It is an interesting fact that, as this excellent account shows, China's rotten banking system should have so many things in common with America's Savings and Loans crisis. In the 1980s, the world's most sophisticated financial market place went through some terrible regulatory mishaps and a $150 billion bailout before the losses from savings and loans sector were staunched.
It is a bit like a time machine. The Chinese banking sector could be described as being in that stage of decomposition that the thrifts were in just before the whole sector collapsed in the late 1980s. That stage is brilliantly described in the chapter by Edward J. Kane, and it has all to do with regulators whose incentives for action are quite different to those of tax payers.
Kane points out in terse, clear prose that US regulators and politicians were motivated by re-election needs, quasi-bribes from their clients in the S&L sector, and a fear of being blamed for the fiasco. Thus, they acted against the interest of the taxpayer by postponing a resolution, and by protecting the thrifts through regulatory changes instead.
This approach turned out to be catastrophic, since the longer the crisis was left to fester, the higher the bailout cost became.
The authors (members of a right-wing think tank set up by the convicted king of junk bonds in the 1980s, Michael Milken) take the viewpoint that government intervention is usually a contributing factor to the worsening of a financial crisis.
They believe that market discipline would have solved the crisis at a far lower cost to the tax payer, but that politicians were concerned that closing down the sector (which had the electorally popular function of extending cheap home mortgage loans to low-and-middle income families) could antagonize valuable voters.
The authors paint a convincing picture showing that flawed regulator policies were indeed the most important factor for the crisis becoming as grave as it did. The authors make the valuable distinction that individual failures were caused by fraud, incompetence and/or bad luck, but that sector overall was destroyed by poor regulatory policies.
The origins of the crisis were, however, economic and were rooted in the increased interest rate volatility that emerged after the oil shocks of the 1970s, as well as from flawed monetary policies. Remember that thrifts lend money out long term (usually 30-year mortgages).
They fund these loans by taking in deposits. Clearly the interest rates the thrifts paid customers on the deposits had to be lower than the returns the thrift were getting on extending their loans.
In the early post-war period, this worked. Short-term rates are usually lower than long term rates, so the thrifts could pocket the difference.
But when short term rates spiked because of fears of inflation in the 1970s, the thrifts became insolvent almost overnight. Liquidity drained out, as depositors went looking for higher rates with the recently-established money-market funds.
As a result, regulators encouraged thrifts to use accounting tricks to understate the extent of their losses, and triggered a bidding war amongst the thrifts when they permitted them to raise the ceiling on their deposit accounts to help recapture the deposits they had lost earlier(thus sharply increasing their costs). They also reassured investors by increasing the amount for each depositor that the government guaranteed to bail out.
This provided perverse incentives to thrifts, the authors point out. Managers of thrifts decided that since they were bankrupt anyway unless they found ways to generate greater returns, and since in any case the government had told them it would bail them out, the best solution was to make potentially very profitable but also very risky investments in real estate developments and later, junk bonds. These were areas they were newly permitted to invest in by a government desperate to get the sector back on its feet.
It is at this stage that the cost of the crisis began to escalate with dizzying speed. That is essentially because the government and thrifts decided to adopt the tactic used by besotted gamblers in Macao casinos: If you keep doubling up, you will eventually win and recoup all your winnings. Unfortunately, you may need a very large sum of money indeed if the wait for a winning bet is a long one.
Real estate had been booming in America, and for a while the gambles paid off. But then the danger of relying on regulatory support rather than superior business competence became clear when the US government brutally reversed the highly favourable tax policies it had extended to the real estate sector. The result was huge losses for the thrifts.
It is clear that China shares many of the regulatory defects of the US, although with local variations. The regulators, through their status as members of the government, have a conflict of interest since the banks are state-owned.
More fundamentally, the fact that the four state-owned commercial banks are so huge means they will never be closed down. That removes a major threat.
The alternative is a foreign listing. It is by no means clear whether this has proved an effective spur to banking reform.
In the meantime, the bad loans pile up as the banks try to outgrow their problem by making ever more risky loans (since the ratio of non-performing loans to the total shrink if the volume of loans increases.)
The Chinese banks are thus at the stage where regulatory attempts to solve the problem become hijacked by special interest and cowardice, leading to spiraling costs for the taxpayer. The scary part is that with the absence of a market exit mechanism the costs will simply continue to rise.
What could bring this house of cards tumbling down?
That is a very tricky question. One could easily argue that the rock-solid government guarantee behind the Chinese banks will prevent capital flight.
The authors do not buy that argument. They come up with the term 'silent runs' to describe how the largest depositors eventually decide that the cost 'has soared so far above dedicated reserves that taxpayer resistance is expected to develop.'
How close is China to this point? Most taxpayers are so far seemingly completely untroubled by the prospect.
And they have a point. Chinese banks are not only awash in liquidity, but the whole country is sucking in funds from speculators, booming exports leading to an estimated $100 billion current account surplus for this year, foreign direct investment surging to $60 billion this year, and forex reserves that are now the second largest in the world and could reach $800 billion at end 2005.
On the debit side, the cost of a bank bailout has been estimated at $600 billion by Moody's. That is a very crude number since valuing a bailout depends on recovery rates, the classification of the debt (less overdue debt is worth more than more overdue debt), the legal environment and other factors.
What Chinese taxpayers (compared to the easily predictable outrage of US taxpayers) think of the equation is anybody's guess. They might feel that with so much cash floating around, at the moment, the problem can still be solved.
The smart one, however, will realize that the problem is future cost. As the authors point out, with no exit mechanism those costs can only grow.
Perhaps the smart, very wealthy tax payers are already beginning to shift their assets abroad. But the still considerable restrictions on where most 'normal' Chinese tax payers can place their money means the government can be complacent about reform, in the knowledge that essential liquidity will likely not dry up.
Preventing taxpayers from having choice (ie through reforming the financial system further), because of the fear they will put their money abroad, is just one more example of the disastrous regulatory distortion the authors write about so eloquently.
