Flawed Western system gives Chinese banks room to expand

In 2008, the US and European banking system as a whole became insolvent, requiring $1.7 trillion in taxpayer bailouts. Even this loss was small compared to the costs of the 'Great Recession' which the banking crisis precipitated - it has taken over four years for the G7 economies to simply regain pre-crisis output levels.

Four years on, problems in US and European banks are still not resolved. Recently JP Morgan was hit by huge losses from complex derivatives trading while Barclays was revealed to have engaged in illegal manipulation of LIBOR - the interest rate which is a cornerstone of international lending. Nor have bank losses been capped - billions of Euros are currently being funneled into Spanish banks to prevent their collapse due to high-risk real estate lending.

While one or two scandals could be explained by accidental factors, a continuing series of crises, attached to huge losses, clearly reveals systemic problems.

The structural flaws in the US and European banking systems are actually well understood by economic experts - the difficulty is not in the analysis, but in taking practical measures to solve the problem. Martin Wolf, the Financial Times chief economics commentator, wrote a lucid series of articles analyzing the issue. He rightly noted that a fatal flaw in the US and European banking systems has been created by a situation whereby banks receive profits but taxpayers pick up any institution-threatening losses. The necessary consequence is the promulgation of risk-taking on a scale destabilizing the banking system.

A large bank, as with other companies, is supposed to make profit if it takes correct commercial decisions and suffer losses if it takes bad ones. Such a structure automatically inhibits risk taking ― a company making excessive numbers of poorly-judged risky decisions will go bankrupt terminating its activity. Companies therefore limit risks to avoid bankruptcy. This fear of bankruptcy is necessary to prevent institutions from taking excessive risks in search of the higher profit rates which are associated with higher risks.

But since the collapse of Lehman Brothers in 2008, which created the largest financial crisis in eighty years, large US and Western banks no longer operate under this structure. After this 'near death' experience, governments drew the conclusion no large bank could be allowed to go bankrupt - in other words, they are 'too big to fail.' Ever since, no major Western bank has been allowed to collapse ― if the existence of a large bank is threatened, central banks pumped in the funds required to save it.

However this removes inhibitions on risk-taking. If private banks retain profits but taxpayers pick up institution-threatening losses, it is entirely rational for banks to seek to engage in high profit but high risk operations as they are safeguarded from the ultimate consequences of mistakes.

Martin Wolf's analysis of a major UK bank therefore sums the situation up well: "Lloyds… has a target return on equity of 14.5 percent… The question… is whether such objectives make any sense. The brief answer is: no."

"…it is perfectly obvious that these cannot be sustainable safe returns in economies growing at 2 percent a year… At a 15 percent real return, the value of cumulative retained earnings would double in five years and increase 16-fold in 20 years. Pretty soon, bank equity would be the only real asset in the world!" Wolf noted.

Therefore, "…these desired returns must represent the result of extreme risk-taking… [the banks] are subsidized, principally because taxpayers provide insurance against catastrophic risk… If a bank says it needs a real return on equity of 15 percent… it is telling you that it is running an enormously risky business."

Under these conditions, a string of future scandals and crises are inevitable ― a large bank, one with a state guarantee of its existence, is an accident waiting to happen - hence the LIBOR scandal, JP Morgan trading losses, and catastrophically risky Spanish real estate loans.

But ending this system of institutionalized excessive risk taking, by reuniting in a single institution responsibility for profits and losses, can only be achieved in one of two ways.

The first is to remove the necessity of a state guarantee of the banks existence - that is private banks must no longer be 'too big to fail'. This solution, advocated by Wolf and some other analysts, is to break up the big US and European banks into units which are sufficiently small that they can safely be allowed to face bankruptcy.

But this is not going to happen. Such a move would meet strong opposition from banks which are naturally satisfied with a system where they retain profits but are protected from institution threatening losses. More fundamentally, the huge scale of modern investments requires very large banks able to withstand the risk of large potential losses. Breaking up the big banks is utopian and will not occur.

The only other way to reunite in single institutions profit making and loss taking is by the state taking responsibility for both, which is China's banking structure. China has smaller private banks but its largest 'system making' banks are state-owned - thereby uniting profit making and loss taking. As China's banks do not have the US and Europe's perverse financial incentive structure, they have not suffered the scandals repeatedly wracking Western banks.

The structure of China's banking system has therefore created a favorable dynamic for China's banks in international competition and aids their current international expansion. To take only one example, ICBC acquired a stake in South Africa's Standard Bank, recently purchased control of Standard Bank's Argentinean operations, financed infrastructure projects in Ecuador, Venezuela and other Latin American countries, became the first Chinese bank to operate in India, and recently received banking licenses for Brazil and Pakistan. ICBC's assets in the Middle East rose by 3,800 percent in the last three years, showing its potential for rapid expansion into international markets.

This trend also helps explain why four Chinese banks - ICBC, China Construction Bank, Agricultural Bank of China and Bank of China - now occupy places in the world's top ten banks in terms of market capitalization.

For the reasons outlined it is impossible for the US and Europe to quickly fix the problems which lie at the core of the structure of their banking systems. Rapid international expansion by China's banks will therefore continue not only due to their own strengths but also due to the structural problems in their Western competitors.