Investigating the Performance of Chinese Banks: Efficiency and Risk Features

Yong Tan

• Publisher: Palgrave Macmillan
• Year: 2016
• Print ISBN:
  9781137493750
• eBook ISBN:
  9781137493767
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

This book applies econometric techniques to test the relationship between efficiency and risk within the banking industry in China. Chapters examine how efficiency has been affected by different types of risk-taking behaviour and how risk has been an important determinant of bank efficiency in the context of the series of reforms impacting banks in China since 1978. The author begins by unpacking these reforms and proceeds to explain relevant theories of efficiency and bank risk before reviewing empirical literature in evaluating risk and efficiency in the banking industry. He then investigates the issues of efficiency and risk in the Chinese banking industry using a number of modern econometric techniques. The final chapters present the results of original empirical research conducted by the author, and provide valuable implications to Chinese government as well as banking regulatory authorities to make relevant policies. 

© The Author(s) 2016

Yong TanInvestigating the Performance of Chinese Banks: Efficiency and Risk FeaturesPalgrave Macmillan Studies in Banking and Financial Institutions10.1057/978-1-137-49376-7_1

Begin Abstract

1. Introduction

Yong Tan¹

(1)

University of Huddersfield Business School, Huddersfield, UK

Keyword

IntroductionAims and objectivesMethodology and dataStructure

End Abstract

1 Introduction

The banking sector in China plays an important role in the development of the country’s economy. According to statistics from the World Bank, at the end of 2012 domestic credit provided by the banking sector in China accounted for 155.1 % of GDP.¹ Therefore, the performance of Chinese banks has attracted great attention from the government, banking regulatory authorities and academic researchers. Technical efficiency, as one of the important indicators of bank performance, measures the extent to which banks have the ability to minimize the amount of inputs used in producing a certain amount of outputs, or use certain amounts of inputs to maximize output production. Two components of technical efficiency, namely pure technical efficiency and scale efficiency, provide more information with regard to the source of efficiency. More specifically, pure technical efficiency relates to the ability of bank managers to utilize the bank’s given resources. Higher ability is reflected by higher pure technical efficiency, while scale efficiency refers to exploiting scale economies by operating at a point where the production frontier exhibits constant returns to scale. Lower scale efficiency indicates that banks have more room to adjust their scale of operation, while the resulting increase in scale efficiency contributes to the overall improvement of technical efficiency.

Technical efficiency measures performance from the perspective of volume of production, while in the normal operation, banks and different companies focus more on minimizing the cost, therefore the analysis of cost efficiency is to some extent much more important compared to the analysis of technical efficiency. Cost efficiency is defined as the distance between a specific bank’s cost and the best practice bank’s cost given the fact that they produce the same output under the same environmental conditions (Isik and Hassan 2002).

Besides examining cost efficiency, the bank’s final goal is to maximize revenue as well as profit. In other words, evaluating the revenue efficiency and profit efficiency has become a favourite model among researchers for evaluating the overall performance of banks in recent years. Errors on both the output side as well as on the input side are accounted for revenue efficiency and profit efficiency. Berger et al. (1993) argue that the inefficiency on the input side might be smaller than the inefficiency on the output side. However, cost efficiency, regardless of whether this is measured by a parametric or non-parametric method, makes the assumption that input prices and output quantities are given, and banks try to minimize cost through the allocation of the optimal level of input. Two sources lead to cost inefficiency. The first is attributed to using an excess amount of input, which is related to technical inefficiency, while the second is derived from a suboptimal mix of input, which is related to allocative inefficiency. However, a bank can also be inefficient when too few outputs or a non-optimal mix of outputs are being produced, given the input they use and the input prices they have. Thus, inefficiency cannot only derive from a cost perspective; it can also derive from a revenue/profit perspective. DeYoung and Nolle (1996) argue that ignorance of the output side in estimating efficiency makes the cost efficiency model biased in evaluating the performance of banks. For example, higher quality financial products and services will incur extra cost. The cost efficiency model will regard this bank as inefficient because the output is ignored and only the input side has been considered. Nevertheless, this bank with cost inefficiency can still be profit efficient due to the fact that customers pay more for higher quality goods and services.

The stability of the Chinese banking industry has been enhanced. According to statistics released by the China Banking Regulatory Commission (CBRC), the non-performing loan ratios over the period 2011–2013 were kept at 1 %, which were lower than the figures for 2008–2010, thus, credit risk undertaken in the Chinese banking industry has been reduced. Furthermore, capital risk undertaken by Chinese commercial banks has also been reduced. CBRC statistics show that by the end of 2013, the average capital adequacy ratio of Chinese commercial banks was 12.2 % which had increased by 1.6 % compared to the previous year. The condition of liquidity risk had improved; as reported by the CBRC, the liquidity ratio of Chinese commercial banks was 44 % by the end of 2013, and although the ratio was lower than the figure for 2012 (45.8 %), it was higher than the figures for 2010 and 2011 (42.2 % and 43.3 % respectively). There are studies examining the impact of risk on bank efficiency (see Williams 2004; Altunbas et al. 2007; Fiordelisi et al. 2011). However, most of these focus on the European banking sector; there are very few studies investigating the impact of risk on efficiency in the Chinese banking sector (see Ariff and Can 2008; Tan and Floros 2013; Zhang et al. 2013). In addition, all the above-mentioned studies focus on the credit risk and insolvency risk in the banking sector, while consideration of different types of risk-taking behaviour in the Chinese banking industry will not only provide policy implications to the Chinese government and banking regulatory authorities to reduce the risk-taking behaviour, but also improve bank performance.

2 Aims and Objectives

There are several aims and objectives of this book. Firstly, it will give the reader a better understanding of the structure and reforms of the Chinese banking sector.

Secondly, it aims to provide a systematic introduction and explanation of the theory of bank efficiency as well as bank risk, which will be useful for students as well as academic researchers.

Thirdly, this book evaluates the efficiency in the Chinese banking industry using recent data, thus providing a general picture of Chinese banking operations to the Chinese government, banking regulatory authorities and academic researchers as well as to the general public who are interested in the Chinese banking industry. The book aims to evaluate the efficiency of Chinese commercial banks in a comprehensive way, i.e. assess the efficiency in the Chinese banking industry from different perspectives of banking production, such as cost perspective, technical perspective, revenue perspective and profit perspective.

Fourthly, the current book aims to comprehensively examine the risk conditions in the Chinese banking industry and more importantly, provide robust findings with regard to the inter-relationships between risk and efficiency using a number of modern econometric techniques. In addition, the book aims to test whether different types of risks of Chinese commercial banks are inter-related with each other.

Finally, this book aims to provide some policy implications derived from the findings to the Chinese government as well as to banking regulatory authorities.

3 Measurement of Bank Risk and Bank Efficiency

The methodology used in this book will focus mainly on three aspects, namely the method used to measure efficiency, the method used to examine bank risk and the method used to test the inter-relationships between risk and efficiency in the Chinese banking industry. With regard to the methods used to measure different types of bank efficiency (technical efficiency, cost efficiency, revenue efficiency and profit efficiency), both the non-parametric Data Envelopment Analysis (DEA) as well as parametric stochastic frontier approach (SFA) will be used. To clarify, the stochastic frontier analysis will be used to measure the cost, revenue and profit efficiencies of Chinese commercial banks, whereas the non-parametric data envelopment analysis will be used to evaluate the technical efficiency in the Chinese banking industry.

In terms of the measurement of the risk conditions of Chinese commercial banks, five different types of risk will be examined, namely credit risk, liquidity risk, capital risk, security risk and insolvency risk. Both the accounting ratios as well as a frontier from a translog specification will be used to measure the risk conditions in the Chinese banking industry. The first four types of risk will be measured by the accounting ratios: credit risk will be measured by the ratio of non-performing loans to total loans; liquidity risk will be measured by the ratio of liquid assets to total assets; capital risk will be measured by the total regulatory capital ratio; and security risk will be measured by the ratio of total securities over total assets. A translog specification will be used to measure the insolvency risk (stability inefficiency).

The third part of the analysis examines the impacts of different types of risk on different measurements of efficiency. The bootstrap truncated regression suggested by Simar and Wilson (2007) will be used in the first instance, while the robustness of the results will be cross-checked by two alternative estimation techniques which include the Tobit regression as well as Ordinary Least Square (OLS) estimator.

In order to further check the robustness of the results with regard to the effect of risk on efficiency in the Chinese banking industry and further test whether there is an influence of efficiency on the risk-taking behaviour of Chinese commercial banks, Seemingly Unrelated Regression (SUR) analysis will be used. The use of seemingly unrelated regression not only tests the impact of efficiency on risk, but more importantly, also examines whether different types of risk-taking behaviour in the Chinese banking industry are correlated with each other.

In terms of the data used in the current book, it includes a sample of 100 Chinese commercial banks (five state-owned commercial banks (SOCBs), 12 joint-stock commercial banks (JSCBs) and 83 city commercial banks (CCBs)) over the period 2003–2013. These three types of Chinese commercial banks are the largest three banking groups in China, according to the size of the assets. In the analysis of the inter-relationships between risk and efficiency, and the inter-relationships between different types of risk-taking behaviour, the current book also assesses for a number of bank-specific, industry-specific and macroeconomic variables to see whether they have any influence on the risk and efficiency of Chinese commercial banks. The bank-specific variables include bank size, which is measured by the natural logarithm of total assets, bank diversification, which is measured by the ratio of non-interest income to gross revenue and bank profitability, which is measured by Return on Assets. Three industry-specific variables are considered: banking sector competition (which is measured by the three-bank concentration ratio), banking sector development, (which is measured by the ratio of banking sector assets over GDP) and stock market development, (which is measured by the ratio of market capitalization of listed firms over GDP). Finally, two macroeconomic variables, inflation and GDP growth rate, are assessed. There are three data sources: data with regard to the bank-specific variables is collected from the Bankscope database, while data of industry-specific variables and macroeconomic variables is sourced from the China Banking Regulatory Commission and the World Bank databases.

4 Structure

The structure of the book can be organized as follows:

4.1 Chapter 2: Chinese Banking Sector and Reforms

Several rounds of banking reforms in China have aimed to improve performance and increase the competitive condition as well as reduce the risk-taking behaviour of commercial banks. This chapter divides the Chinese banking reform into different stages. The first stage covers the period from 1949, the official establishment of the People’s Republic of China, to 1978, a milestone in Chinese history that marked the start of the policy of reform and opening up in China. The second period covers the era between 1978 and 1992. This period stops at the year 1992 due to the fact that between 18 January 1992 and 21 February 1992, the chief designer of Chinese reforms and opening up, Mr Deng XiaoPing, visited several cities located in the southern part of China. This visit indicated that China had officially started to develop the Chinese specific socialism market economy. This period mainly focuses on creating a two-tier banking system. The third period of Chinese banking reform starts in 1992 and ends in 2001. This period mainly concentrated on establishing policy banks, asset management companies, relevant laws in regulating the banking industry in China and also creating a number of joint-stock commercial banks. The last stage of banking reform covers the period 2001–2013. 2001 is an important time point, not only to the Chinese banking industry, but also to the Chinese economy as this was the year that China joined the World Trade Organization (WTO). The successful joining of WTO made the Chinese banking industry face much stronger competition from all over the world. In fact, this stage has several measurements in the Chinese banking reform, such as the establishment of China Banking Reg...

Table of contents

• Cover
• Frontmatter
• 1. Introduction
• 2. The Reforms and Structure of the Chinese Banking Sector
• 3. Theory of Bank Efficiency and Bank Risk
• 4. Literature Review on Bank Efficiency and Bank Risk
• 5. The Measurement of Bank Efficiency and Bank Risk in China
• 6. Efficiency, Risk and Their Relationships: Evidence from Chinese Banking
• 7. Conclusion
• Backmatter