The interest rate liberalization reform in China and an analysis about the effect of changes in interest rate spread on bank's profitability

Master Thesis

The Interest Rate Liberalization Reform in China and an

Analysis about The effect of Changes in Interest Rate Spread on

Bank's Profitability

Statement of originality

This document is written by Zhengyu Yang who declares to take full

responsibility for the contents of this document.

I declare that the text and the work represented in this document is original

and that no sources other than those mentioned in the text and its references

have been used in creating it.

The faculty of economics and business is responsible solely for the

supervision of completion of the work, not for the contents.

Abstract

In this paper, I develop an interest rate liberalization index to measure the

liberalization progress in China and analyze the relation between interest

rate spread and listed banks’ profitability. Both simple average method and

average hierarchy process (AHP) method are applied to develop the index.

Two methods show similar result that the interest rate liberalization reform

in China has completed more than 93%, approaching the end of the whole

process. The analysis of the relation illustrates that Chinese banks’

profitability is not significantly affected by the narrowing interest rate

spread. The main reason is that the real interest spread in banks is higher

than the benchmark interest spread. However, as the interest rate

liberalization moves forward, it still deserves our further investigation that

how banks resist the shock from narrowing interest rate spread on their

profitability. Based on the empirical results, relative advises for banks to

improve profitability and manage risks are given in the last part of this

paper.

Table of contents

1.! Introduction

2.! Literature review

3.! Interest rate liberalization index

4.! Empirical analysis

5.! Summary and Conclusions

6.! References

The Interest Rate Liberalization Reform in China and an

Analysis about The effect of Changes in Interest Rate

Spread on Bank's Profitability

1! Introduction

Over the past 2 decades, People’s Bank of China has gradually promoted the interest rate liberalization reform, following the path on which foreign currency goes before domestic currency, loan before deposit, and long-term wholesale deposit before short-term retail deposit. Since 2003, China’s financial market has shown different trend along with the stimulated development on interest rate liberalization reform. The main theme of China’s financial market within the past 10 years is increased interest rate fluctuation and intensified competition within the financial industry. From a medium or long-term perspective, narrowing of interest rate spread has been an obvious trend. However, in the predictable future, interest rate spread is still the significant symbol of operation performance and comprehensive competiveness of Chinese domestic commercial banks. The management of interest rate level also highlights the pricing and risk management capacity of domestic commercial banks in China.

In the interest rate liberalization reform, financial institutions are the decision makers of interest rate rather than the monetary authority, since interest rate level is adjusted according to their financial situation. In the reform process, an interest rate mechanism will be formed, which regards the benchmark interest rate as foundation, and market interest rate as intermediary. Interest rate is determined by the money supply-demand relationship in this mechanism. China has made considerable progress in liberalizing its interest rate, during the whole financial reform. After more than 2 decades’ reform, various categories of interest rates have been liberalized. For example, loan interest rate of both RMB and foreign currency, deposit interest rate of foreign currency, Shanghai InterBank Offer Rate (SHIBOR), interbank bond repurchase interest rate and so on. However, a ceiling still remains on RMB deposit interest rate. People's Bank of China is taking prudent consideration for this finishing touch. So far, there is no universal quantitative description of China’s interest rate liberalization progress. This presents me the motivation to investigate the process in China and to measure how much the progress has been achieved.

Interest rate spread can be divided into three aspects according to the financial mechanism. The first aspect is the interest rate spread between loan and deposit in commercial banks, the second is the interest rate spread between central bank and commercial banks, and the third is the interest rate spread between domestic and international banking sector. I focus on the spread between deposit and loan interest rate in this paper. Typically, the real interest rate spread equals to the loan interest rate minus the interest rate of deposit. on the other hand, some studies expand the concept of interest rate spread with financial accounting perspective and define it as the difference between the average yield which a bank receives from loans or other interest-accruing activities and the average rate it pays on deposits and borrowings. Considering the former concept can reflect the interest rate level more accurate than the later one, I use the real Interest rate spread in this paper. Interest rate liberalization exacerbates the volatility of interest rate for both deposits and loans and gradually narrows the spread. However, traditional commercial banks’ profit significantly relies on the interest rate spread. What motivates me to investigate as the second topic is that if the liberalization of interest rate would lead to reduction of banks’ profitability.

Since Mid-seventies of last century, financial repression has attracted increasing amount of both political and financial attention worldwide, meanwhile many countries have applied financial reform under the specific historical background. Back then, aggravated inflation leads to negative real interest rate (Grzegorz W. Kołodko, 2000) and disintermediation of banks (Xu Tang, 2010); the rapid development of the European market effectively promoted the globalization of financial markets (Charles P. Kindleberger, 2010). Due to integration and globalization of financial institutions, the restriction of capital became unsustainable; and under the influence of neo-liberalism, many developed and developing countries applied financial liberalization to accelerate economic development.

Financial liberalization can bring many benefits. Developing countries can realize financial deepening and economic growth through deregulating financial market (McKinnon, Shaw, 1973). Liberalization improves the allocation and efficiency of investment by allowing for the better pricing of capital and risk (Abiad, Oomes, and Ueda, 2004). By privatizing state-owned financial institutes, easing access restriction of financial sector and giving financial institutions more autonomy, financial deregulation will dramatically change the risk management and risk-taking as well as incentives of financial institutions governance. The range of financial products should also be expanded, allowing firms and individuals to better manage risk, and providing them with portfolio diversification opportunities. As an important component of

financial reform in China, interest rate liberalization also brings advancement to Chinese banking sector.

A liberalized interest rate environment generally leads to more efficient allocation of financial resources and better risk management for firms and households, widens credit access for previously underserved sectors (especially small and medium-sized businesses). By committing to interest rate liberalization reform, Chinese policymakers hope to ensure that interest rate plays a fundamental role in effectively allocating resources. Government officials have stressed the importance of allowing banks more autonomy in pricing products and services, providing households with more diversified investment choices, and letting market forces determine risk premiums. The complete liberalization of interest rates will help reduce saving rates, boost consumption, and make China’s economic growth more inclusive. In addition, the PBC expects that interest rate liberalization improve financial supervision and facilitate the smooth, effective transmission of monetary policy. These expectations are largely in line with the benefits that interest rate liberalization has delivered to other countries in the past. However, international and historical experience tells us that in addition to a few economies, financial instability occurred in most countries during or after the interest rate liberalization process. America applied interest rate liberalization since 1980s, and 5 years later after completing the whole process, the number of bankrupted financial institutions has increased dramatically, famous as the U.S. Savings and Loans Debacle; another well-known crisis happened in Japan after its interest rate liberalization, so called Japan asset price bubbles. In Chile and Argentina, an abrupt removal of ceilings on credit and interest rate restrictions led to exorbitantly high real interest rates, which required substantial government intervention to restore the health of the financial system due to weak resistance against real shocks and insufficient bank supervision. In Malaysia and Korea, financial liberalization has been more successful, firms and financial institutions have adjusted more smoothly to the deregulated, but still closely monitored environment. The reasons for these different outcomes have been extensively documented (Cho and Khatkhate (1989), Corbo and de Melo (1985), and Luders (1985), and Bart Turtelboom (1991), among others).

The high profit of domestic commercial banks in China is a temporary phenomenon in specific time and environment during recent years. No more than 20 percent profit of China’s commercial banks are from investments, services and other businesses, the remaining 80 percent are all from interest rate spread income. The interest rate spread income is mainly associated with the amount and quality of loans, and the benchmark interest rate spread. Apparently, this temporary phenomenon is not sustainable as the

specific occasion refers to the current status of China’s interest rate liberalization reform. The PBC removed the upper limit of RMB loan interest rate and widened the lower limit to 0.9 times of benchmark interest rate in 2004. At the same time, it allowed deposit interest rate to drop below the benchmark interest rate. Before 2013, this policy created a controlled interest rate spread for banks on a relatively high level from a controlled lower limit for loan interest rate and a controlled upper limit for deposit interest rate. However, along with changes in economic situation and policy environment, controlled interest rate spread becomes unsustainable. After Basel III came out, Chinese policy makers also proposed new supervision criterion. Strict supervision and inadequacy capital limited the capital expansion of commercial banks in China. On the other hand, the protection of interest rate spread is removed because of the promotion of interest rate liberalization reform, which made the price of money completely decided by the supply-demand relationship in the market. On a short-term perspective, the interest rate spread will be inevitably different from that in the past, on a long-term perspective, the comprehensive competitiveness will be affected for sure. “Accelerate interest rate liberalization and capital-account convertibility, build up a deposit insurance system and complete the market-based exit system for financial institutions”. This decision on Major Issues Concerning Comprehensively Deepening Reforms was emphasized at the close of the Third Plenary Session of the 18th CPC Central Committee on November 12, 2013. After approximately 30 years’ reform, the financial system in China has experienced dramatic advancement. However, along with the promotion of the development, the interest rate adjustments in the liberalization background bring challenge to profitability of commercial banks. Narrowed interest spread affects profitability, liberalized interest rate alters the way of profit, and the liberalization process challenges banks’ pricing autonomy as well as risk management. In this paper, the interest rate liberalization process of China is investigated by three different approaches, the organization is as follows. Section 2 briefly reviews some related literatures, background and current situation of interest rate liberalization process, as well as some international experience. In section 3, I will measure the liberalization process using two different methods. Considering that most of the descriptions about China’s interest rate liberalization process are using qualitative method instead of quantitative analysis, two quantitative methods are used here as bold complement. Meanwhile, an econometrics method is used to examine the potential impact of liberalization on banking profitability in this section. Main results are summarized afterward. Section 4 provides the conclusions about the current status of interest rate liberalization in China and some advises about the next step.

2! Literature review

Interest rate liberalization is a tortuous and complicated process in China. Before 1978, China was under central planned economy system. During this period, interest rate was strictly controlled and was rarely adjusted by the monetary authority. Since the implementation of reform and opening up in 1978, interest rate policy has become an important means for state regulation of macro-economy. Meanwhile, the People ‘s Bank of China starts the exploration of establishing a new mechanism for adjusting interest rate. Until 1998, interest rate reform can be divided into 3 phases according to the aim of policies. From 1978 to 1989, the long-standing low level interest rate was the main target of reform. The second phase finished in 1992, with a main task to optimize interest rate structure and to straighten out relationships between various interest rate under different categories. The third phase begins since 1993, the aim of interest rate reform becomes to reasonably improve the interest rate mechanism so that interest rate policy will be and indispensable approach to macroeconomic control and to realize better allocation of resources.

During the early phase of interest rate reform, the monetary authority mainly focuses on controlling inflation by limiting the funding demand of corporates within a certain range to stabilize deposit amount. Along with the gradual deepening of financial reform, interest rate reform has become an important component of financial reform, which embodies the state requirement of macro-economics control. In addition to the inflation rate, deposit, consumption, investment and economic growth should all be taken into consideration. Under the approval of State Council, the blueprint of interest rate liberalization was firstly formed during the Third Plenary Session of the fourteenth central committee in 1993. The Decision of the State Council on Reform of the

Financial System firstly introduced the long-term goal of China’s interest rate reform,

The People's Bank of China shall set the ceiling and floor interest rates of the deposit and loan, further rectify the interest rates relations between deposit, loan and securities; all the different kinds of interest rate should reflect the difference in time limit, cost and risks, so as to keep a reasonable rate differential; progressively set up the market interest rate system based on the central bank's interest rates.

In January 1996, interbank offering rate started to be liberalized, which formed China interbank offering rate (Chibor). The target that interest rate policy regulates turns to be the speed and structure of the growth in money supply. Some demonstrable effects of macro-economics control have emerged, such as suppressed inflation and positive

real interest rate. 5 months later, in order to accelerate the reform, China’s central bank let go of the ceiling on Chibor so that the interbank offering rate could be determined by the funding supply-demand relationship between both transaction parties. The removal of the ceiling on interbank offering rate marked both that indirect control of central bank facilitates the role of interest rate in financial resource allocation and that Chinese monetary authority formally starts up its interest rate liberalization reform. The issuance interest rate of national debt was fully liberalized in 1996. Along with the establishment of nationwide interbank bond market, the transaction interest rate was liberalized in June, 1997. The development of interbank bond market not only widened the range of interest rate liberalization but also created conditions for independent pricing. Interbank bond repo rate and spot bond transaction interest rate realized fully liberalized hereafter. By 1999, the PBC had removed all restrictions on bond market and money market rates, allowing interbank offering, central government bonds and financial institution bonds to be fully priced by the market. These moves paved the way for bank loan and deposit rates in the later years.

The asset-liability structure of China’s financial institutions decides that deposit and loan interest rates liberalization is at a critical position in China’s interest rate liberalization reform. International experience also suggests that liberalization of deposit and loan interest rates are core of China’s interest rate reform. The interest rate spread income from deposit and loan transactions brings most profits of banks in China, which makes deposit and loan transactions occupy a significant position among all kinds of banking businesses. Therefore, the interest rate of deposit and loan are of undoubtable significance in China’s interest rate structure.

The deposit and loan interest rate liberalization process has been continuously pushing forward. Since 1998, the PBC has adjusted the floating range of small and medium enterprises (SMEs)’ lending rate, expanded to 20% times of benchmark interest rate. Meanwhile, the ceiling of lending rate for rural credit cooperatives was expanded to 50% time of benchmark interest rate. Upon joining the World Trade Organization in 2001, China committed to opening up the country’s financial services sector to foreign competitors in five years. This commitment pressured policymakers to modernize China’s financial system and enhance the competitiveness of Chinese banks within that timeframe. Under this background in 2004, the PBC removed all ceilings on lending rates and all floors on deposit rates and reduced the lending rate floor to 0.9 times the benchmark rates. By taking this important step, the PBC allowed banks to price counterparty risks on customers within a floating band but kept interest spreads stable. The lending rates deregulated prior to deposit rates. This approach helps protect banks’ profit margins and shields them from a sudden increase in competition in following

years. The PBC also adjusted the floating range of commercial housing loans to individuals, expanding the floor to 15% and 30% in 2006 and 2008 respectively. In 2012, the PBC raised the deposit rate ceiling to 1.1 times the benchmark rates, and twice lowered the lending rate floor to 0.7 times of the benchmark interest rates. In July 2013, the PBC further removed all restrictions on bank lending rates, making it fully liberalized. In October 2013, the PBC started to publish a prime lending rate based upon the lending rate quotes submitted by nine leading commercial banks. In December 2013, the PBC allowed the issuance of large negotiable certificates of deposit on the interbank market. The latest moves represent small but important steps towards the full liberalization of interest rates. Thus the real interest rates can basically reflect the real situation of market supply d demand of funds.

Deposit interest rate indicates the bank’s cost of debt, and loan interest rate reflects the yield of banks. The relax of interest rate floating range would result in banks deposit interest rate floating to the top, and reducing loan interest rate to compete for savings and customers, e.g. most urban commercial banks, rural commercial banks and credit cooperates increase deposit interest rate by 10 percent, which further compressed interest rate spread and reduced profit. Attracting deposit by high interest leads to aggravated vicious competition within banking sector and instability of financial system.

Chinese monetary authority also promoted the process of interest rate liberalization for deposits and loans of foreign currency. In September 2000, the interest rates of foreign currency loan and large-amount deposit were liberalized. In pace with interest rate reform, the liberalization of foreign currency interest rate was fully achieved until 2004. Fairly competition between domestic venture banks and foreign venture banks realized thereafter.

In January 2007, Shanghai Interbank Offering Rate came into operation as the pricing foundation of bonds and derivative products. It finally became the benchmark interest rate in the money market because of its gradually revealed importance. Meanwhile, China’s central bank constantly improve the interest rate mechanism reform, paying specific attention to the pricing mechanism of financial products in order to achieve reasonable pricing of financial products. The China Financial Futures Exchange (CFFE) has been running mock trading of government bond futures since 13th February 2012. The reactivated of government bond futures is an important driving power of interest rate liberalization reform in China. This is a substantial step in China’s interest rate liberalization reform.

While the central bank has not produced an official time table, market participants do not expect the full liberalization of deposit rates to take place in the immediate future. According to a survey conducted by Deloitte in 2012, more than half of surveyed financial institutions and senior executives predicted that it will take China another 5 to 10 years to achieve complete interest rate liberalization. The survey finding implies that the total time span for China’s interest rate liberalization reform could extend well above 20 years, which is among the longest in the world. Zhou Xiaochuan, governor of the People’s Bank of China, said in March 2014 that deposit rate liberalization will be carried out in the next one to two years. The way of China’s interest rate liberalization is finally approaching the end.

This gradual approach reflects policymakers’ concerns on banking sector conditions, and goals to minimize negative impacts on China’s banking sector and ensure financial market stability. The relatively lengthy process of interest rate liberalization has provided leeway for China’s banking sector conditions to improve. Starting in 1999, with substantial government assistance, state-owned Chinese banks unloaded billions of dollars of nonperforming loans stemming from central and local government-directed lending in the early years. Nonperforming loan ratios of the banking sector declined from the double digits in 2004 to less than one percent in 2012.6 After the recapitalization and restructuring, Chinese banks modernized corporate structure, improved risk management, and built a stronger capital base. These changes positioned them to weather potential challenges that the full liberalization of interest rates would entail.

However, this gradualism has its costs. Market participants react to the prolonged interest rate liberalization process by engaging in regulatory arbitrage. In particular, the viral growth of wealth management products in recent years can be viewed as a de facto liberalization of bank interest rates outside banks’ balance sheets.7 Full liberalization of interest rates could be expected to reduce these types of distortions.

Bhattacharyya, Bhattacharyya and Kumbhakar (1997) report that liberalization had a major impact on productivity and efficiency increases in various industries and the banking sector in some Eastern and Central European countries, as well as China. Embarking on interest rate liberalization about two decades ago, China has made significant progress. However, banking crises have become worldwide phenomena in recent years and it turns out that the key factors appear to be weak management and poor control of risks. Actually, risk is an essential ingredient in bank production. Banks specialize in risk assessment, risk monitoring, and risk diversification (Lei Sun,

Tzu-Pu Chang, 2010). This trend forces China to fasten financial liberalization urgently. The main events are summarized in the end of this setion.

Interest rate liberalization, which allows interest rates to be related to market forces can provide some benefits including (Hanson, 2001; Abiad et al., 2004; Feyzioğlu et al. 2009): (1) improving the allocation and efficiency of investment; (2) better pricing of capital and risk; (3) better risk management for firms and households; (4) enhancing the effectiveness of indirect monetary policy instruments; (5) more credit flowing to sectors previously underserved such as small and medium-sized enterprises (SMEs); (6) improving the financial regulation and supervision. In addition, Liao and Tapsoba (2014) also argued that the complete liberalization of interest rates will help reduce saving rates, boost consumption, and make China’s growth more inclusive. The complete liberalization may be achieved within one or two years (Xiaochuan Zhou 2014), however risks always come together with opportunities, Casserley (1991) thought that risk is everywhere, how to strengthen the risk management during the whole liberalization is becoming gradually important now. As the process carries forward, banks in China are exposed to more financial risks.

Since 2012, China has accelerated the interest rate liberalization process. The ceiling of deposit interest rate has been twice adjusted to 1.3 times and 1.5 times of benchmark interest rate respectively, which actually have already covered the main floating space of banks’ pricing autonomy. As CDs has been introduced into the Chinese market, China’s banking sector has essentially entered the stage with fully liberalized interest rate, just one step before finally canceling the upper limit of deposit interest rate. Currently, the macro-economic and financial ecosystem is undergoing extensive and profound reforms, international experience indicates that with potential opportunities hiding in the severe challenges, interest rate liberalization is a process of survival of the fittest. Historical experience shows that, within or after the interest rate liberalization process, financial instability has occurred in many countries.

The stability of financial system can be easily affected by interest rate liberalization in many ways as following situations

1)! Liberalized interest rate can lead to excessive competition. Financial institutes are capable of utilizing price after liberalization. Competition is easily intensified and banks become more risk-seeking. Interest rate liberalization in America started in 1973 and lasted for 13 years. As shown in chart 1, during the process and 5 years later, the number of failed banks increased dramatically, 82 banks failed from 1973 to 1981, 468 banks failed from 1982 to 1986, and 1808 banks failed in another 6 years. This is so-called “American savings and loan crisis”

chart 1. Number of failed banks in America (1973~1995)

2)! Interest rate liberalization leads to excessive lending, banks would make less prudent lending decisions because of rivalry pressure, seeking high-profits by offering credit to high-risk projects thus increasing non-performing assets of banks. 3)! Japan applied interest rate liberalization from 1977~1994, “Japanese bubble” and

“bank crisis” are two keywords during this period. During the “bubble” time, banks had lent too much money to high-risk industries with land as collateral. When the land depreciated to half of previous value, the quality of banks’ loan got worse, lots of non-performing loans existed. Chart 2 shows the distribution of loans within the society, as we can see from the chart, the quality of bank loan is really sensitive to the price of land after 1990s. When the “bubbles” burst, the price of stocks banks hold dropped sharply, evaporated unrealized capital earnings, and put heavy pressure on their capital adequacy. From 1989, rating agencies gradually lowered credit rating of Japanese banks, as shown in chart 3.

chart 2. Loan distribution in Japanese banks (1980~2000) (%)

4)! After liberalization, interest rate will have more fluctuation, which will easily lead to liquidity risk due to maturity mismatch of deposits and loans; also, severe

competition from interest rate liberalization drive banks financing from international market (Yung C. P, 1998), so that potential debt risk can not be neglect. Last but not least, attention should be paid to adverse selection and moral hazard. Because of Information asymmetry, banks can not clearly distinguish different risk preference, both the quantity and quality of loans will be affected.

3! Interest rate liberalization index

!

As Keynes (1936) noticed that Every single factor in economic system has a certain relationship with interest rate, Henry Kaufman once said, to some extent, changes occurred in financial market so far are centralized embodied in interest rate. Given the importance of interest rate in the national economy, governments in both developed and developing countries have attempted to control interest rates in the past decades. Interest rate repression is a significant feature of economic development in each state. Along with changes in monetary policy objectives and tools, as well as promoting of financial innovation, the wave of worldwide financial liberalization emerged since late 1960s, and the interest rate in particular. From the view of world financial market development trend, reform of interest rate is an inevitable routine to sustained economic growth of each country. Interest rate liberalization plays a key role in China’s financial reform, and is currently breaking though as the most essential area. The reform motivation, implementing time, past courses as well as the risk management, international experience and subsequent breakthroughs have been heavily documented by scholars, demonstrating and analyzing the liberalization process enlightened and inspired, pointing out that this reform is a progressive realizing process, so that the level of liberalization differ from each period. However, the subjectivity of those discoveries is appealing for a quantitative index as reference with increasingly urgency.

Interest rate liberalization process, in china, is a dynamic process, which starts from gradually liberalizing until fully remove the control or restriction on interest rate level and its floating range, thereby forming the determination and adjustment mechanism for interest rate based on market supply and demand. The core principle of this process is transformation, which means transforming from government-regulated to market-driven, by gradually getting rid of government intervention and employing a new regulation and control policy, including changes in level of real interest rate, the way of interest rate determination and the range and magnitude of interest rate floating. Similar inspiration emerged from international experience we discussed in the previous sections. Interest rate liberalization is definitely not an unexpected emergency accomplished in one strike, and therefore the measurement has to be closely integrated with specific practice of reform, reflecting the progressive and repeated characteristics of transformation. Liberalization index can objectively describe the process and accurately provide quantitative analysis instruction as well, moreover, this index can also act as the empirical basis of subsequent reform process and advance path, e.g. main agenda, favorable conditions and constrains. In this section, two different approaches,

simple average method and analysis hierarchy process (AHP) method, are applied to build up China’s interest rate liberalization index, mutually corroborating the solidity of each other and illustrating that China has realized interest rate liberalization to some extent.

3.1! Using simple average method to build up the interest rate liberalization index

Due to better applicability and easier convertibility, simple average method is employed here to build up interest rate liberalization index. According to actual situation of China’s interest rate liberalization process, we choose three indicators real interest rate, way of interest rate determination as well as the range and magnitude of interest rate floating as indicators to construct the index in this paper, logically meaning that common changes among three indicators, even smaller, are of more significance than bigger changes in one single aspect, reflecting that synergistic advancement is the main character of this reform.

A country’s real interest rate is the rate of interest rate an investor expects to receive after subtracting inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate (Guide to financial markets, Marc Levinson, 2005). from the view of Edward S. Shaw and Ronald. I. McKinnon (1988), to eliminate financial repression and achieve financial deepening, the interest rate control must be removed at first, avoiding negative real interest rate. In this paper, we define real interest rate by 1-year deposit interest rate minus inflation rate.

The measurement criteria of interest rate liberalization are whether financial institutions have the autonomy to determine interest rate (Yi Liu, Hong Shen, 2002), therefore the the change in numbers of interest rate categories that the monetary authority controls could be the measurement standard here. There were three different interest rate determination ways in China’s process of interest rate liberalization, in the initial stage of liberalization process, interest rate was total controlled by the government with the lowest liberalization level; when it comes to the final phase, the liberalization is on the highest level determined by the supply-demand relationship in the market. Between these two ends, interest rate in the intermediate state is affected by both the government and the market, partially liberalized and the loan-to-deposit ratio is strictly regulated by the central bank.

Another important evaluation criterion is the floating range and magnitude of interest rate, as the phased goals of the liberalization process, with the incomplete autonomy of determining interest rate for each bank. Bigger floating range indicates more relaxed control on both the upper and lower limit of interest rate, which means the lower official constraint level and more liberalized. From the measurement view, the interest rate liberalization index is divided into 17 categories under 5 criteria, measuring separately and integrating with practical situation.

With a time range from 1979 to 2015, data for each category are collected from China statistical yearbook, various years, website of national bureau of statistics of China and people’s bank of china. Considering the gradualness and repeatability of liberalization process, we employ interval assignment method to express these characteristics. Specific procedures are as follows, after collecting data for each indicator and determining the upper and lower limit, a 4-interval value assignment is applied, namely completely repress, partially repress, partially liberalization and completely liberalization respectively, values 0, 1, 2, and 3 are assigned sequentially. The interest rate liberalization index is composited by annually average value of three indicators, within range 0~3 .

1)! Real interest rate

From 1979 to 2014, the real interest rate in China was positive for 22 years, 0 for one year and 13 years’ negative, the range of positive interest rate is [0.4~7.4] with average of 2.3% and the range of negative interest rate is [-8.0~-0.2] with average of -4.1%. Thus, we set -5%, 0, and 2.5% as threshold for 4 assignment internals and then assign 0, 1, 2 and 3 to intervals ≤ −5%, −5%, 0 , 0, 2.5% , and ≥ 2.5% correspondingly. The results are shown in chart 4.

chart 4. Real interest rate from 1979 to 2014 in China and assigned values

2)! way of determining interest rate !

In this paper, the indicator of the way determining interest rate is measured by changes in the number of interest rate categories controlled by the monetary authority. 17 categories under 5 criteria are defined as follows,

a)! RMB deposit interest rate, 2 categories are included, that are household’s saving deposit interest rate and CDs interest rate;

b)! RMB Loan interest rate has 3 categories, including urban and rural credit cooperation loan interest rate, short-term interest rate and long-term loan interest rate;

c)! Foreign currency interest rate has 2 categories, including loan and deposit interest rate;

d)! 7 categories are included in Money market interest rate, that are SHIBOR, bill discount rate, bond repurchase interest rate, acceptance interest rate and fixing repo rate, financial lease interest rate, short-term government bond interest rate

e)! bond market interest rate contains 3 categories, which are corporation bond interest rate, financial bond and long-term government interest rate.

Considering that the loan-to-deposit ratio was always a regulatory constraint (the upper limit of deposit interest rate and the lower limit of loan interest rate were controlled respectively), we set 0, 1~2, 3~4, and 5 as thresholds for numbers of interest rate criteria controlled by government, assign 0, 1, 2, and 3 for different liberalization levels correspondingly, with respective considerations about practical liberalization situations. Results are shown in the following chart.

chart 5. Values assigned for ways of determining interest rate and interest rate floating

3)! floating range and magnitude of interest rate

Each category of interest rate in China is floating within a fixed range under regulation from central bank. To examine the floating range, we set 4 thresholds for measurement intervals, namely completely repressed (non-floating space), small-scale liberalized (at least 6 categories), wide-scale liberalized (at least 11 categories) and fully liberalized; and magnitude measurement is divided into 4 levels, which are < 30%, 30%, 50% , 50%, 100% ,.and ≥ 100%. Full of reversals and zigzags, China’s interest rate constant fluctuation process effectively started in 1983, Since the central

bank granted Chinese commercial banks 20% adjustment range for interest rate. Results are shown in the following table.

chart 6. Interest rate liberalization index by simple average method

3.2! Using analysis hierarchy process (AHP) to build up the interest rate liberalization index

AHP is a multi-attribute and multi-period modeling approach that has considerable intuitive ascendancy and is theoretically rigorous, as a multi-attribute decision making model, AHP was developed by by Thomas L. Saaty in the 1970s and has been extensively investigated and refined since then. One advantage of AHP is that it reflects how possible changes of elements in higher levels affect elements on lower levels and vice versa. Moreover, it demonstrates an overview of criteria within the whole system. A further advantage of AHP is that a mature criteria system has Applicability regarding to changes within similar situations. Overall, the most significant advantage of AHP is lying in its capability to structure a specific and solid of a complicated, multi-attribute measurement hierarchically. However, using AHP also has some shortcomings. One of these is its complicated calculation which makes it complexly forth putting. Furthermore, opinions about picking weight for each element on different levels may differ from everyone, and the limited number of theoretical elements choosing from

infinite realistic situations also requires the reliable and prudent background consideration. This method consists of five steps.

Applying AHP method to measure the process of China’s interest rate deregulation. The same model based approaches have been applied to many previous researches, e.g. the study of credit granting by Venkat Srinivasan and Yong H. Kim (1987); national waterway design (Saaty and Vargas, T. L. Saaty and L. G. Vargas, 1982); and study of Selecting Suppliers in an Effective Supply Chain by Shahroodi, Kambiz (2012); streams of other documents have applied AHP methodology (Kirytopolos et al 2008; Bhutta and Huq 2002; Onesime et.al. 2004).

chart 7. Analytical hierarchy process

Step 1. build up the hierarchy

Analytical hierarchy process starts from decomposing the principal problem into a hierarchy (Venkat Srinivasan and Yong H. Kim,1987). Different level consists of a set of elements and each element in current level is constituted by elements from next level of the hierarchy. The final level involves the most specific detail criteria of the certain problem. As shown in chart 7.

To assess China’s interest rate liberalization process, we build up a 3-level hierarchy, decomposing the interest rate index from first level into two Criterions on the second level and twelve elements on the last level. As shown in chart 8.

chart 8. Hierarchy for building up interest rate index

To make the liberalization process quantitatively analyzable, we need to quantize each elements. The specific assignment details are shown in the following chart. Apply a value interval 0~1 , 0 means no liberty in interest rates; 1, on the contrary, means completely liberalized; bigger the value indicate a higher level of liberalization. As shown in table 2.

chart 9. Example of value assigned to liberalization level

Notably, in the process of building the index, some subjective judgment could infect the rationality of this index.

Step 2. Structure discriminant matrix

The basic assumption underlying the measurement methodology in AHP is that relative dominance can be measured by pairwise comparisons. (Venkat Srinivasan and Yong H. Kim,1987). A 9-point measurement scale is used in comparison, where 1 represents!

equal importance of element / over element 0 and 9 means absolute importance of element /.over element.

chart 10. Measurement scale

Assuming that assessing the problem requires dealing with pairwise comparisons of a set of n attributes and defining their relative weights. If we indicate the attributes by 11, 12, . . . , 12, the pairwise comparison matrix 3 should be expressed as the reciprocal matrix shown below:

3 = 155 156 165 166 ⋯ 158 ⋯ 168 ⋮ ⋮ 1₈₅ 1₈₆ ⋯ 1⋮ ₈₈⋮ ;.1_;< > 0;.1_;< = 1, >ℎ@2./ = 0;.1_{;< = 1 1<;}. !

The discriminant matrix is obtained from pairwise comparisons of relative importance of each elements, therefore the determining of relative importance of elements is particularly important. Discriminant matrix.Α₅ ,.Α₆ and Α_B are shown in following In this part, data are collected from the aggregate financing to the real economy database and aggregate transaction volume to construct three discriminant matrixes. Scale of social financing refers to the aggregate amount of money the real economy received from the financial system. From an institutional mechanism perspective, the financial system concept here means the overall financial industry, which contains not only bank sector but also other institutions like security and insurance agencies; from the market perspective, from credit market, bond market, to security market, insurance market and intermediate business market, are all covered.

Database of real economy aggregated financing has a solid theoretical basis. Early in Mid-1950s, the Radcliff report has pointed out that the real impact on economy is not from money supply in the traditional sense, but including monetary supply, the liquidity within the whole society. The decisive factor of monetary supply is the entire financial system involves both the commercial banks and non-bank intermediaries instead of just the banking sector itself; thus, monetary authorities should pay their attention to

liquidity within the whole society rather than just the money supply (Nicholas Kaldor, 1960). Later findings from Gurley Shaw Benston George and Mishkin, like financial intermediary theories, have the similar viewpoints, as well as the generalized credit conception proposed by Basel Committee in 2010. Another theoretical support is from Conduction Mechanism of Monetary Policy brought forward by Bernanke, Stieglitz and Tobin, since late 1960s, which considers both the liability and asset sides are affecting the real economy.

Step 3. Discriminant matrix consistency check

in order to avoid inconsistencies in determining the importance of elements, consistency check is prerequisite. This check involves three variables, consistency deviation index, CD, average random consistency index, ED, and consistency ratio, CE.

CD =FGHIJ8

8J5 ,

K_LMN is the largest eigenvalue, n is the order of the matrix. The smaller the CD value, indicting that the matrix is closer to complete consistency. Generally, a larger, n, the order of the matrix, indicates the larger deviation from complete consistency caused by artificial factors. The value of RI is obtained from more than 500 times repeated calculation of eigenvalue of randomly chosen matrix, and associated with the order of the matrix. The consistency ratio CE =_TSRS, when CE < 0.10, the matrix has acceptable consistency.

Step 4. Determine the weight of each element.

To calculate the weight of elements on each level, the Analysis Hierarchy Process first calculates the corresponding largest eigenvector Uof the largest eigenvalue K_LMN, then normalize the eigenvector to get the weight for each element.

Result of single-level weight calculation is shown in the last row of each matrix in the following table, the aggregated weight of each element does not need complicated calculation as well, simply using single-level weight of elements on the third level multiply the weight of element on its upper level, and the results are shown in the following charts.

chart 11. discriminant matrix Α₁

chart 12. discriminant matrix Α2

chart 13. discriminant matrix Α₃

chart 14. aggregate weight of each indicators

Lastly, the interest rate index is the product of aggregated weight of each element on the final level and its own relative importance value.

chart 15. Interest rate liberalization index

chart 16. Interest rate liberalization index in money market and capital market

As shown in the result charts, index built from both simple average method and AHP method are almost the same, mutually demonstrating the accuracy and rationality. According to the index developed in this paper, China’s interest rate liberalization reform has finished more than 93%. The reform process so far can be divided into three phases. The startup stage starts from 1979 to 1995. From 1996 the interest rate liberalization reform entered a dynamically pushing forward stage until 2006. The third stage starts from 2007 with partial breakthroughs and fluctuations until now. Following the sequence that from money market, bond market interest rate, to foreign currency interest rate, and then ceiling of RMB lending rate and floor of RMB deposit rate afterwards, interest rate liberalization reform has made several significant achievements. The level of interest rate liberalization reached a relatively high level

around 2003 to 2006. Because of the increased volatility of domestic economic and disturbance of international financial crisis, the interest rate liberalization process experienced partial fluctuation since late 2007. Until now, the interest rate liberalization index has reached 93%. Except the barrier remains in RMB deposit interest rate, the main interest rate mechanism is already relaxed. In April and May 2015, the upper limit of RMB deposit interest rate was twice adjusted to 1.3 and 1.5 times benchmark interest rate respectively, which encourages the promotion of liberalization process. Removing the restriction on upper limit of deposit interest rate has become a present key point of interest rate liberalization reform in China. Therefore, both the advantages and constrains of continue pushing forward the interest rate reform should be taken into consideration.

The advantages of continue pushing forward interest rate liberalization in China 1)! An excellent occasion. The international experience shows that interest rate

liberalization process lasts at least 2 years and at most 15 years, and the average level is around 10 years. Since China remarkably removed the upper limit of interbank offering rate in 1996, it has been 19 years. From a timing perspective only, China has the condition to finalize this reform.

2)! The development of financial market and opening-up reform provides diversify choice for capital allocation. Different markets have been connected and accessible, for example, domestic and international banking sector, real estate market, money market, bond market and stock market. By spreading and allocating capital to different market choice, it’s easier to realize maintenance and appreciation of values for Chinese economic entities. This will be a shock to traditional financing mode and motivation of the subsequent interest rate liberalization reform.

3)! Appropriate institutional background. After the global financial crisis and overheated Chinese economy in 2007, China’s monetary authority has made up the mind to realize financial deepening by different means during the 12th five-year-plan, such as capital account opening, RMB internationalization, especially interest rate liberalization. Efficient policy substantially supports this reform process to push forward.

The constrains of continue pushing forward interest rate liberalization

1)! There still remains a gap in interest rate spread between Chinese and foreign countries. From 2008 to 2015, the PBC has adjusted interest rate around 16 times, the new one-year deposit benchmark deposit interest rate is 2.5%, much higher than the federal funds rate in America (0%~0.25%), and main interest rate in

Europe (0.75%). More than 2% gap easily leads the international arbitrage fund enter Chinese financial market.

2)! Backward in risk management technique will lead to systematic risk. Because of the high speed economic growth and the remaining financial control in China, Chinese banking system has not experienced great risk, such as economic sharp decline or irregular changes in interest rate. Although the risk-consciousness of Chinese banking sectors has been enhanced, the potential risk is still a hinder of fully liberalizing interest rate.

3)! Chinese financial market is inadequate; the monopoly has not broken yet. In order to develop fair competition within domestic financial industry, Chinese supervision and monetary authority has made efforts to promote the development of various kinds of financial institutions. However, the monopoly position of Chinese banks has not objectively beat yet. Hastily finishing liberalization reform may intensity the monopoly among market players, leading to crisis among small-sized banks and other small financial institutions. This obviously violates the original intention of interest rate liberalization reform.

! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! !

4! The impact of changes in interest spread on commercial banks’

profitability in China

1)! model design

in this part, I will examine the relation between interest rate spread and profitability of banks. Plenty of researches have documented in the similar area, from which applicable methods and approaches can be referenced. Ziyun He (2011) compared the interest rate spread between 4 state-owned banks and 2 joint stock banks in China, using OLS regression model. Guodong Zhao (2010) compared weighted net interest rate spread and found that China’s net interest rate spread level is lower than the average international level. He developed an interest rate spread pricing model which facilitates the future research of interest rate spread in China. Myrna R. Berríos (2013) set net interest spread as dependent variables, and employed general analysis of covariance model to measure whether non prudent highly risky lending diminished bank profitability and cash flows during recent years. Haslem, John A. and Bedingfield, James and Stagliano (1983) reported the association between net interest spread, as one of the key variables, and relative bank profitability, using a longitudinal analysis. In this paper, I apply double logarithmic model since banks’ interest spread and profitability approximately have linear relationship, and this method can better reflect the absolute effect of every one unit change in interest rate spread on banks’ profitability. The original model equation is as follows,

VWX_Y = VWZ + \VW]_Y+ ^_Y

Here, the natural log of Y is the dependent variable and the natural log of X is the independent variable.

In a double-log equation, an individual regression coefficient can be interpreted as an elasticity because:

\ =Δ(a2X) Δ(a2])=

ΔX X

Δ]/] = @a1de/f/egh,i

This mode illustrates that one percent change in X will cause β% change in Y. 2)! Variables and data

To measure the profitability of commercial banks, attention from previous researches have been paid to return on asset (ROA), return on equity (ROE), and net profit. According to MacDonald and Koch (2006), if a group of bank chief officers are cornered and asked to summarize performance for the past year, most would quote

either return on equity (ROE) or return on assets (ROA) of their banks. In this paper, we choose ROE as dependent variable to measure the profitability of listed banks, higher this indicator, means the higher profits from investments and more profits for shareholders; moreover, in DuPont Analysis, ROE can be Gradual decomposed into 3 different financial ratios and analyzed more detailed from profitability, operating capacity and debt-paying ability perspective, therefore ROE is of better synthesis and reflects banks’ profitability much better.

In this paper, I define interest rate spread as real interest rate spread which is consist of benchmark interest rate spread (Bs), floating interest rate spread of loans (Fsl), interest rate spread of loan quality (Slq), interest rate spread of loan term structure (Slts), and interest rate of deposit term structure (Sdts). The specific equation is as follows. !

p@1a./2e@p@de.p1e@.dqp@1r = sd + tda + uav + uaed + ured! !

Each element is defined by the following equations. ! w@2fℎx1py./2e@p@de.p1e@.dqp@1r. sd ... = z2@.g@1p.w@2fℎx1py.a@2r/2{.p1e@ − z2@.g@1p.w@2fℎx1py.wzppz>/2{.p1e@ |az1e/2{./2e@p@de.p1e@.dqp@1r.z|.az12d. tda = az12.fz2ep1fe./2e@p@de.p1e@.dqp@1r − e@px.dep}fe}p@.>@/{ℎe@r.1~@p1{@./2e@p@de.p1e@.z|.az12d /2e@p@de.p1e@.dqp@1r.z|.az12.v}1a/eg. uav = p@1a./2e@p@de.p1e@.z|.az12d − fz2ep1fe./2e@p@de.p1e@.z|.az12d /2e@p@de.p1e@.dqp@1r.z|.az12.e@px.dep}fe}p@. uaed = e@px.dep}fe}p@.>@/{ℎe@r.1~@p1{@./2e@p@de.p1e@.z|.az12d − z2@.g@1p.w@2fℎx1py./2e@p@de.p1e@.z|.az12d. /2e@p@de.p1e@.dqp@1r.z|.r@qzd/e.e@px.dep}fe}p@. ured = e@px.dep}fe}p@.>@/{ℎe@r.1~@p1{@./2e@p@de.p1e@.z|.r@qzd/ed − z2@.g@1p.w@2fℎx1py./2e@p@de.p1e@.z|.r@qzd/ed

Theoretically, interest rate spread is proportionate to bank’s profitability. Thus, my hypothesis here is that the narrower the interest spread, the profitability of banks will be declining, and vice versa.

As shown in the following chart, until 2014, although adjusted for several times, the spread between deposit and loan interest rates has become gradually narrower, and maintain around 3% recently.

chart&17.&Changes&in&Interest&spread&

The model is expressed in this paper as follows:

VWEÄ_Y = VWZ + \VWDu_Y+ ^_Y

Dependent variable VWEÄ is the logarithm of return on equity, and the independent variable VWDu is the logarithm of interest spread.

Panel Data of interest spread and EÄ is collected from 20 listed banks in China (until 2014). Because of different scale and capital structure, EÄ may differ from each bank, we divide 20 listed banks into 5 state-owned commercial banks, 12 national joint-stock commercial banks, and 3 city commercial banks; and calculated the average EÄ of each year. We expected to examine if changes in interest spread have different effect on various kinds of banks.

3)! Econometric results

This table illustrates the association between ROE and interest spread by different bank type. The dependent variable is ROE and independent variable is interest spread (defined as loan interest rate minus deposit interest rate). The value in bracket represents the P value of the t statistic. *, **, *** represent significant level at 10%,5% and 1% respectively.

a)! Changes in interest spread have insignificant effect on EÄ

We can explain this result in different points of view, a) Interest spread is not the only factor that affects return on equity of each bank, there are a lot of other factors, e.g. ROA, loan-to-deposit ratio, capital structure and tax rate. In this paper, we just focus on the effect of interest spread so that ignored others. b) Using DuPont Analysis equation,

EÄ = 2@e./2fzx@.×.1dd@e.e}p2z~@p.×.@v}/eg.x}ae/qa/@p

among three factors in the equation, net income has the same changing direction with loan interest rate, and the equity multiplier has the same changing direction with deposit interest rate. Three factors of EÄ can not change in the same direction with loan and deposit interest rate simultaneously, therefore EÄ is insensitive to changes in interest spread.

b)! Interest spread becomes narrow, but the profitability of banks is enhanced. Theoretically, profitability of banks should be declining as long as the interest spread goes narrow, however, empirical results shows that addition to 3 city commercial banks of which interest spread has the same changing directions with.EÄ , correlation between interest spread and EÄ of 17 other banks is negative. 1% narrower in interest spread indicates 1.42% lower in EÄ of state-owned commercial banks, 0.67% lower in EÄ of joint-stock commercial banks; only city commercial banks have 0.97% increase. After several times official adjustment for benchmark interest rate, the real

interest spread did not suffer too much unexpected change, but profitability further enhanced. We can explain this phenomenon in two aspects,

!! from the real interest rate perspective, real interest rate is far from benchmark interest rate in each bank. For instance, in 2014, interest spread in ICBC is 2.46%, 0.06% more than that in 2013; as well as 2.59% in CMBC, 0.1% more than that in 2013; and both of them are higher than the benchmark interest spread, 2.37% in that year. Although the benchmark interest spread is narrowing, the real interest spread in each bank is rising, instead of falling.

!! another reason caused the empirical result deviates from theoretical hypothesis is that banks are searching for new chance of profit growth, which is also an impact of interest rate liberalization. In 2013 and 2014, the percentage of net interest income in total earing declined or remained unchanged, to make sure of higher-spread or profitability, and to stabilize profit growth, many commercial banks have put great effort on business innovation and transformation. The rapid development of intermediate business leads to higher proportion of non-interest incomes in total earnings. So that bank profitability depends less on interest spread. However, until 2014, there is still a large gap between 33%, which occurred in BOA is the highest proportion of non-interest incomes and 50%~60%, which is the average level in the advanced banks worldwide. Therefore, as non-interest earnings become increasingly important in banks’ profit structure, the effect of narrowed interest spread is undermined.

5! Summary and Conclusion

According to the index developed in this paper, China’s interest rate liberalization reform has completed more than 93%. The reform process so far can be divided into three phases. The startup stage starts from 1979 to 1995. From 1996 the interest rate liberalization reform entered a dynamically pushing forward stage until 2006. The third stage starts from 2007 with partial breakthroughs and fluctuations until now. Following the sequence from money market, bond market interest rate, to foreign currency interest rate, and then ceiling of RMB lending rate and floor of RMB deposit rate afterwards, interest rate liberalization reform has made several significant achievements. The interest rate liberalization has reached a relatively high level around 2003 to 2006. Because of the increased volatility of domestic economic and disturbance of international financial crisis, the interest rate liberalization process experienced frequent fluctuation since late 2007. Until now, the interest rate liberalization index has reached 93%. Except the barrier remains in RMB deposit interest rate, the main interest rate constrains have already been relaxed. In April and May 2015, the upper limit of RMB deposit interest rate was twice adjusted to 1.3 and 1.5 times benchmark interest rate respectively, which encourages the promotion of liberalization process. Removing the restriction on upper limit of deposit interest rate has become a key point of interest rate liberalization reform in China currently. Therefore, both the opportunities and constrains of pushing forward the interest rate reform should be taken into consideration. The opportunities of pushing forward interest rate liberalization in China

1)! An excellent time. The international experience shows that interest rate liberalization process lasts at least 2 years and at most 15 years, and the average level is around 10 years. It has been 19 years since China remarkably removed the upper limit of interbank offering rate in 1996. From a timing perspective only, China has the condition to finalize this reform.

2)! The development of financial market and opening-up reform provides diversify choice for capital allocation. Different markets have been connected and accessible. For example, domestic and international banking sector, real estate market, money market, bond market and stock market. By spreading and allocating capital to different investment channel, it’s easier to realize maintenance and appreciation of values for Chinese economic entities. This will be a shock to traditional deposit and loan mode. In order to maintain competitiveness, China’s commercial banks need to continue the interest rate liberalization reform.

3)! Appropriate institutional background. After the global financial crisis and overheated Chinese economy in 2007, China’s monetary authority has made up the mind to realize financial deepening by different means during the 12th

five-year-plan, such as capital account opening, RMB internationalization, especially interest rate liberalization. Efficient policy substantially supports this reform process to push forward.

The constrains of pushing forward interest rate liberalization

1)! There still remains a gap in interest rate spread between Chinese and foreign countries. From 2008 to 2015, the PBC has adjusted interest rate around 16 times, the new one-year deposit benchmark deposit interest rate is 2.5%, much higher than the federal funds rate in America (0%~0.25%), and main interest rate in Europe (0.75%). More than 2% gap easily attracts the international arbitrage fund enter Chinese financial market.

2)! Backward in risk management technique will lead to systematic risk. Because of the high speed economic growth and the remaining financial control in China, Chinese banking system has not experienced great risk, such as economic sharp decline or irregular changes in interest rate. The banking sector in China is unexperienced in resisting risk. Although the risk-consciousness of Chinese banking sectors has been enhanced, the potential risk is still a hinder of fully liberalizing interest rate.

3)! Chinese financial market is inadequate, and the monopoly has not broken yet. In order to develop fair competition within domestic financial industry, Chinese supervision and monetary authority has made considerable efforts to promote the development of various kinds of financial institutions. However, the monopoly position of Chinese banks has not been objectively beaten yet. Hastily finishing liberalization reform may intensity the monopoly among market players, leading to crisis among small-sized banks and other small financial institutions. This obviously violates the original intention of interest rate liberalization reform. During China’s interest rate liberalization process, narrowed interest rate spread did not lead to lower profitability of banks as hypothesized. what’s more, the profit level of banks is slightly increasing every year. As this increasing pace of profit is slowing down gradually, the non-interest income in the future is of obvious importance. Under the specific background, interest rate liberalization process in china has more profound significance than in other countries. With lower economic growth, relaxed market access and internationalized RMB currency, interest rate reform is making the financial eco-system grim and complicated. Meanwhile, burgeoning internet finance further brings pressure towards traditional financial sector. Various types of internet financial

productions significantly diverted social capital, which increases banks’ cost of debt and intensifies the competition in the market for both human and capital resources. Considering about both domestic operating environment and foreign experience, unfavorable shocks may divide banks into different echelons after interest rates fully liberalized. Banks with more foresight may positively give innovational responses resisting shocks and catching the opportunities; other banks on the end of echelon may suffer a substantial decline in their returns, below average level in the society.

To realize development in the “new normal”, Chinese commercial banks should adjust to the new situation under the interest rate liberalization reform, rapidly alter extensive operating pattern, and establishing refined and detailed management. Some advises for maintaining or increasing profitability are as follows:

1)! Deposit pricing differentiation. The traditional “one size fits all” deposit pricing model can not fit in the modern complicated economic environment. Chinese domestic banks should develop a new deposit pricing mechanism. Under this new mechanism, banks flexibly adjust deposit interest rate depends on the difference between costumers. Under this new mechanism, banks should build up a costumer behavior database, and classify different situations based on different customers’ sensitivity to interest rate.

2)! Risk-based loan pricing. a risk-based loan pricing system is an appropriate way of risk-control for commercial banks. A risk-based loan pricing system means defining the relationship between risk and capital price, and calculating the balanced price based on various risk situation. The big-data technology makes it available to develop a comprehensive database, which is the first and most important step.

3)! Detailed pricing for intermediate transactions. Based on the practical financial judgment and prediction, commercial banks may initiatively adjust the structure and size of capital, optimize the capital-debt structure. Making some credit capital cashable and easing capital occupancy will strengthen the profitability of banks.

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