People queue up at a branch of the Industrial and Commercial Bank of China in Changzhou, east China's Jiangsu Province, on January 16 

The UK's The Banker magazine recently unveiled its 2016 Top 1,000 World Banks rankings, among which 119 are Chinese banks, with 17 making it to the top 100. Sorted by the size of their Tier 1 capital—the core measure of a bank's financial strength from a regulator's point of view—four Chinese banks are ranked among the world's top 10 this year, with the Industrial and Commercial Bank of China topping the list for the fourth time in a row.

The number of Chinese banks holding positions in the top 10 list increased from zero in 2004 to four in 2016, an inspiring transformation that indicates a rise in the strength of Chinese banks' capital. But simmering risks also belie these achievements. A comparison between the 2015 and 2016 rankings shows that the growth of Tier 1 capital slowed substantially among Chinese banks that made it to the top 10.

How important is Tier 1 capital for commercial banks? All in all, it's a core shield that protects banks from risks. The major function of a bank's total capital, composed of Tier 1 and Tier 2 capital, is to cushion against losses and protect banking operations. Current regulations in China stipulate that the Tier 1 capital ratio in commercial banks should be no less than 6 percent and that the capital adequacy ratio should not drop below 8 percent. There are two ways to supplement these financial assets: internal bolstering—mainly from retained banking profits—and external supplements including issuing common shares, preferred shares and bonds.

For Chinese banks, such internal supplements or retained profits account for the bulk of their capital buttressing. The slowdown of Tier 1 capital growth in Chinese banks is mainly caused by the slowing growth of net profits. As China's GDP growth declined from 9.5 percent in 2011 to 6.9 percent in 2015, banks' profits took a nose-dive from 39.3 percent to a mere 2.3 percent.

There are two reasons for the slowdown: Firstly, the continuous growth of non-performing loans has eaten into profits. Secondly, Chinese commercial banks still rely on the sheer expansion of their size to achieve more profits, buying into "the bigger, the better" mentality. Their businesses nonetheless lack differentiation as well as specialization, and their counter-cyclical management capacity has yet to be improved.

It's worrying that some banks are still obsessed with their speed of expansion and seek to open more branches in more areas. By doing so, they will not only miss the opportunities made available through business transformations and upgrades, but also sow future credit risks.

Taking these factors into consideration, how can they shake off their obsession with unabated expansion and instead realize the transformation and upgrading of their business models?

To begin with, banks should reduce their reliance on interest rate differentials and diversify their sources of income. As China presses ahead with interest rate reforms, the gap between the deposit rate and loan rate is narrowing, dealing a heavy blow to the traditional profit model of commercial banks. Therefore, banks should further adjust their operation structures and explore more sources of income to realize sustainable profit growth. In reality, new profit momentum mainly comes from banks' retail businesses, overseas business and subsidiaries.

Second, banks should develop specific financial products and cultivate their core clients through differentiated and specialized business models based on their respective strengths. Some Chinese banks are taking action in this respect.

The Industrial and Commercial Bank of China and the Bank of China, for example, are both prioritizing their overseas financial services as well as their expertise in international operation by offering loans, financial leases, clearing of global trade and overseas mergers and acquisitions services to Chinese companies, especially those that are developing their businesses along the Silk Road Economic Belt and 21st Century Maritime Silk Road. Some small and medium-sized banks now focus on low capital-consuming businesses including asset custody, bank bills and gold leasing.

Third, banks should change their performance appraisal system, which currently pays too much attention to expansion but ignores their profitability and resistance to risk. Moreover, their capability in terms of cost management, capital allocation, pricing of capital and risk treatment should be improved, and a counter-cyclical management style should be supported.

This is an edited excerpt of an article published in Economic Daily  

Copyedited by Bryan Michael Galvan   

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