Liu Mingkang doesn't care for spicy dishes. "I can't stand them," he admits, "they don't agree with my stomach." As an MBA student in London in the 1980s, he would often pre-empt dinner invitations where he suspected hot food – especially from South Asian friends – by offering to prepare the meals himself, so as "to control risk", as he puts it, somewhat wryly. "It all depends on how you deal with [the ingredients]."
As chairman of the China Banking Regulatory Committee, Liu is now trying to identify and control a profoundly different set of risks, but with the same foresight and resolve as in his student days. He is charged with turning around a rapidly growing banking system burdened with a legacy of bad debt and beset with corruption.
The task is daunting, not least for its sheer scale. While there is no consensus over the exact number of banks operating in China nor the number of people employed in the industry, the inefficiencies are illustrated by the fact that Agricultural Bank of China alone employs 470,000 people, and has over 30,000 branches. In contrast, Citigroup, the world's biggest bank, with operations in over 100 countries, has a staff of about 300,000. Yet reforming the system is fundamental to China's economic ambitions.
Liu's vision sounds simple enough: "If you want a market economy, you have to move in a market framework," he tells Emerging Markets in an interview in his Beijing office.
As he sees it, he has two big tasks: to promote "a sound and solid" banking system by strengthening supervision; and to push forward the costly restructuring of China's lumbering banks. "The way I control risk is through market discipline," he says.
To do this, Liu has set about trying to do something that he believes is most basic: to revolutionize China's credit culture by bringing the system in line with international best practices. His agency has set about drafting and implementing an entirely new set of supervisory laws and policies – 86 over the last two years – based on "the core principle of prudential supervision". CBRC sets the rules and makes sure the banks comply.
Urgent
But his job has taken on a new sense of urgency in the wake of recent banking scandals, which analysts believe have made reform in the country more difficult. The fall in March of Zhang Enzhao, chairman of China Construction Bank, the mainland's second biggest lender, was the latest drama to erupt at the bank. In 2003 his predecessor, Wang Xuebing, was arrested on corruption charges and subsequently imprisoned. Taking tougher action against operational risk has become a top priority for Liu.
"In every market you have such news, good or bad, but the substance of corporate governance is there, and the principle is there. Being a regulator we stick to the right direction," he says. "If anything goes wrong, we will put it back on track."
Putting the banks back on track means, on the one hand, weeding out corruption by coming down hard – even on (or especially on) the top bosses: governance reform at all costs. At the same time it means vigorously pursuing a risk-based regulatory agenda, for which Liu is widely renowned.
He is a former president of the state-owned Bank of China, where he was instrumental in reforming the institution. Liu introduced a board of directors (including independent directors), created an independent audit, reduced NPLs and introduced a reclassification of its loans according to standard international categories. It was the first Chinese bank ever to do this.
Liu became head of the CBRC two years ago when the new regulatory body was set up. The agency was carved out of the PBOC, so separating bank supervision from monetary policy. Liu reports directly to China's vice-premier, Huang Ju. "All our power has been reflected in the law," he says, pointing out that part of the regulator's role is enforcement. "We cultivate a risk management philosophy and we work together [with other regulators]." He estimates that 21 banks will meet international standards by the end of the year.
In an effort to tidy up the system, the government has also been recapitalizing its four big banks, this time tying capital injection to governance reform. Bank of China and CCB were both recapitalized last year with $22.5 billion each. Industrial and Commercial Bank of China (ICBC) also received a $15 billion boost recently, and Agricultural Bank of China, the country's other large state-owned bank, is widely expected to be next. Ratings agency Standard & Poor's estimates it will cost $656 billion (43% of China's GDP) to bail out the banking system.
"It's a long way to reform state-owned banks so we've got to raise our vigilance against possible risks – credit risks, operational risks, market risks and strategic risks," he says. "This is a long and historic mission and we know how."
Cultural revolution
Yet pioneering a market framework means forcing a cultural change within the system. It also means introducing the profit motive (traditionally absent from state sector banks in China) and building in financial incentives. Liu is philosophical about what financial sector reform means in China, arguing that profit will never supplant social responsibility as the ultimate guiding principle for banking in the country. As a banker, he says: "You are an agent only. You've got to be accountable and responsible to the whole society."
"You've got to be a profit lover," he adds, "because investors like numbers. But behind the figures you've got to emphasize culture – it's a culture of responsibility and accountability to the whole society."
The purpose of the banking system runs deeper still. "Profitability today can never mean anything in the long run," he says. "You've got to know where you are and where you're heading. We are trying to enlighten people to look forward, behind, left and right, to understand the environment and what their peers are doing. In China, harmony in development of the whole society is important."
Still, he acknowledges that the biggest challenge facing reform lies in human resources.
It's one thing training senior management, quite another ensuring that branch managers and subordinates receive equally rigorous instruction, he says. "What we lack most is talent and experience. The market is still under construction. There's a lot of homework to be done."
Outside in
This is where foreign banks could play a big role. China's banking industry is set to open up in December 2006 as part of its agreement to join the WTO. More foreign players are likely to enter the industry and establish international best practices.
Liu insists that all the new performance criteria, including regulation governing capital adequacy ratios (the benchmark is 8%), are already having their desired effect. "People's mindsets are changing. They are focusing on the most important aspects of a bank's operations: cost, risk and revenues instead of ratios, ratios and ratios."
The importance of Liu's task is hard to overstate. As Zhu Min, executive assistant president at the Bank of China, says: "You've got to get banking right before you can get the financial sector right. It really is the single most important question facing our economy."
Liu points out that in 2004, NPLs of major commercial banks dropped by $48 billion from previous years. Official figures say NPLs stand at 13% of all loans, although S&P puts the figure at 35%. However, there is growing concern that despite such progress, there is the possibility of further bad debt in the system.
To make matters more difficult, for China to meet its target of 8% annual economic growth, bank lending would have to rise by about 15% a year, according to a report by McKinsey, the US consulting firm. The firm estimates, however, that China's banking system can only safely sustain annual loan growth of 5-7%.
Is Liu worried, as many Chinese and foreign economists are, about the prospect of further non-performing loans in the system? "Of course. That's the reason we're fully alert all day long," he says. "But we send out warning signals to the banks. We tighten our risk controls – the speed of loan expansion has been tightened by our CAR weapon."
But Liu is also keenly aware of the limits of his powers. "However strong you are, you function within limits. As the English saying goes 'When the cat is away the mice will play.'" That's why he is vigorously pursuing greater transparency in the system: "We've got to push all banks to disclose information, in good time, and with new benchmarking requirements."
[pq]
"The way I control risk is through market discipline"