Economics & Finance

Closing the capital gap in China’s banks

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funding imbalance Chinese banking system

A unique monetary policy in the Asian powerhouse creates a financial disparity between state and non-state banks, but the market finds its way

By Putro Harnowo, Senior Content Manager, China Business Knowledge @ CUHK

When the US Federal Reserve, or the Fed, delivered an interest rate cut in September, its first in four years, the widely-anticipated decision created a ripple effect overnight. As the same interest rate influences all banks in the US, those with ample cash can park their funds with the Fed while those needing liquidity can tap into the Fed’s resources for a capital boost.

“You can think of the Fed as a big player with whom you can always trade. As a result, every bank has a pretty similar situation in terms of funding,” says Luo Dan, Assistant Professor in the Department of Finance at the Chinese University of Hong Kong (CUHK) Business School. “However, in China, the central bank is the one deciding to give money, and the banks cannot freely trade with the central bank.”

funding imbalance
China’s monetary policy results in some banks having excess funding while others experience a lack of resources.

Unlike many Western countries that primarily use interest rates to control the economy, China employs a different approach known as quantity-based monetary policy. “When the People’s Bank of China implements a monetary policy, it influences the overall quantity of money in the economy,” Professor Luo adds.

However, such monetary policy often favours certain banks, leaving some with more funding than they need while others face shortages. In a new study titled Imbalance and reallocation of funds under Chinese quantity-based monetary policy, Professor Luo delves into the cause of such disparity and how the market navigates its own path to address the issue.

Along with Michael Weber of the University of Chicago, Yang Zhishu of Tsinghua University and Zhang Qi of Shanghai Jiaotong University, Professor Luo conducted a combination of data collection, empirical analysis, model development, and literature review, focusing on the period from 2013 to 2019, with particular attention to the implications for monetary policy and funding imbalances in the Chinese banking system.

Understanding China’s unique banking system

China’s central bank only deals with selected financial institutions called primary dealers, which is crucial in implementing monetary policy. As of 2022, there are 49 primary dealers, consisting of 39 non-state banks, six state banks, two policy banks and two securities companies.

Despite the small number, state banks are massive compared to non-state ones, representing more than 40 per cent of the sector assets. These six include the notable Big Four—Industrial and Commercial Bank of China, Bank of China, China Construction Bank, and Agricultural Bank of China—and two minor ones—the Bank of Communications and Postal Savings Bank of China.

However, due to their non-market objectives and focus on traditional intermediation between depositors and borrowers, state banks are discreet in lending and investment. “We found that state banks act very conservatively when they have extra funds and are reluctant to lend or reallocate funds to other banks,” Professor Luo says.

“We found that state banks act very conservatively when they have extra funds and are reluctant to lend or reallocate funds to other banks.”

Professor Luo Dan

Imbalance as the byproduct of monetary policy

China’s macroprudential regulation aims to reduce the risk and the macroeconomic costs of financial instability. For this purpose, the central bank implements quantity-based monetary policy through several key mechanisms.

funding imbalance
Varying information about each other’s financial health and lending constraints can limit interbank transactions.

Specifically, the central bank sets the reserve requirement ratio, which dictates the percentage of deposits banks must hold as reserves. By adjusting the reserve requirement ratio, the central bank can influence the amount of funds available for banks to lend. A lower ratio will increase the money supply by allowing banks to lend more, while a higher ratio restricts lending and reduces the money supply.

The central bank also provides medium-term lending facilities to primary dealers with collateralised loans, typically with a maturity of one year, to inject liquidity and support lending to the real economy. Despite these mechanisms, Professor Luo discovered the funding imbalance persists.

Banks normally transact with each other through interbank lending and borrowing. However, banks may have different levels of information about each other’s financial health and may face constraints that limit their ability to lend to others.

“State banks with massive sizes and many branches can naturally raise a lot of money from depositors, while they actually may not need that much,” he adds. “Meanwhile, non-state banks, especially those on the east coast of China, have many investment opportunities but may have fewer deposits and funds as they cannot borrow from the central bank sufficiently.”

Tackling funding imbalance in the banking system

Due to the large gap between deposit rates and the return on the money market in 2017, households started to migrate funds out of banks to money market mutual funds, and more broadly, wealth management products. Money market mutual funds are typical investment vehicles that pool money to invest in short-term, high-quality, and low-risk financial instruments.

smartfunding imbaance, chinese banking

“The fact that the state banks are reluctant to lend money to other banks is important because they decide how to allocate the money. If the money moves out of the banking system to money market funds, the money market can decide how to allocate the money, and they are not subject to such conservatism,” Professor Luo says.

Money market mutual funds channel capital from investors to banks and other financial institutions by acting as intermediaries between depositors and borrowers. This process helps redistribute excess liquidity from banks with surplus to those in need, alleviating funding imbalances and reducing reliance on the central bank.

“Money market funds basically allocate households’ money, and banks borrow from money market funds,” he adds.

When the table turns

The high interest rate in recent years has caused a boom in non-bank investment vehicles, and state banks found themselves struggling to attract depositors. Therefore, state banks began to issue a financial instrument called a negotiable certificate of deposit in 2018 and eventually became net issuers in 2019.

As the name suggests, negotiable certificate of deposits are negotiable fixed-term deposits issued by banks offering fixed interest rates and maturity dates, normally within a year, and can be traded like securities. “The good thing about a negotiable certificate of deposit is no need for any collateral, so banks can raise much money without pressure. It’s like a bond, very convenient with high liquidity,” says Professor Luo.

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This change of direction challenges a conventional view of the Chinese banking system, which posits state banks possess abundant financial resources and provide funds for other banks. When state banks shift from net lenders to net borrowers, it allows for a more efficient distribution of financial resources and enables non-state banks to increase their lending relative to state banks, reducing funding imbalance in the system.

Finally, a thorough analysis was conducted to isolate the impact of other factors in the banking system, such as the real estate sector, which has been accounting for a substantial portion of bank loans and overall economic activity, and non-bank financial institutions called shadow banking, which provide some of the key services of banks despite not being traditional lenders. The analysis affirms the lending behaviour shifts reflect the banking system’s underlying dynamics rather than the above confounding factors.