Bank Readiness for Interest Rate Liberalization in China

Transcription

1 1 FINANCE WORKING PAPER Bank Readiness for Interest Rate Liberalization in China Liu Mingkang 1 August Special thanks to the China Banking Association for their help in designing the survey and collecting the data.

2 Contents Introduction Assessing the progress in interest rate liberalization Challenges to net interest margins and product cost pricing Moderate progress in interest rate liberalization Business Operational readiness for interest rate liberalization Business model readiness Strategic shift in enhancing innovation capacity Enhancing market research and tracking competitive position Lack of professional skills as main internal constraint on innovation Lagging financial infrastructure as main external constraining factor Readiness for Risk Management Differential Pricing and Risk-Adjusted Pricing Inadequacies of existing quantitative models is a core internal constraint on risk-pricing Incomplete base rate system and its transmission mechanism as external constraints Next Steps in Enhancing Bank Readiness Impact of external environment on interest rate liberalization Base rate is foundation for market oriented interbank pricing Establish a well-functioning interest rate transmission mechanism

3 Introduction On 8 June and 6 July, 2012 respectively, the People s Bank of China (PBOC) adjusted the renminbi benchmark deposit and lending rates as well as the caps and floors on such rates. Currently, the cap on bank deposit rates has been raised to 110 per cent of the corresponding benchmark rates and the bank lending rate floor was lowered to 70 per cent of the corresponding benchmark rate. These two adjustments on interest rates were important steps in advancing the process of interest rate liberalization in China. According to the Chinese Bankers Survey (2012), jointly conducted by the China Banking Association and PricewaterhouseCoopers (PwC), the adjustments at that time caught the market by surprise. We can infer that the PBOC drove the interest rate liberalization program, with the commercial banks only reacting to the policy initiatives. In the 10-month period since the 2012 liberalization, we have examined how Chinese commercial banks have responded to the policy initiatives and readied themselves for the current interest rate liberalization process. The survey was conducted by interviewing senior bank executives, with the sample covering 6 large commercial banks, 7 joint-stock commercial banks, 4 city commercial banks, 2 rural commercial banks and 10 foreign banks. The survey revealed that the present impact of the interest rate liberalization process was mainly on business operations, but that on the whole, the pace of liberalization was moderate, with acceptable and manageable impact on the commercial banks. The commercial banks made a number of satisfactory preparations to ready themselves for the liberalization process. In the area of business operations, the main strategic adjustment was to enhance innovative capacity, allocating more resources for new businesses and new products. To promote innovation in new product lines and financial instruments, the key measure was to improve market research and understanding of competition from other banks. The specific internal and external barriers to innovation capacity were respectively shortages in professional skills and the under-developed financial infrastructure. In the area of risk management, the preferred strategy was to pursue price differentiation and riskadjusted product pricing. Here, the main internal and external barriers to further innovation in riskadjusted pricing were respectively data inadequacies and flaws of the quantitative models and the incomplete base rate and market guidance/rate transmission mechanism. Furthermore, the survey indicated that the main barriers to interest rate liberalization are the incompleteness of the base rate system which in turn limits the effectiveness of the interest rate transmission/price formation mechanism. Measures to promote the unification of interest rates in the bond market, increasing the number of banks quoting SHIBOR, and enhancing the supporting transaction/dealing functions would be important to improving the base rate transmission process. 3

4 1. Assessing the progress in interest rate liberalization Currently, the main challenge of the interest rate liberalization has been on bank operations and business management, putting pressure on the banks risk management and liquidity management capabilities. Even though many other pressures exists, on the whole, the banks feel that the current pace of interest rate liberalization is moderate and its impact on them is within acceptable and manageable bounds. 1.1 Challenges to net interest margins and product cost pricing The liberalization of interest rates will require the financial institutions to assess their own financial situation and financial market conditions in order to adjust their interest rate pricing accordingly. With full liberalization of deposit and lending rates, the current pricing mechanism will be radically changed with profound implications. According to feedback from the bankers surveyed, the most significant impact of the interest rate liberalization will be the narrowing of net interest margins and the increasing difficulty in product cost pricing. About two thirds of the bankers surveyed voiced their concerns on such issues that challenged the previous spread-driven business model which depended on large clients and scale. In addition, 14.3 per cent of the bankers surveyed believed that interest rate liberalization would force a change in the composition of the banks business and client-mix, and restructure their balance sheet. Currently, commercial banks are clearly feeling the business pressures. Perhaps because the liberalization process is still in progress, only 4.8 per cent of the bankers surveyed expressed concerns about increasing difficulties in risk management and pressures in liquidity management. Even though the interest rate liberalization has intensified competition, only 4.8 per cent of the bankers surveyed believed that it will facilitate financial innovation. This is clearly related to the current regulatory constraints on financial innovation in China. 1.2 Moderate progress in interest rate liberalization Even though individual banks have felt business pressures brought about by interest rate liberalization, the survey revealed that more than half of the banks (54.5 per cent) believed that the current interest rate liberalization was making relatively fast progress with acceptable pressure per cent of the banks in the survey believed that the pace of liberalization was reasonable and only 13.6 per cent of the banks felt that the pace was too fast and had adversely impacted their operations. No bank suggested that the pace should be expedited. The results showed that the current pace of interest rate liberalization is moderate with acceptable and manageable impact on the commercial banks. 4

5 Figure 1. Impact of interest rate liberalization (%) Figure 2. Views on pace of interest rate liberalization (%) 5

6 2. Business Operational readiness for interest rate liberalization In meeting the challenges of interest rate liberalization, many banks have already implemented a number of measures to cope with the changes. The survey assessed the banks own views on their readiness for interest rate liberalization. The results showed that the average score for the six measures was 3.31 out of 5, indicating an overall satisfactory state of readiness. Among the six measures, measures to improve liquidity management and funds flow forecasting and reporting system, received the highest score of This suggested that most banks have coped fairly well with the liquidity pressures after the widening of the band for fluctuation in interest rates. However, it may also suggest that the commercial banks under-estimated their requirements for fulfilling this particular area. The area of fine-tuning strategy of innovation in business model received the second highest score of 3.36, which suggested that banks have already placed high priority on transforming their business model in recent years. The weakest area lay in the product and financial instrument innovation, with the lowest score of 3. This suggests that the commercial banks face difficulties in financial innovation because of internal and external constraints, which means that further (reform) work is necessary in this area. Figure 3. Self-evaluation of bank readiness for interest rate liberalization 2.1 Business model readiness In preparing for the process of interest rate liberalization, different banks adopted different preparatory measures, although there were common themes. More than 90 per cent of the banks stated that their strategic shift in direction was in raising their capacity to innovate. In practical terms, the main measure in terms of product and financial instrument innovations was to improve market research and establish a system to track what other banks are doing. However, improvements were constrained by the lack of professional skills and the lagging financial infrastructure. 6

7 2.1.1 Strategic shift in enhancing innovation capacity Expediting the pace of interest rate liberalization has advanced the need for interest rate risk management. The commercial banks must develop more innovative interest rate products, such as interest rate derivatives, to hedge their own risks. At the same time, the commercial banks can use these products to provide more diversified hedging services for their corporate and retail clients, as well as improve their own revenue. As business and product innovation remains the weakest area in the Chinese banking system, the survey results showed that 90.9 per cent of the commercial banks believed that they should positively enhance their innovation capacity, expand their product and service range and allocate more resources to product and businesses innovation. This showed that banks are paying serious attention to product innovation during the process of interest rate liberalization. The other three areas of strategic shifts by the commercial banks were: developing retail banking business; enhancing the small and medium sized enterprises (SME) business; and creating unique branding and institutional differentiation (68.2 per cent). Under the current stage of development, it is still premature to develop overseas business in order to increase profitability hence only 36.4 per cent of banks selected this strategic direction. Figure 4. Measures for business innovation and strategy adjustment (%) Enhancing market research and tracking competitive position As discussed earlier, the survey revealed that bankers felt that of all the preparations, product and financial instrument innovation received the lowest score. We could conduct a more specific and detailed analysis based on the results of the survey. Banks can promote their product innovation from a number of perspectives. Of these, most banks believed that the enhancement of their market 7

8 research and tracking of their own competitive position (vis-a-vis what their competitors are up to) in the inter-bank market is important (81.8 per cent). The fact that commercial banks would like to know real-time what is happening in product and other innovations means that they would like to coordinate better within the inter-bank market. This also suggests a trend towards risks being more concentrated in the interbank market. Most banks also believed that their performance evaluation system should be more adapted towards intermediary business (72.7 per cent). This result showed that in putting priority on innovation, the banks intend to connect product innovation with performance evaluation. Exploiting the latest advances in information technology is another measure stated by many banks (68.2 per cent). Currently, many banks existing IT systems cannot cope effectively with the changes brought about by interest rate liberalization; specifically, they cannot provide services to clients with differentiated interest rate pricing. Current differentiated interest rate services are still conducted manually (for example, through manual registration books). Such manual services are increasingly inadequate to meet market competitive needs, requiring the speeding up of core IT system capabilities. Figure 5. Measures for product and financial instrument innovation (%) Lack of professional skills as main internal constraint on innovation Historical experience from advanced markets suggests that interest rate liberalization has been an important driver of financial product innovation and a necessary condition for vigorous innovation. However, at this stage, the capacity in bank product innovation is inadequate, with the survey results showing that shortage of innovative personnel as the primary constraint for banks to advance on product innovation (86.4 per cent). This result suggests that interest rate liberalization must move in tandem with the education and training of professional skills. Furthermore, the fact that 77.3 per cent of the banks believed that their management information system is inadequate indicates that the IT system needed for product innovation has not been established and has lagged behind the progress of interest rate liberalization. 8

9 Another 72.7 per cent of the bankers believed that the income sources for commercial banks are not well diversified, suggesting an over-reliance on lending margins as the main source of income, with other businesses and innovations being under-developed. It is also worthwhile to note that 9.1 per cent of the banks believed that the adequate traditional sources of liquidity constrains financial innovation. It is a concern that most of the surveyed banks do not believe liquidity will continue to be adequate. Figure 6. Internal constraints on product and financial instrument innovation (%) Lagging financial infrastructure as main external constraining factor Apart from internal constraints, several external factors also inhibit bank innovation capacity. The survey results showed that the main external constraint is the lagging financial infrastructure, including unfavorable financial regulations, credit culture and other supporting infrastructure (86.4 per cent). Thus, from the banks perspective, it is crucial to strengthen the financial infrastructure to ensure that it facilitates and supports interest rate liberalization. Another 81.8 per cent of the bankers surveyed believed that operational and investment barriers between financial markets still exist, which reveals the vital needs of commercial banks to expand the scope of their business and investment. However, 77.3 per cent of the banks believed that the self-regulatory discipline is not well functioning, suggesting that non-compliance and insufficient self-regulation within the industry is still evident. 9

10 Figure 7. External constraints on product and financial instrument innovation (%) 2.2 Readiness for Risk Management After interest rate liberalization, banks face a more difficult risk management setting, for which a wellplanned preparation is fundamental. Proper management of price-setting will become the core function of risk management. In general, banks focus on differential pricing and risk-adjusted pricing as the main measure for innovative risk pricing. However, this is complex to implement due to the limitations of the quantitative models, the incompleteness of the base rate system and its transmission mechanism, as well as other internal and external factors Differential Pricing and Risk-Adjusted Pricing In the process of interest rate liberalization, banks will experience multifaceted and complex interest rate risks that will significantly affect the market. After years of controlled interest rates, banks lack experience in interest rate management, and also lack the skills and knowledge to manage the risks involved in interest rate liberalization. However, the survey results showed that banks have begun to comprehend the importance of proper preparation for interest rate liberalization. Banks have initiated a series of innovative risk-pricing measures. More than 90 percent of the surveyed banks have taken the following two measures: i) to differentiate and classify products and customers groups, and ii) to adjust risk for price-setting. These two methods have become the priority options. At the same time, banks have increased the evaluation criteria for price-setting (86.4 per cent), changing the effect of pricesetting on the market (77.3 per cent). However, other measures, such as the increase in quantitative methodology in price-setting (68.2 per cent) and enlargement of the coverage of price-setting (59.1 per cent), have not yet been universally applied in the market. 10

11 Figure 8. Bank measures for innovative risk-pricing (%) Source: Inadequacies of existing quantitative models is a core internal constraint on risk-pricing The process of interest rate liberalization will be accompanied by increases in deposit rates and narrowing of interest margins. This will heighten the operational risk for banks as well as increase market risks and credit risks, underscoring the importance of interest rate risk management. In the process, the demand on the capacity of banks to price risk appropriately becomes higher than ever. The survey indicated that because of insufficient knowledge, measurement, monitoring and control capacity, Chinese banks have yet to properly manage market risks, credit risks and operational risks per cent of banks surveyed indicated that their internal quantitative models lack completeness in design, data and proper testing, which has become the major obstacle for risk-pricing. Furthermore, 68.2 per cent of the surveyed banks reported that their IT and management information systems (MIS) cannot as yet fully support and solve the problems associated with innovation. Consequently, the foundation for interest rate risk management is still relatively weak. Inadequate MIS and other limitations remain the core impediments towards developing a fully-functioning risk-pricing system. Nonetheless, nearly 60 per cent of banks have recorded some preliminary success in establishing their mid and back-office controls systems for risk-pricing, where internal assessment and human resources issues are no longer problems. Figure 9. Bank understanding of internal risk-pricing issues (%) 11

12 2.2.3 Incomplete base rate system and its transmission mechanism as external constraints Basically, the incomplete financial infrastructure and base rate system remain impediments to the transition towards effective liberalization efforts per cent of the banks reported that since the financial market is not fully developed, it is not possible to construct a comprehensive transmission mechanism between the base rate and the banks price-setting and deficiencies in setting the base rate do not provide the necessary foundations for bank price setting are the two major external factors limiting banks from risk-pricing. Moreover, 77.3 per cent of the banks reported that insufficient basic financial infrastructure, such as financial regulation and supervision, deposit insurance and other limitations do not provide assurance for banks to set prices on their own. Furthermore, 72.7 per cent of the banks also indicated that the low education qualification of market participants limited the banks capacity to set risk-adjusted prices professionally. In short, there still exist realistically many external factors that prevent banks from enhancing their price-setting ability. Figure 10. External factors constraining risk-adjusted price-setting (%) 2.3 Next Steps in Enhancing Bank Readiness Despite the preliminary success in improving bank readiness in tackling the challenges arising from interest rate liberalization, there is still considerable room for improvement. In response to the question on the next areas to focus on, the surveyed banks identified three areas as crucial: optimize customer relationship systems, improvement in risk management capability and improvement in price setting capacity. These three areas were cited by 95.5 per cent of the banks surveyed. This indicates that the banks have collectively identified client structure, risk management and quality of price setting as their core focus in the process of interest rate liberalization. They also demonstrate that the banks themselves recognize these three areas as being relatively weak and requiring immediate attention. 12

13 Figure 11. Priority next steps to enhance interest rate liberalization (%) 13

14 3. Impact of external environment on interest rate liberalization The success of interest rate liberalization does not depend on the banks alone, but on a number of external conditions and constraints. The external environment can either help or impede further interest rate liberalization. Whilst there have been considerable improvements in the current financial environment, there still exists considerable obstacles in the process of interest rate liberalization. As indicated earlier, the banks generally believe that the incomplete base rate system and the deficiency of transmission mechanism are the main external obstacles. At the same time, unification of the bond market rates, increasing the number of banks quoting SHIBOR and enhancing the dealing mechanisms are fundamental to enhance the base rate pricing system. 3.1 Base rate is foundation for market oriented interbank pricing Of all the external constraints, the incomplete base rate system (86.4 per cent) and the underdevelopment of financial markets (86.4 per cent) are of highest concern. Because of the incomplete base rate system, banks cannot practice effective risk pricing since they are priced on shifting sand. A well established benchmark interest rate system is the foundation for commercial banks to perform risk-based pricing using the base rates, which leads to the pricing of all kinds of financial products. With respect to how to complete the benchmark interest rate system, most banks surveyed suggested two key priorities: integrating the currently segmented bond markets with unified interest rates (59.1 per cent) and increasing the number of banks quoting SHIBOR and strengthening the dealing mechanisms (59.1 per cent). The results indicate that institutional factors such as the segmented bond market and the incomplete SHIBOR quoting system have severely impacted the development of benchmark market rate system. Currently bond markets are regulated by different regulators and this should be reformed to facilitate the inter-market connectivity between transactions in treasury bonds, corporate bonds, financial bonds, medium-term notes, short-term notes and other debt instruments. Furthermore, the short-term funds quoting system, represented by SHIBOR, should be comprehensively reformed to enable the construction of an integrated base rate yield curve as the benchmark indicator for debt markets in China and the guide for banks risk pricing. Figure 12. Measures for reforming benchmark rate system (%) 14

15 3.2 Establish a well-functioning interest rate transmission mechanism The survey results clearly showed that the deficiencies of the interest rate transmission mechanism are the most critical external constraint (68.2 per cent). This implies that we need to use market forces to facilitate an efficient and smooth interest rate transmission mechanism. For commercial banks to make appropriate pricing decisions according to base rate movements, the interest rate transmission process must be well functioning according to micro-decisions of market participants in making timely and appropriate responses to movements in the base rate. In order to make commercial banks and enterprises more willing and capable of making decisions based on interest rate movements, the financial market should be improved in the direction of enhancing market participants capacity to make micro-decisions effectively, such as the number of market participants, their incentives to deal and participate; and clearer definition of the obligations, rights and interests of these market participants. In addition, 36.4 per cent of the banks surveyed believed that the financial derivatives market is underdeveloped and the absence of a deposit insurance system is another major concern. The reasons for these concerns lie in the importance of financial derivatives in hedging interest rate risks and the key function of a deposit insurance institution in differentiating commercial bank credit and other risks, which would make the market rates more active and lively. 15

16 Figure 13. External impediments to interest rate liberalization (%) 16