The Estimation of Bank Efficiency and the Shadow Prices of the Bank Capital and Bad Loans in
Chinese Commercial Banks
Mingquan Zhou
Supervisors:
Professor Dimitris Margaritis Dr Paul Geertsema
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Chinese economy started to slow down since 2015 and the Chinese government termed this phenomenon as the New Normal economy1. Against the backdrop of the slowing economy, issues about increasing non-performing loans (NPLs) and over-leveraging across industries have attracted growing attention. GDP growth rate decreased from 9.6% in 2011 to 6.8% in 2017. Meanwhile, NPLs quadrupled (from 427.87 billion CNY to 1705.7 billion CNY), and the provision coverage ratio decreased from 278.1% to 181.4% over the same period2. The Chinese banking industry is engaging in reducing its exposure to financial risk3.
Generally, high NPLs may indicate the onset of a banking crisis (Francis & Osborne, 2012; Gambacorta & Mistrulli, 2004; Kaminsky & Reinhart, 1999), and sufficient equity can supply a cushion to absorb losses, particularly during periods of financial distress (King, 2009).
Bad loans tend to be positively associated with bank size, however, large banks that benefit from implicit state guarantees may not be as vulnerable as small and middle size banks be (Anginer, Demirguc-Kunt, Huizinga, & Ma, 2018; Gambacorta & Mistrulli, 2004; Kwan &
Eisenbeis, 1997). Therefore, a proper indicator of banks’ risk status including the impact of bank size is essential. Recent research shows that shadow prices are timely predictors of the state of a banking system (Hasannasab, Margaritis, & Staikouras, 2018). Hence, the main purpose of this study is to investigate the state of the Chinese banking industry during 2011- 2017. Specifically, it focuses on the estimation of the shadow costs of risk control in China (NPLs’ reduction and recapitalization) and the evaluation of the performance of Chinese commercial banks.
Existing literature on the Chinese banking industry mainly focused on the efficiency estimation, yet their shadow costs have seldom been studied. This study will therefore estimate shadow costs of Chinese commercial banks. Although CAPM is the sole methodology employed by the Federal Reserve System (King, 2009), it may not be suitable for valuing the cost of equity capital for small or non-listed firms (Hasannasab et al., 2018; Pratt, 2003).
1The term “New Normal” of the Chinese economy, proposed by President Xi Jinping in 2015, represents the Chinese economy has stepped into a new phase that was different from the high-speed growth pattern.
Source: http://www.chinadaily.com.cn/opinion/2014-10/10/content_18716671.htm
The Normal Growth period in this paper (2011-2014): GDP growth speed above 7% and over-leveraging in industries, and the New Normal period (2015-2017): GDP growth rate under 7% and appealing for deleveraging across industries
2 Data are from the National Bureau of Statistics of the People’s Republic of China and the China Banking Regulatory Commission.
3 The China Banking Regulatory Commission (CBRC) proposed guidelines for curbing the rapid rise of NPLs and encouraged commercial banks to replenish capital funds, increasing the ability to absorb and disposing of risk in the CBRC Annual Report in 2016.
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Further, I require a suitable method for pricing NPLs. Directional distance functions have the desirable feature to model technologies with expected and unexpected outputs (e.g. NPLs).
Therefore, this study will follow previous work (Färe & Grosskopf, 2006; Fukuyama & Weber, 2008; Hasannasab et al., 2018) using this method to calculate the shadow prices of equity capital and NPLs, and to measure the efficiency of Chinese commercial banks simultaneously.
Thus, the main contribution of this essay is the provision of additional informative indicators (the shadow prices of NPLs and equity capital) for the evaluation of the soundness of the Chinese banking system.
This study will analyse results across bank types recognizing such differences can affect banks’ performance and risk management effectiveness (Dong, Firth, Hou, & Yang, 2016; Dong, Meng, Firth, & Hou, 2014; Zhang, Cai, Dickinson, & Kutan, 2016). Research on the cost of equity capital in developed markets demonstrates that equity costs relate to the banks’ capital structure and performance (Allen, Carletti, & Marquez, 2015; Cohen & Scatigna, 2016;
Hasannasab et al., 2018). For example, Hasannasab et al. (2018) estimate the price of equity capital in the US market and find that well-capitalised banks tend to have a low price of equity capital. They attribute this result to the lower level of market risks which larger banks have.
Besides the influence of capital structure, my research will also test whether there is a significant relationship between efficiency and shadow prices, which may help to provide information on how to balance risk control, efficiency management, and other supervisory requirements.
The empirical results show that the average prices of NPLs and equity capital are 2.4351% and 2.5782% respectively, and their highest values reach as high as 11.2307% and 11.664%. Both the two shadow prices are higher than those in developed markets, indicating there are more risks in Chinese financial markets. This finding is consistent with the fact that the issue of NPLs is more severe in China (Dong, Firth, Hou, & Yang, 2016, Zhang, Cai, Dickinson,
& Kutan, 2016).
I also find that differences in shadow prices indeed exist between bank types.
Government-controlled banks (GCBs) generally have the lowest price for NPLs but the highest shadow cost of equity capital. At first glance, Chinese GCBs are considered to be in good condition, yet because of political interventions into them, they are generally criticized for their complex systems and inefficient operations and risk management. Moreover, I find that the shadow price of NPLs positively relates to the NPLs size and bank size, while the NPL price
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and the shadow cost of equity capital are negatively related to the bank efficiency score. The number of NPLs can suggest the difficulty of dealing with NPLs. The negative relationship between shadow prices and efficiency can be interpreted as that efficiency is a kind of soft bonus to efficient banks.
Contrary to findings for the developed financial markets, the cost of equity is positively related to bank size in both periods, yet this cost for the largest banks experiences a sharp decline in the New Normal period. This phenomenon can be explained by the unstable banking hypothesis, describing that large banks tend to be involved in high-risk business and relied more on short-term debt (Laeven, Ratnovski, & Tong, 2016). Besides, compared to medium and small banks, large banks tend to face stricter capital control regulation because their bankruptcy is more likely to bring adverse effects on systematic soundness. Moreover, I detect that in the New Normal period, there may exist capital regulatory arbitrages through the negative associations between the shadow prices of equity capital and the sizes of NPLs.
In addition, the results show that state-owned enterprises banks (SOEBs)and private or foreign banks (PCBs) are more efficient than GCBs, which is consistent with previous studies (Dong, Girardone, & Kuo, 2017; Wang, Huang, Wu, & Liu, 2014).
The results of this study are envisaged to serve as an input during the NPL’s management process as NPLs have been an everlasting issue in the Chinese banking system because quantitative evidence on their opportunity costs has been scant. Combining the information of shadow costs of NPLs and of equity capital, research-based suggestions about risk management can be provided not just from a qualitative perspective but also from a quantitative one. For example, the Chinese government is encouraging banks to establish asset management companies to deal with bad assets; in this situation, the results of our research can supply information for related institutions to find a generally accepted price for NPLs.
