 15.92% 92.61% 72 t-Stat -4.776 (0.0000***) Size of the board Before 2.77 0.113 2.74 2.64 2.94 10 After 2.79 0.119 2.83 2.40 2.94 72 t-Stat -0.693 (0.2508) Board independence Before 22.54% 0.114 21.43% 0.00% 41.18% 10 After 35.07% 0.037 33.33% 26.67% 45.45% 72 t-Stat -3.272 (0.0048***) External Before 3.82% 0.076 0.00% 0.00% 20.00% 10 21
supervisor After 23.74% 0.094 22.65% 0.00% 57.14% 72 t-Stat -0.157
(0.0000***)
The results show that state ownership decreased after foreign strategic investment, but the change isn’t significant. The percent of top 1 shareholder increased dramatically on the contrary, the finding is opposite from the assumption of decreased largest shareholding after foreign strategic investment. The two facts imply that ownership structure of these banks wasn’t changed much with foreign strategic investment as expected. A possible explanation for this finding is that the largest shareholder, especially the state wants control over domestic banks, and foreign investors are subjected to strict limitations on shareholding. Even though, the government and the banks aim to work on the issue of ownership concentration, introducing foreign investors won’t make big changes on this matter. Looking into the details of the observations, we find that top 1 shareholder was still the central government after foreign strategic investment for all the banks analyzed except for Shenzhen Development Bank and Minsheng Bank. The top1 shareholder of the two banks was foreign strategic investor and domestic private investor respective. The percentage of top 3 shareholders increased dramatically as expected. As the interest of shareholders converges with that of bank, principle-agent issue can be improved as well. The findings on board independence and External supervisor are also consistent with the expectations.
5. Impact on bank performance
5.1 Descriptive statistics on bank performance
Along with the rapid economy growth in the past 10 years, Chinese bank reform also achieved a remarkable progress. How much of such progress can be contributed to foreign strategic investment? Based on financial data, we will analyze the operation efficiency of 13 list commercial banks and investigate the effect of foreign strategic investor on bank profitability, operation efficiency and creativity by empirical method.
5.1.1 Performance index selection 1. Bank profitability
Profitability based measurement can serve as a robust and inclusive way to measure the performance and reflect its asset efficiency. Two variables will be included to measure bank profitability:
(1) ROAA: Return on average asset. ROAA is estimated by dividing the net income by average total assets.
(2) ROAE: Return on average equity. ROAE is expressed as net income to average shareholders' equity. It can give a more accurate indication on bank profitability, especially when the shareholders' equity value has changed considerably during a fiscal year.
2. Capital Ratio
The capital ratio is the percentage of a bank's capital to its risk-weighted assets. Basel II requires that the total capital ratio must be no lower than 8%. Capital ratio requirement is put in place to make sure that banks won’t t take on excess leverage. Core capital, also known as Tier 1 capital, is the measure of a bank's financial strength based on the sum of its equity capital and disclosed reserves, and sometimes non-redeemable, non-cumulative preferred stock. Tier 2 capital, or supplementary capital, comprises undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt. Two variables will be included to measure capital ratio:
(1) Total Regulatory Capital Ratio (TRCR) = Total capital (Tier 1 + Tier 2) / Risk-adjusted assets
(2) Tier 1 Regulatory Capital Ratio (T1RCR) = Tier 1 capital / Risk-adjusted assets
3. Operation efficiency
Cost / Income ratio (CIR) is used to measure bank operating efficiency. The ratio gives investors a clear view of how efficiently the bank is being operated. The lower the ratio is, the more profitable the bank will be. Unusual changes in the ratio may imply potential issues: if the ratio increases over a certain period, it means that costs are increasing at a higher rate than income.
4. Asset quality
Asset quality of commercial banks is closely related to their risk resistance capacity. Nonperforming loan ratio is adopted to gauge asset quality of banks. A nonperforming
loan is either in default or close to being in default. NPL ratio is calculated as gross non-performing loans divided by total gross loans.
5. Innovation Capability
Creativity and innovation is an important aspect to add strength to bank operation, and it can be realized through products and services provided by banks. Commercial banks in China heavily rely on traditional source of revenue, such as loan-making. Fee income, service charge and other type of noninterest income do not constitute a large part of bank’s revenue. Here the ratio of non-interest income to gross revenues (NII) is selected to measure the innovation ability of banks. Table 5-1 shows all the variables included to measure bank performance：
Table 5-1 Variables of Bank Performance
Area measured Variable Abbreviation
Profitability Return on Average Asset ROAA Return on Average Equity ROAE Capital ratio Total Regulatory Capital Ratio TRCR Tier 1 Regulatory Capital Ratio T1RCR
Operation Cost / Income Ratio CIR
Asset Quality Non-Performing Loan Ratio NPL
Innovation Non-Interest Income NII
13 listed banks are selected. Data is collected three years before and after foreign strategic investment; data of the investment year is excluded (For Bank of Nanjing, Investment year is 2005 when BNP Paribas is introduced). There are 490 observations in total, with a time range from 2000 to 2009. The data is collected from Bankscope.
5.1.2 Descriptive statistics
Table 5-2 displays the results of t-Test on bank performance 3-year before and after foreign strategic investment.
Table 5-2 Descriptive Statistics on Bank Performance
This table compares the changes of bank performance variables, namely ROAA, ROAE, TRCR, T1RCR, CIR, NPL and NII. The time horizon is 3-year before and 3-year after foreign strategic investment. The data of the entry year is excluded. The table also reports the t-statistic and p-value (in bracket) showing whether the difference is significant at 10%, 5%, 0r 1% level (***, **, and * indicate significance at 10%, 5%, and 1%, respectively)
Variable Mean SD Median Min Max Sample
ROAA Before 0.576 0.2658 0.53 0.23 1.35 35 After 0.929 0.3599 0.98 0.14 1.73 39 t-Stat -4.765 (0.0000***) ROAE Before 14.405 15.929 11.79 -27.92 83.46 35 After 17.839 4.7378 16.96 6.04 31.17 39 t-Stat -1.210 (0.1168) TRCR Before 8.768 1.805 8.76 5.01 11.68 32 After 12.270 5.282 11.73 3.7 30.14 37 t-Stat -3.733 (0.0003***) T1RCR Before 6.614 1.981 6.43 3.24 10.68 19 After 9.614 5.186 8.97 3.68 26.85 37 t-Stat -3.054 (0.0018***) CIR Before 44.476 5.987 44.7 33.11 57.03 35 After 37.246 5.953 38.15 23.49 48.65 39 26
t-Stat 5.129 (0.0000***) NPL Before 7.736 6.951 4.61 0.61 28.93 30 After 2.623 1.909 2.21 0.36 9.35 39 t-Stat 3.862 (0.0003***) NII Before 10.279 13.789 6.19 -0.72 79.43 35 After 9.546 5.390 8.46 -3.8 25.1 39 t-Stat 0.290 (0.3865)
Both ROAA and ROAE were significantly improved. It proves that profitability of listed banks in China was considerably increased. TRCR and T1RCR were significant at 1% level. CIR decrease dramatically. The same happened to NPL. NII decreased, but not significant. It shows that bank profitability, operation, capital ratio and asset quality were all improved. Bank innovation capacity was not improved after foreign strategic
investment.
5.2 Empirical analysis on bank performance
Descriptive statistics shows that positively changes in bank performance took place after foreign strategic investment. However, this doesn’t necessary mean these changes are caused by introduction of foreign strategic investor. Regression models are built to control other factors may also have an impact on bank performance.
Yi.t =α + βPi.t+γZi + µXi.t+ Ɛi.t (5-1)
In model 5-1, dependent variable Yi.t is test variable of bank i at year t. The regression takes three dependent variables, namely ∆ROAA, ∆CIR and ∆NII. The changes of performance are applied because they can be served as better indicator of the effect of foreign strategic investment. And change ratio captures impact on a relative level; Data of relative performance is more comparable among different banks. Independent variable Pi.t stands for 3 variables related to foreign strategic investor，investment rate of strategic investor IR, Ratio at Board（director assigned by strategic investor/ total director in the board）D1 and dummy D2 (If in management committee, 1 for yes，0 for no). Zi stands for macro factor, here is GDP growth rate. Xi.t is control variable on banksector, the study chooses LN (TA) to control the size of the bank as big banks are more likely to get investment from foreign strategic investor. Moreover, Loans to Customer Deposits ratio (LCD) is adopted to measure the development of banks in recent years. XI distinguishes different type of banks, 1 for state-owned banks, 0 for non-state-owned banks. Table 5-3 summarizes variables in the model.
Table 5-3 Regression Variables Type of variable Abbreviation Definition
Dependent variable
∆ROAA Change of Return on Average Asset ∆CIR Change of Cost to Income Ratio ∆NII Change of Non-Interest Income/ Gross Revenues
Independent variable
IR Investment Rate of Strategic Investor
D1 Ratio of Strategic Investor Director at Board
D2 If in Management Committee
Control variable
XI Type of Bank
GDP Gross Domestic Product Growth Rate LN(TA) LN( Total Assets )
LCD Loans to Customer Deposits
Considering most banks introduced foreign strategic investor during 2004-2006, the study uses panel data of 13 listed banks from 2006 to 2009 to set up three models as listed below. Data of 2006 is used as baseline to calculate changes of ROAA, CIR and NII. The data is collected from Bankscope, bank annual report and World Bank.
∆ROAAi.t= α + βPi.t+γZi + µXi.t+ Ɛi. (5-2) ∆CIRi.t= α + βPi.t+γZi + µXi.t+ Ɛi. (5-3) ∆NIIi.t= α + βPi.t+γZi + µXi.t+ Ɛi. (5-4)
There are two types of panel data, random effect model and fix effect model. As P values are all bigger than 0.01 after Hausman test in Eviews, the study chooses random effect model to do the regression. Table 5-4 is the regression results:
Table 5-4 regression results
This table indicates the relation of changes of ROAA, CIR and NII with independent variables (IR, D1 and D2) and controlled variables (XI, GDP, LN (TA) and LCD). The regressions use data of 13 listed commercial banks from 2006 to 2009. The table also reports t-statistics in brackets below the coefficient. (***, **, and * indicate significance at 10%, 5%, and 1%, respectively)
Variable ∆ROAA ∆CIR ∆NII
C 0.507 (0.141) -0.099 (-0.179) -9.516 (-2.343) IR -0.382 (-0.110) 0.673 (1.255) -0.598 (-0.152) D1 4.655* (1.923) -0.079 (-0.211) -2.574 (-0.940) D2 -0.053 (-0.127) -0.061 (-0.954) 1.235** (2.619) XI -0.336 (-0.510) -0.069 (-0.675) -0.459 (-0.617) GDP -5.008 (-0.650) -0.767 (-0.645) 7.700 (0.883) LN(TA) -0.219 (-2.870) 0.010 (0.312) 0.612** (2.574) LCD -1.709 0.130 1.047 29
(-1.112) (0.547) (0.602) R2=0.1852 R2=0.1017 R2=0.3417
DW=2.6096 DW=2.8355 DW=3.2393
Investment ratio of foreign strategic investor is negatively related to change of return on asset and that of non-interest income rate and positively to the change of cost to income ratio，but the results are insignificant. The observations of the 13 listed banks
demonstrate that ROAA went down and up in 3 years after foreign strategic investment without certain pattern. The possible explanation is that strategic investor may not know Chinese market well enough to make encouraging changes in a short period. The lock-off period normally is 3 to 5 years, which is not long enough for foreign strategic investor to integrate with Chinese banks, especially in culture area; therefore, there may be lags. And the engagement of foreign strategic investor in corporate governance in Chinese banks may not as deep as expected. Even strategic investors have seats in the board, but the directors assigned usually were not involved in management board. The fact of this may limit the impact of strategic investor. The increased cost ratio with more foreign strategic investment is possibly caused by the increased salary expense for foreign strategic director. The finding that increased rate of foreign strategic investment is related to decreased non-interest income ratio is inconsistent with the assumption either. The alternative explanation is that banks with more foreign strategic investments were those with poor performance on non-interest income and more motivated to introduce foreign strategic investments.
Ratio of Strategic Investor Director at Board has negative effect on increase of non-interest income ratio, while positive effect is found on increased return rate on assets and decreased cost ratio, but none of the results is significant. The positive effects are
consistent with the expectations on foreign strategic investment. While the negative effect on increased non-interest income ratio is inconsistent with the assumption. The
alternative interpretation is similar as mentioned in previous paragraph that banks with poor performance on non-interest income are more likely to introduce foreign strategic investments to improve the bank innovation ability; higher foreign strategic investment rate usually requires more foreign strategic directors at board.
Whether foreign strategic investor is in Management Committee is negatively related to change of ROAA and that of CIR, but the effect is not significant. It has positive effect on change of non-interest income ratio; this result suggests that foreign strategic investor involvement in Management Committee contributed to the improvement of bank
operating efficiency and creativity. The finding of XI (type of bank) indicates that bank profitability and innovation capability of stated-owner banks is worse than that of Joint-stock commercial banks and city commercial banks, the possible explanation is that state-owned banks are less flexible and adoptable to new products and services. However, the result shows that state-owned banks were associated with decreased cost to income ratio compared with joint stock commercial banks. While traditional corporate governance theory assumes that state-owner banks tend to have higher agency costs.
From the descriptive and empirical analysis, the study demonstrates that most indicators of bank performance, including profitability, capital ratio, ratio of nonperforming loan and operating efficiency were improved. But few of the improvements can be contributed to factors associated with foreign strategic investor. Bank profitability, operating
efficiency and creativity were even negatively related to foreign strategic investment. The possible explanations are: First, it may take more time for foreign strategic investors to integrate with Chinese market and transfer skills and experience into visible changes; second, banks with foreign strategic investment may invest more and take more
prudential practices and aim for long-term return at the expense of short-term profitability; third, the upper limit on ownership may restrict foreign strategic investor’s ability to make positive changes as expected; fourth, there may be pre-selection bias in the sample. Banks with foreign strategic investors might be those with poor performance and having strong incentive to introduce foreign strategic investment. The observations also suggest that macro-economic environment and policy position had played an important role in bank creativity while no obvious contribution to bank profitability is found.
6. Conclusion
The study first explains the Chinese bank system and the background of introducing foreign strategic investment as it is important to understand and assess the efficiency of foreign strategic investment. It’s the way Chinese government had to choose during the transition period to deepen bank reform. Then, based on corporate governance, ownership structure and bank performance theories, we evaluate the relationship between foreign
strategic investor, corporate governance and bank performance. The descriptive statistics of data on governance structure of listed banks from 2001 to 2013 supports part of the assumptions. But we found that bank ownership concentration rate and the nature of owner didn’t change much with foreign strategic investment, the largest shareholder was still the central government. However independent monitoring and supervisory system was built up, which is good sign. The concern is that director assigned by foreign strategic investor in most case was non-executive director, whose voice may not always be heard and therefore the influence the decision making process was limited.
The comparison of performance indicators three-year before and after foreign strategic investment demonstrates the tremendous improvement on bank performance. The regression results reveal that only few of the changes were contributed to foreign strategic investment. This finding is not consistent with the prevailing expectations that foreign investors can inject not only capital but also superior operational and managerial skills and advanced risk management practices to improve bank performance. The unexpected findings might suggest that people used to be too optimistic on the effect of foreign strategic investment. But it should also be pointed out that there’re limitations with this study. First, only listed banks with foreign strategic investment are included in the governance and performance analysis. 9 non-listed commercial banks with foreign strategic investor are not taken into consideration in the study due to data availability. And the banks covered in the study may be those have more incentives to introduce to foreign strategic investors due to poor performance. At last, there may be other important variables not included in the regression model or other factors might affect bank
performance but not detected or controlled.
Just as a coin has two sides, every story has two perspectives. Chinese banks who had introduced foreign strategic should also reflect on their incentives. They may be eager to expand themselves through IPO and with the big name of foreign strategic investor; they can speed up the process and increase the chance of success. Therefore, they may be blind and not select foreign strategic investors carefully according to their own situations. Such mismatching would not bring in positive changes expected.
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