Reform of the internal control and internal incentive systems of the commercial banks   Speech of Governor Zhou Xiaochuan at the Beijing Finance Expo September 1, 2005, Beijing   Steady progress has been achieved in China´s banking reform under the guidance of the CPC central committee and the State Council. In the transition from the planned economy to market economy, the government still intervened a lot in the banks´ internal operations and the banks have not established sound credit culture, leading to large amount of non-performing loans. The improper management system under which decision powers were equally distributed from the head office to the branches and sub-branches as well as the ineffective internal control and internal incentive system both contributed to the large non-performing loans of the banks. The government has provided enormous support to the banks, and the banks themselves have also made tremendous efforts to dispose of the non-performing loans with their existing capital and the profits accumulated in recent years. In such a context, strengthening the internal control and internal incentive systems has become one of the most important reform measures. Priority efforts should be made to improve the internal control system of the banks, promote a sound credit culture and establish effective loan-granting procedures. The banks have started to enhance their internal control, reform the decision-making process and strengthen the centralization of decision powers. On the other hand, the banks will also need to enhance their credit support to the small and newly established enterprises. In the past, the banks tended to compete for a few large enterprises. This is not good for the development of the entire economy. The State Council has always stressed that, in pursuing the banking reform, credit support to the small and newly established enterprises must be strengthened. We have to learn from past experiences and try to strike a proper balance between banking reform and credit support to small enterprises.   With technological advances and financial product innovation, the risk profile facing the financial sector has changed. There have been less low-risk businesses and more high-risk businesses. For example, the hi-tech enterprises are generally risky. Some newly established small enterprises may also be very risky even if they are not engaged in hi-tech business, as they do not have sufficient capital and stable business operation, thus unable to obtain guaranteed or collateralized loans from the banks. We must fully recognize the importance of small enterprises in the national economy. Meanwhile, the financial sector has become increasingly information-based. An important aspect of financial product innovation is the trading of financial risks based on more transparent information. In particular, the development of credit derivatives has enabled the banks to effectively control the risks. This has also posed new challenges to the banks´ internal control and internal incentive systems. Since the risks can be traded in the financial market, the banks should try to achieve a proper balance between risk and return, instead of simply seeking minimum risk.   In some banks and insurance companies, the joint-stock reform and improvement of corporate governance are currently underway or have been completed. One of the incentives is to provide stock options for the senior managers. This is an important feature in the principal-agent relationship and corporate governance. Its effectiveness depends on whether it is applied properly. One issue is how to define senior managers. Some companies tend to include many people into this category. That may not be good. Of course, it also depends on the nature of the company. For commercial banks, if the performance and NPL ratios of different branches differ substantially, the use of stock option as an incentive may produce negative effect. Moreover, the credit managers, particularly the senior credit managers, are believed to be the lifelines for the banks, but their performance may differ a lot, and the use of stock options as an incentive may not be proper. Therefore, the banks must make good use of the internal evaluation and incentive mechanism to enable the senior manages to effectively perform their duties.   The above are the backgrounds against which the following issues will be discussed.   First, from the longer-term point of view, the internal control system of the banks can be designed as a more flexible arrangement. Past experiences show that some grass-level bank branches performed poorly in their loan business. Their NPL ratios were high. Many loans were extended on the basis of special connections between the bank officials and the customers, and some credit officers even granted loans in exchange for personal gains. Of course, some branches did a good job in their loan business. It´s desirable for the bank head office to take back some power from the branches of poor performance. However, problems may arise if the power is unduly concentrated in the head office, as the credit demand of the small enterprises at the local level may not be met. Moreover, if the bank branches no longer extend loans, but only take deposits and conduct other business such as fund transfers, their contacts with the local enterprises will become weaker, and they will know less about these enterprises. In addition, given that it´s getting increasingly difficult to compete for large customers, the banks will need to find new ways to develop their loan business for the medium- and small-sized enterprises, for example, by setting up relevant departments specializing in credit business to these enterprises. The banks may then face a dilemma, since they may not have qualified staff to carry out such business, as the local branches have long lost contacts with their corporate customers.   A bank should establish a clear restraint mechanism under which its branches will be removed of loan-granting power if their performances in the credit business are too poor. However, it is desirable that the branches be left some room for improvement. For example, instead of completely taking away loan-granting power from the branches, the bank may allow them to do one or two loan businesses per year. Of course, for those credit managers with very poor performance, these one or two loans may also turn into non-performing loans. But generally speaking, with strengthened internal control, centralization of power, and gradual improvement of decision process, the banks will be able to control their loan losses.   What is more important is the change in economic situation. The small enterprises have been playing an increasingly important role in the economy, particularly with respect to export and employment. Many large enterprises rely on small and newly established enterprises for the supply of production components and spare parts. The capital market should play a larger role in supporting the development of these growing enterprises, but currently it is still unable to provide sufficient financial services. The commercial banks should and can do a better job in this area.    The second issue is regarding the internal incentive system of the bank. The use of stock options as an incentive for the senior managers has always been a problem in China. As to who should be included in the senior management, the listed companies tend to give a very broad definition. In fact, a distinction must be made between the incentives for senior managers linked to the overall economic returns and those linked to the specific performance. For the commercial banks, these two types of incentives have different features and should be differentiated clearly. Some loan officers performed well, while some do a poor job, so incentives for the senior credit managers should not be linked to the overall economic returns of the banks, but to their own performances. Of course, in some countries, stock options are widely used in some large companies, but the amounts differ substantially, and in those areas where performance varies significantly, internal incentive systems are mainly used. In China, in the past, the state-owned commercial banks gave bonus to the staff based on their ranks. Nevertheless, it should be recognized that the performance of the banks depends critically on an integral system linking the credit managers, risk control, asset disposition and back office oversight. Given that performances of the credit managers vary substantially, an effective incentive system must be set up. Without such a system, the credit officers may not properly perform their duties. For example, they may only focus on loans to the large or state-owned enterprises, and do not grant loans to the small or privately owned businesses, in order to avoid risks and troubles. The credit officers may be largely affected by such negative incentives. With one single mistake, they may be punished for violation of regulations or dereliction of duty, and may even be permanently prohibited to engage in such business. In sum, improper internal incentives will lead to insufficient financial services and undue competition for a few large customers. This is harmful to economic development. Major changes in economic structure, such as sharp fluctuations of oil prices, may pose significant risks to the banks´ credit to the main sectors and the large enterprises, and may even lead to systemic risks. How to establish an effective incentive system is a major challenge to the commercial banks in their reform process. Domestic banks will also face competition from the foreign financial institutions that have gradually entered the Chinese market. Some medium- and small-sized commercial banks with strong innovative spirit will make rapid progress in this area. This is an issue that deserves careful attention by all banks, particularly the large banks.   The third issue is the pricing capability. In the transition from planned economy to market economy, China has found itself lack of some abilities, in particular, the pricing capability, for both domestic products and exports. The pricing capability in the financial markets is even weaker. This is partly due to the price control system adopted in the past under which most prices were set by the government and the financial institutions had no pricing power, and partly because of the lack of pricing training for the staff. Moreover, since the enterprises in the past were not responsible for their own profits and losses, they did not have the incentives to set their own prices. Without an effective incentive system and a clear business goal, such as maximizing returns for the shareholders, the enterprises will have no incentive to set their own prices, because no matter at what levels they set the prices, some negative effects, including those from the media and the customers, may arise. There are mainly two factors that need to be considered in the pricing of credit products. One is the cost of funds. The other is risk premium. The judgment on risk premium often varies, and the criteria based on which judgment is made also change as time goes.   In China, many new enterprises do not have sufficient capital and their ability to obtain collateralized or guaranteed loans is weak. So pricing of credit to these enterprises is a very important issue. Restrained access to credit of the medium- and small-sized enterprises is to a large extent due to the ineffective pricing by the banks. At the end of October 2004, the central bank removed the interest rate ceilings for loans. Some banks have already made active efforts to improve their pricing capability, and have enhanced their credit support to the medium- and small-sized enterprises. We hope that other banks can also make progress in this area. The organizational structure and incentive system of the financial institutions specializing in credit to small enterprises are different from other financial institutions. Reforms have to be made in the above two areas in order to enhance credit support to the small enterprises.   In China, many issues, including the state share reform we currently conduct, are related to the pricing problem. One of the major problems behind the state share reform is the weakness of pricing capability. Whether the financial institutions are more affected by market or by the government in pricing the financial products is also an issue that deserves attention. In sum, efforts should be made to develop the pricing capability of the financial institutions.   The reform of the exchange rate regime also involves the pricing issue. The pricing and trading of foreign exchange forward products are related to foreign exchange risks. Ten years ago when the foreign exchange forward transactions were first introduced to the market, people hoped that the central bank could bear all the risks. In the past, participants in the life insurance industry also thought that their interest losses should be born by the government, as the interest rates were set by the government. Therefore, they are reluctant to do their own risk analysis and take measures to prevent risks.   The fourth issue is concerning the characteristics of the financial institutions. While seeking to avoid excessively large risks, the financial institutions must also take some risks and trade these risks. Risk appetites of different financial institutions vary significantly. To avert risks or sell risks involves the consideration of market environment and market depth. Instead of holding the loans till maturity, the banks can now sell the associated risks. On the liability side, asset securitization has also been widely used. The cost of fund has changed significantly. Of course, such changes are cyclical, with the cost varying for different periods. At present, the banks find the interest rates in the inter-bank market more attractive than those for deposits. So the banks need to adopt new risk management strategies. Many financial institutions have not yet learned how to profit from moderate risk-taking, and have not actively considered trading in the secondary market. This is also related to the capital adequacy ratio. To what extent the banks can expand their balance sheets depends on the costs of core capital and supplementary capital. The banks have to adapt to market changes. Another issue is the risk management strategy of the banks. Regularly paying interests to the depositors, the banks take relatively low risks. But low risk does not mean no risk. The banks have to consider how to reduce risk, avoid risk and sell risk. They also have to understand that maximum returns for the shareholders and strengthened competitiveness cannot be achieved without taking some risks. The Chinese banks still need to make improvement in this area.   The commercial banks and their incentive systems will change significantly when the risks become tradable. Internal problems related to income distribution and incentive mechanism have emerged, and the problems varied significantly among different banks. In the past, commercial banks and investment banks adopted quite different practices in this area. However, in recent years, the commercial banks have adopted some of the investment banks´ practices.