Banking Reform in China: Gradually Strengthening Pillar or Fragile Reed?

Abstract

Two decades of policy lending created a large bad debt burden in the loan portfolios of the four large state-owned specialty banks that together dominate all aspects of banking in China. The government has recognized the need to restructure these insolvent banks by setting up bad debt agencies with a narrow purpose to work out or sell bad debt. This reform does not sever the link between the bank and the client so that soft lending will continue. Drawing on the experiences of fast track transition economies, we make two emendations to the Chinese banking reform program. First, establish hospital banks to take both the bad loans and the undesirable clients. In working to restructure some of these SOEs, the hospital banks will develop the skills of investment bankers and venture capitalists. Second, begin the gradual divestiture of the state form the large banks by selling small blocks of shares on the domestic market and using stock options to create proper incentives for bank management. This reform package would jump start the stalled development of capital markets in China and strengthen its dominant banking sector.