Chapter 3 Does Financial Regulation Enhance or Impede the Efficiency of China’s Listed
2. CBRC’s Regulation of China's Banking Industry
4.1 The Static Efficiency of Listed Bank
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Benefit and Efficiency: The cost income ratio, defined by operating expenses divided by operating income, can be used for benchmarking by the bank when reviewing its operational efficiency. Lower is better. Francis (2004) observes that there is an inverse relationship between the cost income ratio and the bank's profitability. Ghosh, Narain, and Sahoo (2003) also find that the expected negative relation between efficiency and the cost-income ratio seems to exist. Xiong and Sun (2009) pointed that the cost to income ratio had a significant negative effect on efficiency of bank. Zhou and Wong (2008) showed that the cost to income ratio has a negative sign, which shows that the efficiency of management is quite important in determining interest margins, and that poor management lowers the interest margin.
Liquidity: A liquidity problem usually arises from the possible inability of a bank to accommodate decreases in liabilities or to fund increases on the assets’ side of the balance sheet (Athanasoglou, Delis and Staikouras 2006) The higher this ratio is, the stronger is a position of a bank to absorb liquidity shocks (Ayadi and Pujals, 2005). Liquidity had a positive effect on cost efficiency and allocative efficiency. Keeping a larger share of liquid assets seems to be more efficient because it minimizes the costs of borrowing (Tochkov and Nenovsky, 2011). However, since liquid assets tend to be low yielding, a higher ratio implies lower earnings. As a measure of liquidity, the ratio may reflect how well the funding sources match the funding uses.
Capital Adequacy: Capital Adequacy is a measure of a bank’s financial strength, in terms of its ability to withstand operational and abnormal losses. Adequate bank capital can function to reduce bank risk by acting as a buffer against loan losses, providing ready access to financial markets in turn to guards against liquidity problem and limiting risk taking but also constraining growth (Zhong, 2007). Most banks regulators see capital adequacy regulation as a means of strengthening the safety and soundness of the banking industry. In China, with the establishment of the CBRC in 2003, the 8% minimum capital adequacy ratio. As a supplement to capital adequacy ratios, a leverage ratio is introduced. If the ratio is set too low, it will not effectively constrain the banks’ rapid expansion
4. Empirical Analysis
4.1 The Static Efficiency of Listed Bank
The DEA model requires that input and output variables should satisfy monotonicity20. Both these two types of variables were positively related as verified by the correlation analysis. We use input-oriented21 model under the assumption constant return to scale (CRS)
20 DEA model usually impose monotonic (i.e. when the input increases, output can not be reduced) assumption.
21 Please refer to the footnote 10 on page 17.
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to analyze the static efficiency for all China listed commercial banks. Table 3-5 shows the empirical results. Previous studies using static efficiency have shortcomings. They do not measure the persistent and intertemporal effects. To measure the impact of a policy on bank efficiency in the long run, we should use a dynamic model rather than a static model.This study emphasizes the dynamic efficiency and static efficiency is compared and contrasted.
Table 3-5 The static efficiency of the China listed commercial banks
Bank Type 2005 2006 2007 2008 2009 2010 2011
All Listed Banks 0.7251 0.7026 0.8237 0.8515 0.8281 0.8970 0.8845
4.2 The Relationship between the Efficiency and Financial Regulation 4.2.1 The Correlation Analysis
We further study whether the characteristic of financial regulation affects the efficiency of bank. We then use Tobit regression model to study the relationship between the financial regulation and the static efficiency of bank. The study selects the identical significant financial regulation variables under the estimation method as the carry over activities in DSBM model.
We again apply the correlation analysis on explanatory variables to examine multicollinearity. The correlation coefficient of the capital adequacy ratio was highly related with the tier 1 CAR and leverage ratio (0.966 and 0.914). The CAR, tier 1 CAR and leverage were placed in different Tobit regression models. Appendix Table A3-1 lists the coefficient of correlation.
4.2.2 The Financial Regulation in China’s Listed Commercial Banks
Table 6 lists the descriptive statistics for regulation indicators. Table 3-6 shows that the loan-loss provision ratio stands at 2.37%. The ratio did not meet the CBRC’s requirement.
The tier 1 CAR of listed commercial banks in China was significantly higher than the minimum requirement (6%) as prescribed by Basel III. The leverage ratio (for regulation measures expected to be implemented) was close to 4.46%, which met the requirement. In addition, the loan-loss provision ratio must not be lower than 2.5 percent. Currently, the average loan provision coverage ratio of Chinese commercial banks is close to this level.
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Table 3-6 Summary statistics for variables Statistics
Variables Mean Max Min SD Regulated ratio
provision coverage
ratio 180.55 499.6
0 43.05 99.90 shall be no lower than 150%
loan-loss provision
ratio 2.37 5.97 0.71 0.80 shall be no lower than 2.5%
cost to income ratio 36.77 49.37 23.49 5.26 less than 45%
loan to deposit 66.64 79.96 47.79 7.11 less than 75%
current ratio 30.59 78.44 11.71 13.26 shall be no lower than 25%
capital adequacy 11.56 30.67 -1.47 3.91 shall be no lower than 8%
tier 1 capital adequacy
ratio 8.84 26.85 -1.47 3.76 Basel III requirement of at
least 6%
leverage ratio
4.99 12.22 -0.83 1.92
leverage ratio no lower than 4%, 1% more than the Basel III requirement of at least 3%.
4.2.3 Tobit Regression Model
The explained variables in Tobit regression model are obtained from the static efficiency in SBM model. Then, we estimate the relationship between financial regulation and the static efficiency of bank between 2005 and 2011. Table 7 shows that our empirical results. We only select the same significant results of all listed bank as the carry over activity in DSBM model.
Table 7 shows that the cost to income ratio had a significant negative effect on the static efficiency of all listed commercial banks. The ratio may reflect a bank's ability to control costs, and thus, reflect its efficiency. The higher the cost to income ratio, the less efficient a bank is. The loan to deposit ratio had a significant positive effect on the static efficiency. As a measure of liquidity, the ratio may reflect how well the funding sources match the funding uses. China listed commercial banks that possess higher loan to deposit ratio are more efficient. But, the CBRC imposes a loan to deposit ratio that limits banks’ lending to no more than 75% of their total deposits. Therefore, the loan-to-deposit ratio restricts a bank’s lending to a specified percentage of deposits. The current ratio had a significant positive effect on the static efficiency. A high current ratio indicates lower risk in the bank as the institution has more assets by which to pay off liabilities. For the China listed commercial point of view, the higher ratio of liquidity may significantly enhance the efficient operation of banks.
We find the capital adequacy; the provision coverage ratio and loan-loss provision ratio did not significantly affect a bank’s static efficiency. The establishment time had a significant negative effect on the static efficiency. Regulation may be good for bank stability, but not for bank efficiency. In order to fit the new requirements, it is imperative for commercial banks to change their profit models. Table 8 lists the empirical results of these hypotheses.
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As shown in Table 3-7, only the cost to income ratio, current ratio and the loan to deposit ratio had a significant effect on the static efficiency of all listed banks. We then study the relationship between financial regulation and the dynamic efficiency of banks. The results are shown in Table 3-7 and Figure 3-2.
Table 3-7 The relationship between the static efficiency and the characteristics of financial regulation for all listed banks
Note：***, **, * represent significance at the 1%, 5%, and 10% levels, respectively.
4.3 The Relationship between Financial Regulation and the Dynamic Efficiency of Bank The characteristics of financial regulation therefore significantly affect the concurrent static efficiency of bank mergers in the short run. Previous studies using static efficiency have shortcomings. Instead, we believe that due to the properties of the regulation policy, if the study uses a static point of view to measure the regulation policy effects on bank efficiency, it may not consider the persistent and intertemporal effects of the policies.To measure the
Adjusted R-squared 0.3643 0.3569 0.3558
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impact of a policy on bank efficiency in the long run, we should use a dynamic model rather than a static model
Table 3-8 Summaries of hypotheses results
Result
Hypothesis Descriptions Model 1 Model 2 Model 3
Asset Quality H1 The provision coverage ratio has no effect on the technical efficiency of a bank.
consistent consistent —
H2 The loan-loss provision ratio has no effect on the technical efficiency of a bank.
— — consistent
Benefit and Efficiency
H3 The cost to income ratio has no effect on the technical efficiency of a bank.
inconsistent inconsistent inconsistent
Liquidity H4 The loan to deposit has no effect on the technical efficiency of a bank.
inconsistent inconsistent inconsistent
H5 The current ratio has no effect on the technical efficiency of a bank
inconsistent inconsistent inconsistent
Capital
H7 The tier 1 capital adequacy has no effect on the technical efficiency of a bank.
We finally use DSBM model to study the time-deferred effect on the dynamic efficiency of bank. The study adopts the same significant results (cost to income ratio, current ratio and loan to deposit ratio) under Tobit regression model as the carry over activity in the DSBM model and analyze the change in financial regulation characteristics whether have time deferred effect on the dynamic efficiency.
Figures 3-2 show that the efficiency trend was the same between static and dynamic efficiency. We compare the difference between static and dynamic efficiency. Our goal is to verify the difference between a more accurate measure of the dynamic model and the static efficiency.The standard deviation of dynamic efficiency was smaller than the static efficiency.
The static efficiency of banks was less stable in the short term. The dynamic efficiency of all listed commercial banks fluctuated less than the static efficiency. In an environment with asymmetric information, a bank’s decision-making process is unobservable. The characteristics of financial regulation provide market clues as to the efficiency condition of a bank’s operation.
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The static and dynamic efficiency
0.6500 0.7000 0.7500 0.8000 0.8500 0.9000 0.9500 1.0000
2005 2006 2007 2008 2009 2010 2011 Year
Efficiency
Static Dynamic
Figure 3-2 The static and dynamic efficiency: all listed banks 5. Conclusion
The CBRC will adopt stricter financial regulations than Basel III, but the regulation policy has not yet been implemented. This research explores how the previously implemented financial regulations have affected bank efficiency in the past. China listed commercial banks that possess higher loan to deposit ratio and current ratio are more efficient. The higher the cost to income ratio, the less efficient a bank is.
To measure the impact of a policy on bank efficiency in the long run, we should consider the persistent and intertemporal effects of the policies and use a dynamic model rather than a static model. Our goal is to verify the difference between a more accurate measure of the dynamic model and the static efficiency. By the long-term observation of the dynamic efficiency, the dynamic efficiency of all listed commercial banks fluctuated less than the static efficiency.
In an environment with asymmetric information, a bank decision-making is unobservable. The characteristics of financial regulation provide market clues if a bank is operating at the most efficiency condition. This also explains that banks face a trade-off between financial stability and efficiency. Regulation may be good for bank stability, but not for bank efficiency. In order to fit the new requirements, it is imperative for commercial banks to change the profit model. Therefore, the banking sector should make more efforts on credit structure adjustment and credit quality improvement in the coming period of time, which is also the expected goal of the CBRC in its efforts to boost the implementation of new regulatory standards.
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Chapter 4 Does Financial Regulation Affect the Profit Efficiency and Risk of Banks?
Evidence from China's Commercial Banks22
1. Introduction
China had planned to introduce the bank capital standards, putting China under the global Basel III regime, at the start of 2012 year, a year ahead of the phase-in period stipulated in the Basel agreement. By moving the start date to January 1 2013, China confirmed that those original plans were too ambitious. China will not postpone implementation of tougher global bank capital rules despite a delay in compliance by U.S.
banks. The new timeline brings China in line with other countries. China had cited worries that the stricter rules would dampen domestic lending and hurt the economy at a time of global instability as reason for postponing the implementation from the original target date.
The China Banking Regulatory Commission (CBRC) released a set of guidelines for the banking industry, including imposing stricter requirements on capital bases, leverage, provision and liquidity, known widely as the China version of the new Basel III. The New Standards adopt capital adequacy rules and leverage ratios that are even more stringent than those of Basel III. In particular, the core tier 1 capital adequacy ratio will be set at 5 percent, 0.5 percent higher than Basel III.The required leverage ratio will be set at 4 percent, 1 percent higher than required by the Basel III agreement. The challenges of implementing Basel II/III in China are clear: more stringent local requirements.
With a tougher definition and level of capital, there will be pressure for banks to understate their risk-weighted assets. In addition, the new capital requirements will greatly restrict commercial banks’ credit expansion and may swallow their profits, leading to a decline in return on assets and return on capital. Upon the implementation of the new rules, Chinese banks will have to consider possible ways of replenishing capital again. According to the ‘official supervision approach’, official supervision can reduce market failure by monitoring and discipline banks thus weakening corruption in bank lending and improving the functioning of banks as intermediaries (Beck, Demirguc-Kunt, and Levine, 2006).
Alternatively, powerful supervisors may exert a negative influence on bank performance.
Capital serves as a buffer against losses that can absorb the possibility of bank failure (Dewatripont and Tirole, 1993). The leverage ratio has the role of helping to contain the compression of the risk based requirement. In the meantime, strengthened capital supervision will help to lower the probability of banking crisis. Barth, Caprio and Levine (2006) study
22 Tung-Hao Lee and Shu-Hwa Chih, ”Does Financial Regulation Affect the Profit Efficiency and Risk of Banks? Evidence from China's Commercial Banks”, North American Journal of Economics and Finance 【SSCI, 2012 Impact Factor: 0.825】Accepted, In Press, Corrected Proof, Available online 7 June 2013.
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what affects bank regulation and how banking regulation works. Their research on most countries shows that strong regulators and capital adequacy standards do not improve bank efficiency. Barth, Caprio, and Levine (2004) put forward various reasons for and against restricting bank activities. However, overall their results indicate that restricting them may not only lower banking efficiency but also increase the probability of a banking crisis.
From the long-term point of view, as China economic growth is highly dependent on credit supply, the banks need to grow their loan scales at certain rates so as to support the sustained economic growth. Therefore, they will be faced with the needs for capital supplementation in order to keep up with the regulatory requirements on capital adequacy ratio. Pasiouras (2008) mentioned that stricter capital adequacy, powerful supervision and market discipline power promote technical efficiency. However, only the latter one is significant. Too little capital increases the danger of bank failure whilst excessive capital imposes unnecessary costs on banks and their customers and may reduce the efficiency of the banking system. Furthermore, economic theory provides conflicting predictions about the impact of regulatory and supervisory policies on bank performance (e.g. Barth, Caprio, and Levine, 2004; 2007).
Traditionally, commercial banks in China have reported a coverage ratio against non-performing loans in their financial results as an indicator. Chinese banks should be required to maintain such a provision coverage ratio at a 150% minimum. Furthermore, The CBRC issued a new 2.5 minimum loan-loss provision ratio for banks. It reflects how the regulator wants Chinese banks to set aside a precautionary amount of reserves ahead of the likelihood that an increasing proportion of their loans should turn bad. The new requirement represents the single biggest source of uncertainty for Chinese banks. This would result in bank non-performing loan levels rising, profitability falling and banks still needing more provisions. Banks will be also faced with the pressure of capital supplementation due to credit expansion.
Financial regulation will directly affect the behavior of commercial banks. Especially, as China commercial banks still follow the conventional business model, their ratios of deposits to total liabilities and of loans to total assets are relatively high. The main purpose of financial regulation is to enable banks to improve the liquidity and solvency. However, the implementation of bank regulation will enhance the efficiency or impede the efficiency? The goal of financial regulation is to enable banks to improve liquidity and solvency. The implementation of new regulatory standards will make the banking industry more robust, safeguard long-term stability of credit supply, thus supporting the sustained growth of economy. Stricter regulation may be good for bank stability, but not for bank efficiency.
This also shows that policymakers and banks face a trade-off between financial stability and efficiency. Therefore, we assessed the impact of the regulatory indicators in advance.
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Therefore, China will not postpone the implementation of Basel III and adopt the stricter financial regulations than Basel III and their own unique regulation indicators are the reason the study chooses the Chinese banks as the sample. This research investigated the characteristics of China's financial regulations and explored how the regulations affect the profit efficiency and risk of commercial banks in China. In addition, we also explored the trade-off relationship between efficiency and risk.
The study first use a profit model of the data envelopment analysis (DEA) and Z-score to investigate efficiency and risk from China commercial bank point of view. Our study covers a period of 8 years between 2004 and 2011. We then used the Tobit regression model to determine the relationship between financial regulation and efficiency and used the OLS regression model to determine the relationship between financial regulation and risks.
This study is described as follows: First, previous studies have classified Chinese banks as state-owned banks, joint-stock banks, city and rural banks, and foreign banks according to the bank established. This classification method may not play the function of regulatory policies on risk prevention. Banks should be classified in accordance with the operating status.
Furthermore, Chinese banks deemed to be systemically important banks (large bank) will be required to meet capital adequacy ratios of 11.5 percent, while other banks (small and medium banks) will be held to a 10.5 percent minimum.
This also means that the regulatory requirements for systemically and non-systemically important banks in the future will be the difference. Unlike other studies, this study used bank assets as a classification standard from the financial risk and differential regulatory perspective. We adopted 1 trillion as a standard and divided Chinese banks into two categories:
large and small banks.
large and small banks.