China’s Changing Business Model of Banking

Prof. Dr. Horst Loechel

China Europe International Business School, Frankfurt School of Finance & Management
German Centre of Banking and Finance at CEIBS
699 Hongfeng Road, Pudong, Shanghai 201206, P. R. China
hloechel@ceibs.edu

Helena Xiang Li
(Corresponding author)
Frankfurt School of Finance & Management
Sonnemannstrasse 9-11, D-60314 Frankfurt am Main, Germany
h.x.li@fs.de
 2

China’s Changing Business Model of Banking

Prof. Dr. Horst Loechel

China Europe International Business School, Frankfurt School of Finance & Management
German Centre of Banking and Finance at CEIBS
699 Hongfeng Road, Pudong, Shanghai 201206, P. R. China
hloechel@ceibs.edu

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

Working paper, May 2011

Acknowledgements: The authors are very grateful for extensive discussions with Prof. Chang Chun and Dr.
Zhu Honghui of China Europe International Business School. The authors would like to express deepest
thanks also to Ludwig Fella, Dr. Stephan Popp, Constantino Riviello, Dr. Hans Schniewind, Marcus
Wassmuth, Julia Wu and Prof. Zhao Xiaoju for providing valuable insight into the development of China’s
banking industry and to seminar participants of the Brown Bag Seminar at Frankfurt School of Finance &
Management as well as to participants of the Asian Business & Management Conference for fruitful
discussions and comments. This research is part of the EU-China Research Fellowship Program, a
co-operation between China Europe International Business School and Frankfurt School of Finance &
Management in the framework of the EU-China Business Management Training Program, which is
generously sponsored by the European Union.
 3

Abstract

The recent turmoil of the global financial system urges both academics and professionals to
rethink the fundamental question of the appropriate banking business model. For emerging
economies, the paradigm of the Western style of high risk and high leverage trading business
model has clearly failed. The current discussion on business model choice is of special
relevance for China where the banking reform turned a new page in the transformation from
the segregated to the universal banking system after a track record of thirty years reform
success.

Surprisingly enough, academic research about the gradual transformation of China’s banking
business model is still rare especially in an international context. The current paper aims to
close this gap by conducting comparative studies based on data of banks from China, Europe,
the UK and the USA. The analyses reveal that the profitability in Chinese banks is mainly
determined by the high interest margin and lending growth. The guaranteed interest margin
through the rigid interest rate regime distorts the risk pricing mechanisms in the loan business
in comparison to established risk pricing in Western peer banks. The ongoing gradual
liberalization of currency and interest rates bears the greatest challenge for the current
profitability model of Chinese banks. The diversification in fees and commissions income
business is vital for the competitiveness of Chinese banks. In terms of business lines
composition, the diversification is already under way, particularly through the establishment
of bank-owned fund management companies.

However, we show that the current transformation, so far, is not accompanied by the high
leverage of risks. This is due to a strict regulatory environment, which limits non-interest
income business of Chinese banks to services fees and provisions from customers instead of
trade on their own accounts. Given the momentum of stricter bank regulation on an
international level as well, a system convergence between Western and Chinese banking
business models could be expected in the foreseeable future.

Keywords: Banking business model, financial crisis, universal banking, banking in China

JEL classification: G01, G20, G21, G28

 4

I. Introduction
In the most disastrous years of crisis in decades for the global banking industry, Chinese
banks celebrated record making advances in the global banking league of market
capitalization, total assets, profitability and improving their brand. The state-owned
commercial bank (SOCB) giants ICBC and CCB1 led the pole position of global banking
profitability ranking in both 2008 and 2009.2. This is against the backdrop, that the whole
banking industry was deemed insolvent with a non-performing loan (NPL) ratio of over 30%
only ten years ago.3 China has begun its banking reform with gradual, but persistent and
cautious steps: beginning by separating policy lending from SOCBs, to later a hundred billion
dollar bail-out of the whole banking system by transferring NPLs to separate asset
management companies., followed by establishing a modern corporate governance structure
and the introduction of foreign strategic participation as well as bringing banks to capital
markets step by step. 4 Despite the long lasting discussion of severe problems such as
operational inefficiency, lack of risk management skills, policy lending and so on, the fact can
not be neglected that the vanilla business model and strict regulation insulated China’s
banking sector in most instances from the spill-over of the recent financial turmoil.5

The belief that the Western banking model should be regarded as the sample model for
banking reform in emerging markets was severely shaken by the financial crisis. Many
lessons have been learned. That increasing returns by inflating risks, a popular model which
most Western banks credited to their success before the crisis, has proved to be unsustainable.
A new round of debates broke out among academics and banking managers on banking
business models in the crisis.6 One line of thought claims the radical way back to “narrow
banking” in which banking business is mainly limited to deposits, lending and settlements.
Another view points out the fact that the business scope in banking has undergone essential
changes in the last three decades, as a compulsory adaption to changes in the business
environment. Interest margin has been marginalized by aggressive global competition.
Growth potential in corporate lending is limited by substitutes in corporate bond markets.
Alternative investment in money markets, investment funds and insurance products has
channeled deposits directly into capital markets. And institutional investors have gained
ground as major lenders and investors of some banks.

As a consequence, capital market linked services have gained weight as revenue source, with
a gradual move to more exposure to market risks instead of credit risks. Alongside the
changed role of banks from financer to capital market services provider, other functions in
which banks had a dominant role have been also undermined: The settlement function of
banks has been increasingly outsourced to external IT specialists. Rating agencies and
financial information providers have been increasingly replacing bank’s role as credit monitor.
Even more seriously, banks seemed to have lost part of their most valuable assets – their
creditability – through the current crisis. Considering the challenging operating environment
in banking, BCG calls for changes of a bank’s role from “risk taker” to “trade facilitator”.7
1
ICBC: Industrial and Commercial Bank of China; CCB: China Construction Bank.
2
According to The Banker ranking.
3
See Woo (2002), p. 388.
4
See for instance Neftci and Xu (2007), Loechel and Zhao (2006), Wu (2005) and García-Herrero, Gavilá and Santabárbara
(2006) for an overview of the reform process.
5
Backed with the strong performance of Chinese banks in the crisis, Liu, Mingkang, Chairman of China Banking Regulatory
Commission (CBRC), expressed his full conviction in China’s banking regulation concept in his published article “Basic
rules helped China sidestep financial crisis” in Financial Times Asia. See Financial Times Asia, June 29th, 2009, p. 7.
6
For competing opinions on banking business model after the crisis, see for instance Dobbs and Kuehner-Hebert (2008) and
Rizzi (2009).
7
See BCG Creating Value in Banking 2009.
 5

We believe that the financial crisis will not only change the mind-set of private households
and the risk perception of investors, but also marks the narrowing of the business scope of
banks. Additionally, it calls for a stronger customer-oriented instead of capital-market focused
business model centered on commercial banking business activities.

The implications of this turnaround are of special value for Chinese banks. The system shake
of the financial crisis was partially caused by some banks’ extensive risk taking in trading and
leveraging, resulting in paper gains through financial innovation far beyond the real economic
needs. The narrow business model in China’s separated banking system and strict foreign
capital control prevented the infection of the global financial turmoil. Based on the
experiences of the transformation from the separated to the universal banking model8 in
Western banking, Lv Suiqi, Deputy Chair of the department of finance at the Peking
University, stressed that “Chinese banks however could no longer rely on the old business
model based on interest rate spread. Instead, it is essential to explore other revenue sources
such as asset management products to increase the core competitiveness of commercial
banks”.9 However, Chinese banks face the dilemma to adapt their business model in the more
and more liberalized environment in terms of currency, interest rates and capital markets,
without a convincing paradigm of international universal banking standards. Due to the
financial crisis, further deregulation of China’s banking sector towards an integrated banking
business model was even slowed down upon to the results of reconsideration of the benefits
and risks of the Western style of banking model. Liu Mingkang, Chairman of CBRC10, for
instance stated at the Luijiazui Forum in May 2009 in Shanghai: “We don’t discuss universal
banking.”11

Against this background, the current paper reflects the revenue diversification process in
Chinese banks, compared against their business model in European and Anglo-Saxon peer
banks. To our best knowledge, this paper has the unique value to first address the business
model transformation in China’s banking sector in an international context.12 The main
hypothesis is that China’s banking business model is gradually moving from a segregated
towards a universal banking system, forced by interest rate liberalization, capital market
development and further opening of domestic financial markets.

In detail we prove that the profitability of Chinese banks is so far mainly driven by an interest
margin above the level of Western banks. As the interest margin is artificially held high in
China through an administrated interest rate regime, this business model can not be sustained.
Moreover, we discover that the risk pricing mechanism is still not established in Chinese
banks’ lending practice. The guaranteed interest margin and stable loan growth provide little
incentive to improve risk management skills and to diversify revenue sources through
innovative non-interest income products. Compared to Western banks with high activity in
proprietary trading, we notice that fees and commissions instead of trading income dominate
the non-interest income in Chinese banks. We also identify that synergies in China’s first trial
of universal banks in the form of bank’s majority holding in asset management companies are
realized through economies of scale since bank related funds are larger in size and provide

8
In this paper, we define “universal banking” as the combination of commercial banking, investment banking, asset
management and other related financial services in contrast to the separated banking business model, which limits banks
activities to commercial banking businesses alone. The “universal banking” model can be extended to an “integrated financial
services provider” model by adding insurance to the service scope.
9
Professor Lv, Suiqi made this statement at the 21st Century Finance Wealth Management Conference on April 24th, 2009
organized by the 21st Century Business Herald. See http://finance.ifeng.com/money/20090514/657193.shtml (Chinese).
10
CBRC: China Banking Regulatory Commission, the regulatory and supervisory body for banking in China
11
See The Wall Street Journal Asia, May 18th, 2009, p. M2.
12
For a comprehensive overview of China’s financial sector in general see Zhu, Cai, and Avery (2009).
 6

favorable management and custody fee condition.

As the internationalization of the Chinese currency quickens, the pace as demonstrated with
the ambitious appeal of Chinese Central Bank governor Zhou Xiaochuan to rebuild the global
currency system,13 the liberalization of the domestic interest rate system of China to more
market orientation is simultaneously foreseeable. At the same time, promotion of direct
financing through capital markets to reduce the current high risk concentration of over 80%
financing through bank loans will fuel the capital market development in China and therefore
disintermediation14. Chinese banks face the unique challenge and opportunity of business
model transformation to more engagement in non-interest income business with balanced fees
and commissions, high portion of investment in high-graded government, financial and
corporate bonds, limited trading for risk hedging and restricted exposure in equity and
derivative products. There is no reason to believe that this controlled as well as highly
regulated extension of the commercial banking business model of Chinese banks will be
accelerated towards a Western style high-leveraged trading and asset business model.

The paper is organized as follows: After a short review of relevant research in section II, the
evolution and the driving forces of China’s banking sector from a separated to universal
banking system are introduced in section III. Section IV analyzes the return and risk impact of
interest income and non-interest income in Chinese banks in comparison with their peers from
Europe, the UK and the USA. Section V evaluates the first trial of universal banking model in
China – bank’s majority holding in asset management companies and identifies the synergy
sources in Chinese universal banks. A conclusion in section VI summarizes the results and
provides outlook for future development of banking business model in China.

II. Literature Review

The exacerbation of the crisis was triggered by Lehman Brothers declaring bankruptcy of on
September 14th, 2008.15 The linkages among financial institutions created a domino effect
and the large-scale engagement in speculative subprime real state sector allowed the fast
moving pandemic to spread to almost all universal banks. The result was a global dry-up of
credit and market liquidity and a recession in the global economy. Voices became louder to
force banks to return to their basic roots: deposit and loans and the narrow function of a
“utility bank” model16. However, the crisis provided evidence that stand-alone investment
banks without a stable financing source from deposits are vulnerable to market disrupts and
bankruptcy risks.17 As a result, both leading investment houses Goldman Sachs and Morgan
Stanley were converted to bank holding companies, conducting commercial deposit taking
and lending services. The current crisis renewed the long-lasting academic interest engaging
with the expansion of bank’s business scope in non-interest income businesses and its impact
on the risk and return profile of diversified banks.

13
See Zhou (2009).
14
Disintermediation is defined as the “elimination of financial intermediaries, e.g. brokers and banks, from transactions
between borrowers and lenders or buyers and sellers in financial markets... Disintermediation has been a consequence of
improved technology and deregulation.” See The Oxford Dictionary for the Business World, Oxford University Press 1983, p.
235.
15
For a judgement of the crisis in historical comparison see Reinhart and Rogoff (2009).
16
See UK Independent Commission on Banking, Issues Paper September 2010, p. 31.
17
For discussions about banking business model after the crisis, see for example Schildbach (2009).
 7

Unfortunately, years-long academic debates and practices still have not yet brought
conclusive results for our insight in this research area. Previous studies18 generally believe the
revenue enhancement and risk diversification gains from bank’s expansion in non-interest
income businesses. However, this conclusion has not yet been conclusively proven on the
basis of various ambiguous empirical results. Allen and Jagtiani (2000) find that combining
banking with securities services and insurance activities reduces the overall risk. DeYoung
and Rice (2004) reveal persistent outperformance in terms of higher sharp ratio of diversified,
non-traditional banking compared to traditional banking for over 1,200 US banks for the time
frame from 1993 to 2003. Ebrahim and Hasan (2004) evaluate the gains from the view of the
capital market and find out that banks with heavier involvement in non-interest income
business are credited with more growth potential and consequently with higher market
valuation. In contradiction to this point, Stiroh (2004) points out that the volatility in trading
revenue largely diminishes the risk reduction through diversification in non-interest income
businesses and the interest and non-interest income become more correlated over time.
Laeven and Levine (2007) investigate the diversification discount of financial conglomerates
and show that the benefit gains from economies of scale and scope can not compensate the
costs due to an agency problem in financial conglomerate. This leads to a trade discount of
financial conglomerates on the capital market. Similar results are found by Schmid and Walter
(2008). They reveal comprehensively the existence of conglomerate discount in the financial
services industry and conclude that the total balance of functional diversification is
value-destroying. However, with more differentiated analysis, they show that the combination
of commercial banking with insurance and the combination of commercial banking with
investment banking produce significant premiums. Kwan and Ladermann (1999) review the
portfolio effects of business divergence in banking and conclude that both securities and
insurance services are more profitable and more risky than banking. They emphasize however
the necessity to differentiate sub-activities in securities and insurance and point out that
securities underwriting and insurance agency businesses for instance can reduce the overall
risk of bank holding companies. De Jonghe (2009) explicitly examines the impact of bank
diversification on financial system stability and concludes that interest income is less risky
than non-interest income in crisis time. The ambiguous empirical results seem to draw
together the following overall picture: The diversification in non-interest income is regarded
as the solution to compensate the shrinking interest income in time of disintermediation in
banking. Compared to interest income, non-interest income business has higher return and
higher risk pattern. The overall performance of financial conglomerates is determined by the
trade-off of scale and scope economies with diseconomies from conflict of interests and
agency problems. Within non-interest income business, the composition in underwriting,
trading and agency services further determines the return and risk profile.

The above results from academic research on the revenue and risk impact of non-interest
income business were in large extent confirmed by the development path in banking in the
last years. Backed by business cycles’ upward trend in the overall economy and capital
markets, the diversification in Western banking, especially in proprietary trading, granted
years of double-digit capital return and induced the radical transformation of bank’s role from
lenders to traders. The excessive engagement in profit making from speculative asset bubbles
beyond the needs in real economy uncovered the risk side of the business model and is
blamed as one of the main causes of the financial crisis. Critics are becoming louder to bring
banks to their “basic functions”. Our understanding of the “basics” is the bank’s role as
financial intermediary to serve the real economy, both as lender and capital market service
18
For an overview of benefits and costs in integrated financial services providers, see for instance Loechel, Brost and Li
(2008).
 8

provider in the sense of a universal bank, rather than business scope restriction which is not
affordable in the post-disintermediation time with balanced role of bank and capital markets
financing. This new understanding of banking business model requires a new framework to
supervise risks in banking. Blundell-Wignall, Atkinson and Lee (2008) propose to bundle
diversified services in banking only under “non-operating financial holding” to prevent risk
transfers. Change of paradigm to integrated risk management takes into consideration for the
interactions of various risks from interest and non-interest income within a financial
conglomerate group. 19 Compulsory disclosure of non-interest income business lines has
become necessary to evaluate the aggregated risk profile of a universal bank.

The current emergence of research from Chinese scholars about the topic also reflects the
high relevance of the above discussion on bank’s diversification in non-interest income
business for Chinese banks. Chen (2009), for instance, recently points out that the restriction
of banking business scope leads to bank’s concentration on lending business, which in turn
causes pro-cyclical credit expansion. Mao (2008) addresses the point that the high risks from
proprietary trading diminish the diversification benefit of universal banking in the crisis and
emphasizes that the non-interest income business in universal banking should concentrate in
fees and commissions services.

However, the change of China’s banking business model towards non-interest income and
hence towards the universal banking system is still a relatively new phenomenon and the
amount of relevant research is rare.20 The current paper aims to fill this gap and contribute to
the general debate on banking business model after the financial crisis.

III. Transformation of Segregated to Universal Banking System in China

As if by a miracle, Chinese banks escaped almost unaffected from the recent crisis, in great
extent as a result of the fact that Chinese banks still follow the narrow banking model with
strict restrictions on the engagement of investment banking and the strict foreign currency
control policy in China prevents risk transfer from international capital markets. This
segregated banking system was established in 1993 with the issuance of “Resolution on
Financial System Reform” of the State Council and with Article 43 of the Law of People’s
Republic China on Commercial Banks issued in 1995:

“Commercial banks are not allowed to conduct trade in shares or make investment in
fixed assets of non-self use within the People's Republic of China. Commercial banks are
not allowed to make investment in non-banking institutions and enterprises within the
People's Republic of China.”

Correspondently, the separation of securities from banking is regulated through Article 6 of

the Securities Law of the People’s Republic of China enforced in 1998:

“Securities business shall be engaged in and administered as a business separate from

the banking business, trust business and insurance business. Securities companies shall
be established separately from banks, trust companies and insurance companies.”

The integration of banking in insurance institutions is restricted according to Article 104 of

19
See for instance the recent research results of BIS on interaction of market and credit risk, BIS (2009).
20
Sauders and Walter (1996) are among the first to address the development of universal banking in the Asia Pacific context.
 9

the Insurance Law of the People’s Republic of China issued in 1995:

“The use of funds of an insurance company is restricted only to bank deposit, trading of
government and financial bonds, and other forms of fund utilization stipulated by the
State Council. The funds of the insurance company may not be used to set up securities
operation organizations or to invest in enterprises.”

According to the above laws, the combination of banking with securities, real estate and
insurance services, which are usually integrated as in the European style of financial services
providers, are prohibited by law in China. Even in international comparison with developing
countries, China still belongs to the 10% minority of countries with the most strict activity
restriction in the banking sector21. Furthermore, the Provisional Rules Governing Money
Brokerage Firms issued in 2005 grants only non-bank institutions permission to set up money
brokerage firms. China’s choice for the segregated banking model is anything but accidental.
The Chinese Academy of Social Sciences (2001) argues that this decision made in the 1980s
was in accordance with the acknowledgement of the draw-backs of conflicts of interests
inherent to universal banks, a result based on comparative studies on the America style
separated banking system and the European style universal banking system. They determined
furthermore that there was a lack of skill in managing risks in diversifying institutions in the
immature stage of China’s financial institutions at that time.

With the quickening pace of financial innovation and shrinking transaction costs, the decline
of net interest margin in commercial lending business driven by global competition, and the
acceleration of disintermediation of traditional commercial banks, major economies with
segregated financial system such as the UK (in 1986), Canada (in 1987), Japan (in 1992) and
the USA (in 1999) deregulated the activity separation. China’s accession to the World Trade
Organization (WTO) and the consequent opening of its financial markets calls for a level
playing field in the banking industry in accordance with international standards. With the
entry of foreign universal banks, Chinese banks feared the loss of business opportunities in
cross-sector services to foreign competitors, as Chinese banks would miss the chance to build
up capacities for cross-sector services due to strict activities permission in a separated
banking system. The government also noticed that the high concentration of financial assets
of over 80% as bank savings (see figure 1) born concentration risk for the entire financial
system and the limited variety of financial products could gradually not meet the increasing
market demand for diversified financial services. Financial conglomerates with holding
subsidiaries in banking, securities and insurance emerged 22 and some banks like BOC
actually by-passed the restriction by setting up subsidiary for cross-sector services in
securities and insurance abroad like in Hong Kong.

21
See IIB Global Survey (2009) and Barth, Caprio and Levine (2001).
22
For the development of financial conglomerates in China, see for instance Lin (2003).
 10

Figure 1. Distribution of Savings in China

In 2004, an opening clause“...with the exception stipulated by the State” was introduced to
Article 43 of the Commercial Bank Law and Article 6 of the Securities Law regarding
business restriction, which marked the first step in the loosening of activities restriction.
Banks should leverage their dominant position in the financial system to foster diversified
financing sources and channel funds to capital markets through providing products and
services in securities and asset management.

With the overall market enthusiasm for bank’s diversification in other revenue sources than
lending and to promote capital market development, PBC23, CBRC and CSRC jointly issued
in February 2005 the Administrative Rules for Pilot Incorporation of Fund Management
Companies by Commercial Banks, which established the legal permission for SOCBs and
joint-stock commercial banks (JSCBs) as primary shareholders in equity-holding of fund
management companies. Banks are permitted to sell fund products of affiliated fund
management companies on a commission basis, however only under third-party condition.
The aim was to channel the high liquidity in bank deposits to capital market investment, to
increase competition between fund management companies, and to diversify bank’s revenue
resources. This step was regarded as a significant step to transition China’s banking system
from the segregated to the universal banking model with a holding structure. Pilot permissions
were granted to three of the “big five banks”: ICBC, CCB and BOCom24. Already before this
deregulation, BOC circumvented the sector separation by setting up its majority holding fund
management company through its holding subsidiary in Hong Kong in 2004. After the
liberalization, the shares were transferred to BOC in 2008. As the last SOCB, ABC got its
license in 2008 and founded its own fund management company. All five bank-held fund
management companies were established as joint ventures with foreign financial institutions.
The permission was expanded to two JSCBs - SPDB25 and China Min Sheng Bank, setting
up joint venture fund management companies in 2007 and 2008 respectively. As depicted in
figure 2 and figure 3, the liberalization of bank’s participating in fund management companies
triggered an expansion in market share of bank related asset managers – in the form of bank
subsidiary, bank affiliation and financial conglomerate affiliation 26 . The fifteen fund

23
The People’s Bank of China (PBC) is the Central Bank in China. The regulation and supervision of financial institutions is
carried out through the “central bank plus three commissions” (Yi Hang San Hui) system in China. Three commissions
include the sector supervisory bodies CBRC, China Securities Regulatory Commission (CSRC) and China Insurance
Regulatory Commission (CIRC).
24
BoCom: Bank of Communications
25
SPDB: Shanghai Pudong Development Bank
26
Bank subsidiary is defined in this paper as a fund management or securities company majority-held by a bank, bank
affiliation is a fund management or securities company minority held by a bank and financial conglomerate affiliation is a
 11

management companies with bank-linkage occupied 38.70% of total market share in total
assets under management among the total of sixty fund management companies on the market
only three years after the liberalization beginning in 2005.

Figure 2. No. of Fund Management Companies Figure 3. Market Share of Fund Management
Companies per Total Assets 2008
50 45
45
40 8.16%
6.41%
35
30
25
20
15 24.14%
7 61.30%
10 6
5 2
0
Bank subsidiary Bank affiliation Financial Stand alone Bank subsidiary Bank affiliation
conglom erate
Financial conglom erate affilation Stand alone
affilation

Source: Wind

Moreover, the equity link of banks with fund management companies promotes the agent and
custody services in banking. Although banks with fund management affiliates are only
allowed to conduct business contracts with their affiliates under the same condition as with
the third party, the business cooperation with affiliated parties is more intensified and the
scope of cooperation is broader and deeper. This is especially due to the fact that bank as sales
agent may favorably choose affiliated funds, securities and insurance companies as a partner.
The cooperation with affiliated companies is however restricted through Article 8 of the Law
of People’s Republic of China on Securities Investment Fund enforced in June 2004, “A fund
trustee and a fund manager should not be the same party, and should not make capital
contribution to or hold the shares of each other”. Since eleven of the total fourteen banks with
a custody license are listed on the exchange, the above Article is in current discussion to be
removed in order to enable fund management companies to optimize their investment
portfolios including shares of their custody banks. The manifold possibility of cooperation of
banks with their affiliates can be illustrated with the following example: Industrial Bank Co.
Ltd., Industrial Securities Co. Ltd. and Industrial Fund Management Co. Ltd., for instance,
signed a memorandum of understanding (MoU) for strategic alliance in 2007 to share client
base, distribution channel, product information and training capacities.27 The lifting of the
separation of banking from fund management in 2005 changed dramatically the landscape of
the distribution model in fund products. As shown in figure 4, bank gained significant ground
in fund distribution and took over almost 80% of the market share within two years after the
policy liberalization.

fund management or securities company with a financial conglomerate as major shareholder which also has equity
participation in banking within the group.
27
According to company news, available at: http://www.cib.com.cn/netbank/cn/About_IB/Whatxs_New/2007080611.html
(Chinese).
 12

Figure 4. Fund Sales Channel

90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
2004 2005 2006 2007

Fund Bank Security

Source: Securities Association of China

This policy change opened new sources of revenue with high growth potential in the presence
of the booming capital market. Total bank custody fee skyrocketed in 2007 and almost
reached the mark of five billion CNY (see figure 5). With the vast branch network, broad
customer base and capital strength, the “big five”28 banks dominate the fund custody market
and took over 90% the market share, as illustrated in figure 6.
Figure 5. Bank Custody Fee

60 500
450
50 400

Rebased 1998=100
350
in 100m CNY

40
300
30 250
200
20
150
100
10
50
0 0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Fee SH Com posit Index

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

Figure 6. Market Share of Fund Custody 2007

Other banks, 9%

BoCom , 8% ICBC, 31%

ABC, 14%

BOC, 16% CCB, 22%

Source: Securities Association of China

28
The “big five” banks refer to the largest five banks in China ICBC, CCB, BOC, Agricultural Bank of China (ABC) and
BoCom.
 13

Compared to the rapid rise of banks in the fund management market, bank’s equity holding in
securities firms is limited. There is only one securities subsidiary of a bank in China – BOC
International (China) Ltd. - founded as a subsidiary in 2002 by Bank of China International
Holdings, a Hong Kong based wholly-owned subsidiary of Bank of China Ltd. Securities
affiliates of financial conglomerates have long track record in securities services and hold
13.86% of total market share. However, 96 stand-alone securities companies still dominate
the market, with 77.47% of total assets in the securities market, as shown in figure 7 and
figure 8. From the policy side, there is no expectation to see a rapid liberalization and the
consequent expansion of bank’s market share in securities services in the near term, as what
happened in the fund management market with a strong supporting policy favoring bank’s
engagement. The cautious approach of the Chinese government in dealing with securities
services demonstrates its great concern about the transfer of volatile capital market risks to the
banking system.

Figure 7. No. of Securities Companies Figure 8. Market Share per Total Assets 2007

120
1.25% 6.08%
96 13.86%
100
1.35%
80

60

40
77.47%
20
1 3 5 1
Bank subsidiary Bank affiliation
0
Bank Bank affiliation Financial Insurance Stand alone Financial conglom erate affilation Insurance subsidiary
subsidiary conglom erate subsidiary Stand alone
affilation

Source: Securities Association of China, China Securities Yearbook

It seems the financial crisis did not deter China from its plan of a gradual loosening of
activities restriction in banking. In November 2009, CBRC issued the Provisional Rules on
Commercial Bank’s Share Holding in Insurance Companies, granting bank’s equity
participation in insurance companies. Over time the big four SOCBs and JSCBs have built up
financial holding conglomerates with business lines covering banking, securities, asset
management, leasing, insurance etc. with subsidiaries at home and abroad.

Different from the Western style of universal banks, proprietary trading, which is deemed
much more risky, is mostly allowed to be carried out through stand-alone securities
subsidiaries. This is in order to prevent risk transfer from capital markets to bank deposits, not
to mention the fact that China has not yet set up deposit insurance system either for
state-owned or for private banks.30 Early permissions in trading were granted for trading in
low risk class assets like government bonds and other fixed-income securities as well as
foreign currencies. The license was linked with strict capital and human resource requirement.
For instance, the Rules on Proprietary Trading in Foreign Currency of Financial Institutions
issued in 1993 set USD 20 million as the minimum capital for foreign currency trading. The
management and trader should have gained working experiences in trading for five and three
years respectively. The scope of the type of securities is however gradually expanded from
low risk class assets like foreign currency positions, government, financial and corporate
bonds to stocks, commodities and derivatives, with the belief that banks have gained

30
However, a deposit insurance system covering 98% of bank deposits is expected to be launched in 2012 according to
China Economic Review (2010), see http://newcer.chinaeconomicreview.com/en/node/39978.
 14

knowledge over time. Permissions are however predominantly granted to preferential SOCBs
and advanced JSCBs which can meet the strict requirements in capital strength, risk
management capacity and specialist know-how.

The overall result shows a rapid expansion of Chinese banks into non-interest income sector
since the policy change in 2005. Universal banks in China benefited from the capital boom
from 2005 to 2007 and gained considerable market shares in fund distribution, custody and
insurance agent services. With the trend of the internalization of the Chinese currency and the
subsequent liberalization of interest rates as well as the development of China’s capital
markets and disintermediation to more direct financing, the move of Chinese banks from the
narrow banking model to the universal model seems to be irreversible. The meltdown of the
Western banking model with excessive leveraged trading is seen as a confirmation for China’s
caution in liberating Chinese banks’ engagement in proprietary securities trading. In the
following section, we compare the current business model of Chinese banks with banking
models of Western peer banks, to try to understand the return and risk impact of revenue
diversification in non-interest income in Chinese, European and Anglo-Saxon banks and to
prognosticate the further pace of this transformation.

IV. China’s Banking Business Model in International Comparison

4.1. Data description

In this section, we compare the business models of Chinese banks with their European, UK
and US counterparts, using financial data both for the top banks defined as the top five banks
per total assets in their respective regions/countries and the whole country/region sample
over the time frame from 2003 to 2008.31 We try to understand how differently Chinese
banks operate compared to their Western peers and evaluate the sustainability of their current
model. Data has been collected for commercial banks from the database Bankscope32. In order
to capture the whole business range in universal banking, we use the consolidated financial
statements of the selected commercial banks.33

Figure 9 provides a comparison of the development in total assets in top banks. As shown in
figure 9, the largest banks are concentrated in the Euro zone. In Europe, seven banks passed
the total assets threshold of one trillion USD (Deutsche Bank, BNP Paribas, Société Générale,
Banco Santander, UniCredit, ING Bank and Calyon) at the end of 2008. All big four Chinese
SOCBs (ICBC, CCB, ABC and BOC) reached the level of their international peers with over
one trillion USD total assets. Barclay, RBS, HSBC from the UK and Bank of America,
Citibank from the US play in the same league of large banks with over one trillion assets.
With the increasing financial depth in China (currently 278% of GDP, compared to 314% for
the Euro zone, 326% for the UK and 385% for the US) and the predominate role of bank
deposits as financial assets (currently 58% in China compared to 31% in the Euro zone, 32%
in the UK and 23% in the US)34, a further expansion of assets in Chinese banks in the next
years is expected.

31
The total sample size is summarized in appendix A.
32
Bankscope universal format is applied.
33
Consolidated reports are only available for 17 Chinese banks. For the remaining Chinese sample banks, unconsolidated
bank reports are applied. Since the majority banks with unconsolidated reports do not have subsidiary entity, the results are
not affected by this limitation.
34
See McKinsey Global Capital Markets: Entering a New Era (2009).
 15

Figure 9. Average Total Assets – Top 5

Figure 10 . Average Total Assets - Top 5

2,500,000

2,000,000
in million USD

1,500,000

1,000,000

500,000

0
2003 2004 2005 2006 2007 2008

China Europe UK US
S
Source: Bankscope

4.2. Business model comparison

Revenue pattern - interest income

In the following section, we explore the pattern of revenue resources in banking. We first take
a look at the composition of revenue sources in the top five banks. Figure 10 manifests the
high reliance on lending business in top Chinese banks. The average portion of non-interest
income in gross revenue of 14.8% lies far below the level of peer banks in Europe with 51.8%,
in the UK with 46.5% and 41.0 % in the USA. The figure clearly indicates that Western
commercial banks have more balanced revenue sources between interest income and
non-interest income businesses, while Chinese banks still struggle for a break-through in
creating value beyond the lending business. Based on this observation of top banks, we
assume:

Hypothesis 1: Compared to Western banks, the profitability pattern in Chinese banks still has
a significant higher reliance on interest income from lending business, determined by net
interest margin, asset quality and asset growth.

Figure 10. Non-interest Income / Gross Revenue - Top 5

70

60

50
Percentage

40

30

20

10

0
2003 2004 2005 2006 2007 2008

China Europe UK USA

Source: Bankscope
 16

To test hypothesis 1, we conduct in the following regression analyses for the testing fields.35
The OLS model is used for the following regression equation (Basic model: China, Europe,
UK and USA model 1):

ROAAit = α + β1 * [Ln (total assets)] it + β2 * [equity/total assets] it

+ β3 * [net interest margin] it + β4 * [cost income ratio] it
+ β5 * [growth of total assets] it + β6 * [impaired loans/gross loans] it
+ β7 * [non-interest income/gross revenue] it + εit

With the above equation, we try to test the influence of the above seven explanatory variables
for i bank at time t on profitability measured with ROAA36. We choose asset return (ROAA)
instead of equity return (ROAE) as a profitability indicator, because Chinese banks
experienced higher fluctuation in equity through asset injection and IPOs in recent years, and
some banks even had negative equity before capital injections. The seven explanatory
variables include the natural logarithms of total assets, equity ratio, net interest margin, cost
income ratio, asset growth, impaired loan ratio and non-interest income ratio. The total
regression results are summarized in appendix B.

The seven variables in the basic models jointly explain 43%, 24%, 51% and 51% (adjusted R)
of the return pattern in China, Europe, the UK and the USA respectively. In regard to
profitability determinants, net interest margin remains the strongest driving force in China
(0.1877), and has similar impact on US banks (0.1662). Yet the impact of margin in UK banks
(0.0748) generates the asset return coefficient of 0.0748, and is even not significant for
European banks. In Western banks, keeping better asset quality plays a more important role
than margin, with asset return coefficients of -0.0626 in Europe, -0.2049 in the UK and
-0.2875 in the USA, whereas the NPL ratio has no significant impact on asset return in China.
Non-interest income business contributes to higher profitability in Chinese, European and US
banks (with coefficients of 0.0072, 0.0144 and 0.0100 respectively). Also the asset growth
contributes to the increase of asset return in China (0.0030) and in the UK (0.0241). This
result reconfirms the high dependence on net interest margin and asset expansion in Chinese
banking.

Regarding the lending business, the profitability depends mainly on two determinants: net
interest margin and loan quality. The above regression analyses confirm the achievement of
China’s banking reform in reducing the NPL ratio. For example the average of the top five
banks decreased from 17.6% in 2003 to 2.6% in 2008, as shown in figure 11. This
multifaceted success resulted from the government’s tremendous efforts from the bail-out
removing NPLs to separate asset management companies in 1999 and 2000, improving
lending practices with more market orientation replacing policy lending, better risk
management through restructurings and IPOs in 2004 and 2005. The high asset quality
however is partially due to the lending practice of concentrating loans in large companies,
mostly state-owned-enterprises (SOEs), since loans of those companies are implicitly
guaranteed by the state and the market power of those large firms generates assured return.
The result is that 84% of bank loans were lent to 1% of large companies, whereas the more
efficient SMEs37 were under-financed by banks in China.38 Therefore, the regression results
show an insignificant impact of asset quality in Chinese banks’ asset return, in contrast to the

35
Since we believe the business patterns in banking differ much in the respective testing fields due to regulation and
operating environment of the testing countries/regions, we conduct OLS regressions separately.
36
ROAA: return on average assets, ROAE: return on average equity.
37
SME: Small and medium enterprise
38
McKinsey Putting China’s Capital to Work: the Value of Financial System Reform (2006).
 17

findings in Western banks.

Figure 11. NPLs / Gross Loans - Top 5

20
18
16
14
Percentage

12
10
8
6
4
2
0
2003 2004 2005 2006 2007 2008

B5 EURO UK USA

Source: Bankscope

We further examine the determine factors of net interest margin, another factor beside asset
quality in lending business. As exhibited in figure 12, Chinese top five banks enjoyed an
average interest margin of 2.6%, compared to the European average of 1.1% and 1.3% in the
UK. The low margins in continental Europe and in the UK can partially be explained by the
fierce competition within these banking markets and the dominant universal banking model in
which interest margin is kept low to maintain long-term client relationships for cross-selling
high value non-interest income products and services. Only in the USA, banks achieved a
slightly higher average margin of 2.8% in recent years.

Figure 12. Net Interest Margin - Top 5

4.0
3.5
3.0
Percentage

2.5
2.0
1.5
1.0
0.5
0.0
2003 2004 2005 2006 2007 2008

China Europe UK USA

Source: Bankscope

Although the interest margin in absolute terms in China is comparable with that in the USA,
the environment influencing the interest rate is different in China. PBC, the central bank of
China, sets a ceiling of deposit rate and a floor of lending rate, which, for example, guarantees
an official net interest margin of current 3.06% for one-year loan, as illustrated in figure 13.
The low deposit ceiling rates under the inflation rates for years partially leads to the
overinvestment and the export-led growth model of China.
 18

Figure 13. Net Interest Margin in the Guided Interest Regime 1991-2011

14.00
12.00
10.00
8.00 6.31
6.00
4.00 3.25

2.00 3.06
0.00 -1.65
1991.04.21

1993.07.11

1995.07.01

1996.08.23

1998.03.25

1998.12.07

2002.02.21

2006.04.28

2007.03.18

2007.07.21

2007.09.15

2008.09.16

2008.10.30

2008.12.23

2010.12.26

2011.04.06
-2.00
-4.00
-6.00
-8.00

Deposit rate ceiling Lending rate floor Guaranteed margin Real deposit rate

Source: PBC, NBSC

This guided interest rate system was established through Interim Measures of the
Administration of RMB Interest Rates in 1990 and the revised version Administrative
Provisions on RMB Interest Rates issued in 1999, which granted the central bank PBC the
authority to set the deposit rates ceiling and lending rates floor for corresponding maturities.
The interest rates on the inter-bank markets and repo rates are allowed to be negotiated
between institutional market participants. A floating of the lending rate within the range of 0.9
and 2.0 has been permitted since 2004. The ceiling deposit rate is however obligatory. The
goal is to use a guided interest rate as macro-prudential measure for monetary control, as well
as to prevent banking losses through fierce competition creating a setting of high interest rate
promise and deteriorating lending rates, resulting instability of the financial system. For
foreign currency depositing and lending, the price mechanism is more market oriented since
only the interest rate for deposits under the limit of 3 million USD is capped with a guided
interest rate issued by PBC. However, the strict capital control in flows of foreign currency
diminishes the freedom in market pricing. The guaranteed profit margin in RMB lending
keeps Chinese banks away from the level playing field with international banks which price
loans solely according to risk perception and market conditions. The artificial higher profits
partially conceal the inefficiency in pricing and risk management and impede innovation in
new products and services within China’s banking sector.

The higher officially set margin can only be maintained with the current system of capital
control for foreign currency capital account. With the internationalization of the Chinese
currency and an increased openness of its financial market in the foreseeable future, it is
expected that the interest rate regime will be reformed in the direction of more market
orientation as set as a goal in China’s twelfth five-years-plan starting from 2011. Chinese
banks, which fail to build up risk pricing capacity and a balanced revenue portfolio, will risk
their ability to face the competition of international banks on a level playing field.
 19

Based on the above observations concerning China’s policy of interest rate fixing, we assume:

Hypothesis 2: Due to the administrated interest rate regime, the risk pricing mechanism in
lending is distorted in Chinese banks.

We test the risk pricing mechanism in banking by exploring the correlation of other
profitability determinates with net interest margin. The results are summarized in appendix C.
The striking observation is the converse correlation of loan quality with interest margin in
China compared to the positive correlations in European and UK banks. While the risk pricing
rule – lower asset quality in terms of higher NPL ratio, higher margin – functions well in
Europe and in the UK with positive correlations between impaired loan ratio and net interest
margin (0.2403 and 0.5388 respectively), the negative correlation in China with -0.1997 is
statistically significant at the 1% level. This can be partially explained by the fact that the
administrated net interest margin increased from 3.33% in 2003 to 3.42% at the end of 2007
for one-year loans with the government’s intention to prevent the overheating of the economy
with higher lending costs. And the same time, the NPL ratio decreased constantly due to better
risk management. This observation indicates the fact that the government administrated
interest rates distort risk pricing mechanism in lending practice of Chinese banks.

Furthermore, the close relationship between cost income ratio and net interest margin in
China with -0.4608 confirms that rather the high interest margin instead of operational
efficiency is the real source of lower cost income ratio in China. In respect of the size effect,
the negative sign of correlation with total assets shows that large banks in all test fields are not
able to use the market power to push through higher margin, which dilutes the concern of the
monopoly power of current large size banks. The consistent negative correlation between
non-interest income ratios with net interest margin in all testing fields (-0.6203, -0.1205,
-0.1662 and -0.3229 in China, Europe, the UK and the USA respectively) documents the
disintermediation process in banking: As net interest margin in loan business narrows, banks
are looking for other revenue engines in non-interest income business. The highest correlation
between net interest margin and non-interest income ratio in China (-0.6203) demonstrates
that the high-administrated interest margin reduces in large extent the incentive of revenue
diversification in Chinese banks. The high negative correlations between total securities ratios
with net interest margin reveal that the thin margin in lending business further drives banks to
diversify in securities services (-0.4620, -0.1162, -0.2432 and -0.2297 in China, Europe, the
UK and the USA respectively), in China however with stronger diversifying in available for
sale securities (-0.5066), in Europe, the UK and the USA stronger in trading securities
(-0.1570, -0.5239 and -0.1136 respectively).

To summarize the results from the analysis of interest income as a source of revenue, the
profitability pattern in Chinese banks has the highest dependence on net interest margin.
Especially in European universal banks, high diversification in non-interest-income
businesses diminishes the importance of pure margin increase on asset return. At the same, the
relationship between net interest margin and impaired loan ratio follows a unique inverse
pattern compared to the consistent findings of loan risk pricing in Western banks: lower loan
quality and higher net interest margin, which documents the distorted risk pricing mechanism
as a result of the administrated interest rate regime in China. Although the loan quality
experienced considerable improvement in recent years, net interest margin was not adjusted
and was kept artificially high, partially in accordance with macro-economic measures to
encounter an overheated economy through loan expansion. These findings cause concern of
the sustainability of the current business model in Chinese banking sector: At the latest when
big SOEs turn directly to capital markets for fund raising and the interest rate is liberalized
 20

and adjusted to an international conventional level, Chinese banks which fail to build up
capacities to balance interest income and non-interest income business will suffer from a
sharp decrease in profitability.

Revenue pattern - non-interest income

Having recognized the backlog in revenue diversification, Chinese banks took tremendous
efforts to develop non-interest income businesses, backed by supporting policy and taking
advantage of the capital market boom for insurance and funds agency and custody services. In
absolute terms, the scale of net income from fees and commissions lies however half to
two-third back of the level of comparable banks from the UK or Europe, as shown in Table 1.
And the potential in bancassurance products is not fully explored in China. It is remarkable
that the revenue scale of securities trading in Western peers almost reached or even surpassed
the level in fee and commission business, whereas the scale in trading of Chinese banks
amounted to only a small fraction of net income from fees and commissions.

Table 1. Overview of Non-interest Income Business in Top 5 Banks in 2008

Net G/L on Assets at

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

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

Measured by the fraction of trading assets in the total assets, the limitation of Chinese banks’
trading activities is evident, with an average rate of 1.1% (20.1% in Europe, 13.8% in the UK
and 9.3% in the USA), as illustrated in figure 14. The low revenue diversification in Chinese
banks results on the one side from the fact that the loan business generates sufficient profit
thanks to high interest spread and loan growth rate, on the other side from the underdeveloped
stage of capital markets as well as limited experience and resources in cross-sector services.
Another remarkable fact is that only a small fraction of investment securities (BOC for
example 5.3% in 2008) belongs to the active trading securities designated as the asset class
“financial assets at fair value through profit and loss” and the majority of the investment
securities are high-graded bond securities of the public sector (BOC in 2008 for example with
66.7% government and public sector bonds, 27.1% bonds of financial institutions, 5.5%
 21

corporate bonds and 0.8% equity and other securities)39.

Figure 14. Trading Securities / Total Assets - Top 5

30%

25%

20%

15%

10%

5%

0%
2003 2004 2005 2006 2007 2008

China Europe UK USA

Source: Bankscope

When we compare the results from 2008 with those of 2007 in table 2, it is noticeable that the
high volatility in trading income is in great contradiction to the stable income flows from fees
and commissions. In crisis time, losses from trading can even diminish the total net fees and
commissions income, as the case of Deutsche Bank in 2008. Net fees and commissions
remain however as stable positive revenue sources over years. The composition of
non-interest income in fees and commissions as well as in trading income of each bank shows
the extent of a bank’s transformation from a capital market service provider and advisor to
capital market risk taker.

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

Net G/L on Assets at

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

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

39
Source: BOC Annual Report 2008.
 22

We extend the above regression analyses by adding the regression variables trading securities
ratio and available for sale securities ratio, as well as customer deposits ratio to the regression
equation (China, Europe, UK and USA model 2) to test the impact of securities trading on
asset return. The results are summarized in Appendix B.

The surprising finding is that proprietary trading, either classified as trading securities or
available for sale securities, does not generate significant higher asset return over the testing
period in all testing fields, as indicated by the insignificant coefficients of securities ratio.40
This could be due to the fact that the high volatile trading results from one year to another are
only averaged out over years and do not generate constant higher asset return.

The coefficients of net interest margin in extended models reconfirm that the profitability in
Chinese banks is mainly driven by higher interest margin (0.1418 in China model 2), whereas
the effect of margin in Western banks is not significant.41 Non-interest income contributes
constantly to higher asset return in European and UK banks with coefficient of 0.0109 and
0.0122 respectively.

Risk pattern

In the following, we investigate the risk reduction effect through diversification in

non-interest income, and this can be the case, if:

Hypothesis 3: The volatilities of interest income and non-interest income are not at all or are
negatively correlated.

Regarding non-interest income (NII), we also separate the effect of fees and commissions (FC)
instead of trading income. We determine the risk term as the absolute deviation of the yearly
outcome of different business lines from the business line’s average value over sample years
for the individual banks.42. We test the correlations of the risk factors in the three business
lines. As shown in table 3, fees and commissions income is significantly correlated with
non-interest income in China, the UK and the USA with correlations of 0.2362, 0.4501 and
0.4823 respectively, which indicates that income from fees and commissions is the driving
force of non-interest income in those countries. In all testing fields, the correlations between
interest income and non-interest income are statistically not significant, which implies the
potential of risk reduction through combining interest income with non-interest income.

Noticeably, fees and commissions income is positively correlated with interest income in UK
and US banks (with correlations of 0.2877 and 0.4834 respectively), but not significant in
China and in Europe. In the UK and the USA, both interest income and fees and commissions
could be more influenced by movement of macroeconomic determinants like interest rate
level or general capital market mood, whereas fees and commissions in Chinese and European
banks stem from more stable sources like credit card fees and custody fees, which are less
sensitive to determinants of interest income.

40
We replicate the extended model regression excluding data sets from 2008 for the four testing fields to exclude the sharp
decrease in financial markets during the crisis. Neither the coefficients of trading securities ratio nor those of available
securities ratio are statistically significant at 10%.
41
In model 2, the sample concentrates on the largest banks which more frequently disclose trading activities compared to
small-sized banks usually concentrated in commercial lending. Therefore, our results show the less relevance of lending in
asset return in large diversified banks.
42
In case the average value turns out to be negative, the risk term is not included in the analysis, with the assumption that
long-term average return should not be negative.
 23

Table 3. Risk Correlation

China Europe UK USA

II FC NII II FC NII II FC NII II FC NII
II - - - -
p-value
obs.
FC 0.0846 - -0.0041 - 0.2877 ** - 0.4834 ** -
p-value 0.4078 0.9435 0.0450 0.0226
obs. 98 305 49 22
NII -0.1257 0.2362 ** - -0.0091 0.0316 - 0.0247 0.4501 *** - 0.1208 0.4823 ** -
p-value 0.2174 0.0192 0.8734 0.5831 0.8608 0.0012 0.2515 0.0230
obs. 98 98 311 305 53 49 92 22
II: interest income; FC: fees and commissions income; NII: non-interest income.
*** / ** / * Statistically significant at 1% / 5% / 10%
Source: Bankscope

We further compare the risk factors for interest income (II), fees and commissions income
(FC) and non-interest income (NII) separately43 for the sample period and generate the mean
risk factor for respective testing countries/regions. As shown in table 4, the fluctuation of
revenues from fees and commissions as well as from total non-interest income business in
Chinese and UK banks is statistically significant higher that that in traditional interest income
business (30.68%, 53.87% and 29.17%, 34.17% higher for China and the UK respectively).
Non-interest income in US banks also has a higher volatility than interest income (20.30%
higher). However, the variation of fees and commissions business in Europe and in the USA
and that of total non-interest income in Europe are statistically not significantly higher than
that of interest income. The overall results indicate that European banks especially have built
up stable non-interest income sources.

Table 4. Risk Comparison

China Europe
Variable
II FC NII II<FC II<NII II FC NII II<FC II<NII
Mean 39.28% 69.96% 93.16% -30.68% *** -53.87% ** 88.60% 39.53% 67.39% 47.89% 21.21%
obs./p value 98 98 98 0.0000 0.0285 311 305 311 0.7979 0.6448
UK USA
Variable
II FC NII II<FC II<NII II FC NII II<FC II<NII
Mean 22.91% 51.53% 57.08% -29.17% ** -34.17% *** 26.99% 16.70% 47.29% 1.85% -20.30% ***
obs./p value 53 49 53 0.0149 0.0046 92 22 92 0.7508 0.0028
II: interest income; FC: fees and commissions income; NII: non-interest income.
*** / ** / * Statistically significant at 1% / 5% / 10%
Source: Bankscope

Summarizing the above findings, the current profitability in Chinese banks depends heavily
on high guaranteed margin and lending growth. Diversifying business portfolio especially in
fees and commissions income businesses will contribute to a more balanced and sustainable
risk adjusted return model in Chinese banks.

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

Management Companies
In this section, we use the unique transformation process of Chinese banks’ equity
participation in asset management companies after the liberalization in 2005 as a template to
demonstrate the benefits of the transformation towards the universal banking model in China.
By matching 539 asset management funds with their respective asset management companies,
we differentiate the funds between bank-majority holding funds (bank funds), bank-minority
holding funds (affiliate funds), funds held by a financial conglomerate (conglomerate funds)
43
The risk factor for trading income is not used here since most mean values in trading income turn to be negative as the
result of sharp down-ward movement in capital markets in the financial crisis.
 24

and stand-alone funds (stand-alone funds). We analyze the characteristics and performance
difference of those funds using data from 2007 to 200844 and try to identify the different
characteristics between bank funds and stand-alone funds. Data are drawn from the database
wind.

As illustrated in Table 5, bank funds emerged after the liberalization of bank’s majority
holding in asset management companies in 2005. However, over 70% of asset management
funds are still held by stand-alone fund management companies which were founded much
earlier than bank funds.

Table 5. Founding Year of Asset Management Funds

Bank Affiliate Conglomerate Stand-alone
(No.) (No.) (No.) (No.)

1998 0 1 2 2
1999 0 1 4 9
2000 0 0 1 0
2001 0 1 1 3
2002 0 1 4 14
2003 0 1 8 31
2004 0 2 8 31
2005 4 2 6 31
2006 7 4 14 52
2007 5 3 12 42
2008 17 4 14 82
2009 17 5 11 82

However, the test of asset size shows that bank funds, affiliate funds as well as conglomerate
funds are significantly larger in size measured both with total assets and net assets under
management at the end of 2008, as summarized in table 6. This result demonstrates that
bank-related funds are able to draw investor’s attention and attract more financial resources.
The comparative advantage of banks in fund distribution lies in the reputation of established
brand and vast distribution network through bank branches.
Table 6. Fund Total Assets Comparison
Mean Difference
Variable Bank > Affiliate > Conglomerate >
Bank Affiliate Conglomerate Stand-alone P value P value P value
Other Other Other
Total assets 2008 in bn CNY 5.8746 5.3785 5.8679 3.4274 1.8748 *** 0.0080 1.3057 * 0.0849 2.1151 *** 0.0000
obs. 29 19 73 284 405 405 405
Net assets 2008 in bn CNY 4.9928 5.1457 5.5560 3.2632 1.2007 ** 0.0437 1.3226 * 0.0683 2.0230 *** 0.0000
obs. 33 20 74 298 425 425 425
*** / ** / * Statistically significant at 1% / 5% / 10%
Source: wind

Due to the larger size of assets managed by a single fund, especially bank funds are able to
offer fund products with favorable condition by lowering management and custody fee, which
in turn attracts more assets and intensified the economics of scale. In average, bank funds
require 0.12% and 0.01% lower management and custody fee respectively, as shown in table
7.

44
This time frame is chosen for reason of better funds data availability only from 2007 on.
 25

Table 7. Fees Comparison

Mean Difference
Variable Bank < Affiliate < Conglomerate <
Bank Affiliate Conglomerate Stand-alone P value P value P value
Other Other Other
Management fee in % 1.1340 1.2820 1.2092 1.2559 (0.1151) ** 0.0245 0.0457 0.7144 (0.0347) 0.2282
obs. 50 25 85 379 539 539 539
Custody fee in % 0.2220 0.2300 0.2289 0.2326 (0.0098) ** 0.0349 (0.0010) 0.4493 (0.0023) 0.2942
obs. 50 25 85 379 539 539 539
*** / ** / * Statistically significant at 1% / 5% / 10%
Source: wind

Regarding the portfolio structure, we identify that funds with bank linkage invest in, on
average 6% to 8% more in fixed-income products and 4% to 8% less in equity securities, as
depicted in table 8. This result can be interpreted with the fact that Chinese banks have a
longer tradition and gained expertise and market presence in bond market, especially through
inter-banking markets and can extend this expertise in their fund subsidiaries.
Table 8. Fund Portfolio Comparison
Mean Difference
Variable Bank = Affiliate = Conglomerate =
Bank Affiliate Conglomerate Stand-alone P value P value P value
Other Other Other
Stock% 58.43 54.26 58.61 63.49 (3.5888) *** 0.0000 (7.9489) *** 0.0000 (3.9399) *** 0.0000
obs. 9,012 7,781 28,925 107,945 153,663 153,663 153,663
Bond% 32.55 35.20 32.63 24.70 5.6921 *** 0.0000 8.4399 *** 0.0000 6.7082 *** 0.0000
obs. 9,012 7,781 28,925 107,945 153,663 153,663 153,663
Other% 8.55 10.20 8.72 11.61 (2.4001) *** 0.0000 (0.6466) *** 0.0000 (2.5858) *** 0.0000
obs. 8,966 7,752 28,913 107,710 153,341 153,341 153,341
*** / ** / * Statistically significant at 1% / 5% / 10%
Source: wind

We further compare the performance of bank related and stand-alone funds using the daily
return of net asset value of funds during the years from 2007 to 2008. We evaluate both the
absolute daily return and the abnormal daily return defined as the return over the benchmark
with the same portfolio structure. The second measurement should take into account the
different portfolio structures of bank-related and stand-alone funds as identified above. For
stock investment, daily return of Shanghai Composite Index is chosen as benchmark; for bond
investment, daily return of China Composite Bond Index is chosen. And we assume the
investment of the rest of the assets in the portfolio are short-term in liquid markets and
therefore choose the daily return of Shanghai Interbank Overnight Rate (SHIBOR) as a
benchmark. As summarized in Table 9, the performance of bank-related funds do not differ
much from that of stand-alone funds, both in terms of absolute return and abnormal return
compared to benchmark. This result indicates that banks are not surely the better asset
manager on the Chinese capital market. The reputation of big Chinese banks is still not a
sufficient condition to attract over-performing asset managers to deliver better performance
than fund managers in stand-alone funds.
Table 9. Fund Performance Comparison
Mean Difference
Variable Bank = Affiliate = Conglomerate =
Bank Affiliate Conglomerate Stand-alone P value P value P value
Other Other Other
Fund NAV daily return (0.0644) (0.0505) (0.0435) (0.0654) (0.0041) 0.8874 0.0104 0.7393 0.0209 0.2358
obs. 8,990 7,774 28,898 107,821 153,483 153,483 153,483
Fund NAV daily abnormal return # (0.0298) (0.0117) (0.0436) (0.0389) 0.0095 0.7414 0.0275 0.5715 (0.0063) 0.7209
obs. 5,812 1,952 18,344 61,245 87,353 87,353 87,353
*** / ** / * Statistically significant at 1% / 5% / 10%
# Abnormal return = fund daily return - portfolio daily return, portfolio daily return = stock% * SH composite index daily return + bond% * China composite bond index daily return + other% * SHIBOR daily return
Source: wind

Consolidating the above findings, we conclude that potential synergies of bank’s equity
participation in asset management companies are realized through reputation and distribution
network of banks to attract funds flows as well as lower management and custody fees
condition through economies of scale. Chinese banks especially apply their expertise in fixed
assets investment in their funds products, generating economies of scope.
 26

VI. Conclusion and Outlook

The overall results of the above analyses confirm our suspicion of Chinese banks’ high
dependence on net interest margin in generating asset return compared to their international
peers. Due to the rigid interest rate regime, the risk pricing mechanism is still not established
in the lending practice of Chinese banks. Compared to the still narrow business model in
China, European banks exhibit the highest level of disintermediation. Valverde and Fernández
(2007) explain that European universal banks charge low net interest margin for client access
and create value through bundling and cross-sell high value-added non-interest income
businesses. As volatilities of interest income and non-interest income are not correlated for all
testing fields, potential diversification benefits are realizable through revenue diversification
in non-interest income, especially in fees and commissions businesses.

Having recognized that the current narrow banking model can not be sustained after the
interest rate liberalization and with the aim of participating in returns from the rapid
development of capital markets, Chinese banks gradually diversify in non-interest income
businesses with fees and commissions in dominance and limited securities trading. Over a
short time period, China’s major banks have successfully leveraged their strong brands and
distribution networks to build up a presence in fund, insurance agency and custody services.
Economies of scale in bank related funds are transferred to investors through lower
management and custody fee. Economies of scope are achieved by sharing expertise in
investment in fixed-income products.

The cautious liberalization of bank’s engagement in proprietary trading especially in trading

equity and derivative products as well as of bank’s participation in securities companies
reveals that China learned the lesson of Western banks with over-leveraged trading and
over-risked universal banking model of pre-crisis time. A downscale of trading in Western
universal banks could bring about the convergence of a post-crisis universal banking model
with more stable and moderate return and balanced interest, fees and commissions and trading
income.

The transformation towards the universal banking model in China even goes further by
including insurance services as well. This development opens-up the way for the
establishment of the third banking business model in China, in contrast to the separated and
the universal, which is the integrated financial service provider. In November 2009, China’s
banking regulator, CBRC, issued Provisional Rules on Commercial Bank’s Share Holding in
Insurance Companies, which permit bank’s equity participation in one insurance company.
After the failure of the banc assurance model in different European countries, perhaps China
could become the new frontrunner with regards to integrated financial service provider. A lot
of research is still needed to understand the full variety of the transformation of China’s
banking sector in an international context.
 27

Appendix

A. Total Sample Description

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

B. ROAA Regression Results

Variable China (1) China (2) Europe (1) Europe (2) UK (1) UK (2) USA (1) USA (2)
Ln total assets 0.0297 *** 0.0215 -0.0450 -0.0744 -0.0499 -0.0089 -0.0364 0.2252
t value 2.6700 0.9800 -1.2200 -1.4600 -1.0700 -0.1100 -1.3500 0.9300
p value 0.0080 0.3290 0.2250 0.1460 0.2890 0.9120 0.1780 0.4050
Equity/total assets 0.0202 *** 0.0370 ** 0.0747 *** 0.0706 *** 0.0364 * 0.0705 * 0.0255 ** -0.0888 *
t value 2.6300 2.5700 4.7900 3.7200 1.9600 1.8500 2.5500 -2.6700
p value 0.0090 0.0120 0.0000 0.0000 0.0530 0.0770 0.0110 0.0560
Net interest margin 0.1877 *** 0.1418 ** 0.0450 -0.0703 0.0748 *** -0.0215 0.1662 *** 0.5813
t value 6.1400 2.1200 0.6000 -0.6500 2.8700 -0.0900 3.6500 0.8700
p value 0.0000 0.0370 0.5490 0.5170 0.0050 0.9290 0.0000 0.4350
Cost income ratio -0.0165 *** -0.0219 *** -0.0123 *** -0.0182 *** -0.0073 ** -0.0086 * -0.0233 *** -0.0419 **
t value -7.1100 -5.1500 -5.6800 -5.6100 -2.4200 -1.9000 -15.9600 -3.1200
p value 0.0000 0.0000 0.0000 0.0000 0.0180 0.0690 0.0000 0.0360
Trading securities/total assets - 0.8487 - 1.1087 - -1.2107 - 5.5174
t value 0.7900 1.1400 -0.6400 1.0300
p value 0.4330 0.2560 0.5270 0.3610
Available for sale securities/total assets - -0.1105 - -1.1059 - -0.8173 - -2.1165
t value -0.2300 -1.2000 -0.7800 -1.1000
p value 0.8210 0.2310 0.4410 0.3320
Customer deposits/total assets - -0.7034 - 0.6326 - 0.1926 - -1.9943
t value -1.4800 1.2000 0.2700 -1.2600
p value 0.1420 0.2290 0.7910 0.2780
Growth of total assets 0.0030 ** -0.0009 0.0006 0.0011 0.0241 *** 0.0043 -0.0011 0.0019
t value 2.4700 -0.3900 0.3300 0.4900 5.9400 0.9500 -1.0500 0.2500
p value 0.0140 0.6970 0.7420 0.6250 0.0000 0.3540 0.2960 0.8130
Impaired loans/gross loans -0.0037 0.0092 -0.0626 *** -0.0694 ** -0.2049 *** -0.0028 -0.2875 *** -0.4189 **
t value -1.1900 0.7400 -2.8800 -2.5500 -6.3600 -0.0800 -7.1300 -3.0100
p value 0.2370 0.4610 0.0040 0.0110 0.0000 0.9370 0.0000 0.0400
Non-interest income/gross revenue 0.0072 *** -0.0036 0.0144 *** 0.0109 ** 0.0034 0.0122 * 0.0100 *** 0.0048
t value 3.4100 -0.7300 4.6200 2.5100 0.8500 2.0100 4.5100 0.1800
p value 0.0010 0.4650 0.0000 0.0120 0.3960 0.0560 0.0000 0.8630
Constant 0.3024 1.4866 ** 1.0107 * 1.8818 ** 1.0660 * 0.3927 1.9118 *** 2.5461
t value 1.3100 2.6000 1.9300 2.4100 1.8700 0.2800 5.2100 0.7800
p value 0.1930 0.0110 0.0540 0.0160 0.0650 0.7850 0.0000 0.4780
F value 29.6900 10.0100 22.9200 13.2700 13.1300 3.6500 64.0100 51.3000
R-squared 0.4462 0.5557 0.2513 0.2609 0.5506 0.6133 0.5150 0.9923
Adjusted R 0.4311 0.5002 0.2403 0.2412 0.5087 0.4452 0.5070 0.9729
Obs. 266 91 486 387 83 34 430 15
*** / ** / * Statistically significant at 1% / 5% / 10%
Source: Bankscope
 28

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

China Europe UK USA
Ln(Total Assets) -0.1350 *** -0.1176 *** -0.3503 *** -0.3398 ***
p-value 0.0082 0.0000 0.0000 0.0000
obs. 383 1,348 236 472
Equity/Total Assets 0.1847 *** 0.0450 * 0.4854 *** -0.0404
p-value 0.0003 0.0983 0.0000 0.3810
obs. 383 1,348 236 472
Cost Income Ratio -0.4608 *** 0.0503 * 0.0115 -0.0223
p-value 0.0000 0.0658 0.8614 0.6304
obs. 383 1,339 235 469
Net loans/Total Assets 0.4035 *** -0.0290 0.3781 *** 0.3614 ***
p-value 0.0000 0.2890 0.0000 0.0000
obs. 383 1,335 234 469
Trading Securities/Total Assets 0.1019 -0.1570 *** -0.5239 *** -0.1136 **
p-value 0.3107 0.0000 0.0000 0.0241
obs. 101 833 72 394
Available for Sale Securities/Total Assets -0.5066 *** -0.1748 *** -0.0431 0.2620 **
p-value 0.0000 0.0000 0.6670 0.0174
obs. 373 990 102 82
Total Securities/Total Assets -0.4620 *** -0.1162 *** -0.2432 *** -0.2297 ***
p-value 0.0000 0.0000 0.0008 0.0000
obs. 382 1,283 188 467
Customer Deposits/Total Assets 0.1665 *** -0.0800 *** -0.1197 * 0.2637 ***
p-value 0.0011 0.0044 0.0905 0.0000
obs. 383 1,267 201 450
Bank Deposits/Total Assets -0.0857 0.0250 0.1206 * -
p-value 0.1011 0.3746 0.0939
obs. 367 1,264 194
Growth of Total Assets 0.0600 0.0033 -0.1000 0.1358 ***
p-value 0.2840 0.9129 0.1711 0.0037
obs. 321 1,073 189 456
Growth of Total Loans -0.0195 0.0121 -0.1097 0.2197 ***
p-value 0.7284 0.6953 0.1351 0.0000
obs. 321 1,055 187 447
Impaired Loans/Gross Loans -0.1997 *** 0.2403 *** 0.5388 *** -0.0272
p-value 0.0004 0.0000 0.0000 0.5672
obs. 310 571 100 445
Loans/Customer Deposits 0.1812 *** 0.0565 * 0.1618 ** -0.0580
p-value 0.0004 0.0582 0.0231 0.2288
obs. 383 1,126 197 433
Non-Interest Income/Gross Revenue -0.6203 *** -0.1025 *** -0.1662 ** -0.3229 ***
p-value 0.0000 0.0002 0.0126 0.0000
obs. 383 1,291 225 471
*** / ** / * Statistically significant at 1% / 5% / 10%
Source: Bankscope
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