How to Counter Negative Effects of Guanxi Ties in Financial Sector?

Guanxi is an intangible resource that gives rise to intricate relational networks. For centuries, guanxi has been a building block of the Chinese business world. In 21st century China, this culturally distinct form of purposeful networking still matters, often shaping the behaviours and decisions of economic agents and exerting impact on management activities and firm performances.

The heavy emphasis of the guanxi culture on reciprocity, loyalty and the binding power of personal relationships goes against the objective of achieving efficiency in market economy. This Research White Paper highlights some of the detrimental effects of Guanxi ties in the financial sector: connected analysts and auditors issue optimistically biased opinions while playing down or staying silent about negative information; investors are led to believe the accolades earned by connected analysts through guanxi are marks of the latter’s competence; and IPO firms’ earnings are exaggerated and their long-term performance is affected due to banker-auditor ties.

On the other hand, those who have guanxi connections build up a collusive relationship with their connections, often making personal gains at the expense of the principle of fairness and independence. For example, fund managers can get their connected analysts to write positively biased reports on their stocks, and auditors can command higher fee premiums by virtue of their connections with bankers in IPO deals. In sum, guanxi ties do have the advantage of facilitating information sharing, but their costs to the market often exceed their benefits.

Our findings have practical implications for various sides of the financial market, including investors, regulators, audit firms and audit committees.

Investors investing in IPO stocks should be wary of poor audit quality stemming from banker-auditor social ties. When formulating policies that touch on the independence of audit committees and outside auditors, it would be sensible for regulators to consider the role informal personal ties play. Given that investors do discount the earnings audited by engagement auditors who have guanxi connections with corporate executives or audit committee members, mandatory disclosure of such affiliation would be helpful. Likewise, public accounting firms eager to improve their performance should take into account the guanxi factor when allocating scarce quality control resources and assigning individuals to audit engagements. Industry practitioners who want to strengthen corporate governance should also be aware of the impact of guanxi on external auditing when developing firm-level governance structures.

To find out more about a specific topic, click on the links below to navigate to the relevant chapter:

INTRODUCTION – Where Guanxi Matters: The Modern Chinese Financial Sector

PART I – The Influence of Guanxi on the Fund Manager-Analyst Relationship

PART II – Does Guanxi Affect the IPO Process in China?

PART III – Guanxi and Auditing

PART IV – Can Guanxi Help Analysts to Uncover Bad News?

CONCLUSION – How to Counter Negative Effects of Guanxi Ties in Financial Sector?

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