Efforts by commercial banks and financial watchdogs have gone a long way to improve the country's banking industry in recent years.

The non-performing loan (NPL) ratio by the four largest State-owned commercial banks - the China Construction Bank, the Industrial and Commercial Bank of China, Bank of China and the Agricultural Bank of China - by the national standard of four category classification, dropped 3.81 percent and 3.95 percent, respectively, in 2001 and 2002.

The outstanding amount of NPLs by the four banks dropped 90.7 billion yuan (US$10.9 billion) and 65 billion yuan (US$7.8 billion), respectively, in the two years.

By the end of March this year, the NPLs of the four banks, by the international standard of five category classification, fell 1.99 percent to 24.13 percent.

Encouraged by these optimistic turns and pressed by the pending comprehensive opening of the country's banking industry to foreign competitors, the banking supervisory authorities had ordered the four State-owned banks to reduce their NPL ratios by 3 to 4 percentage points a year from 1 to 2 percentage points a year in the preceding years.

Disposal of existing bad assets and tighter procedures for issuing new loans are the two major factors for cutting the NPL ratio.

In the past two years, the four State-owned banks recovered more than 150 billion yuan (US$18.1 billion) in cash from handling bad assets.

The four banks also participated in the debt-to-equity reform of some companies.

But the introduction and implementation of safeguards in respect of new loans is a quite complicated issue. Because the NPL ratio was decided by the amount of NPLs and the outstanding amount of loans, the more loans means the lower the NPL ratio.

The number of new loans was comparatively large in that period due to the development of the economy and the nation's banks.

The new loans granted by the four State-owned banks reached 641.3 billion yuan (US$77.3 billion) and 939.8 billion yuan (US$113.2 billion) in 2001 and 2002.

During the first quarter of this year, this figure rose year-on-year 356 percent to 499.6 billion yuan (US$60.2 billion).

And in the last two years, new loans contributed no less than 55 percent to the drop of NPL ratio.

In order to ensure that the drop in NPLs was not the result of new loans being issued, the China Banking Regulatory Commission ordered State-owned banks to reduce the outstanding amount of NPLs by 70 billion yuan to 80 billion yuan (US$8.4 billion to US$9.6 billion) this year.

As for the quality of new loans, the State-owned banks report that since 2000 their NPL ratio has been less than 1 percent.

It is true that the quality of new loans improved, due to the improvement in banks' credit management mechanism and the country's sustainable economic development.

But the quality improvement was also based on the traditional measurement of four category classification.

This measurement mainly takes into account whether the loans are overdue or not. It seldom has regard to the borrower's willingness to return the loan or their ability to repay it .

It cannot, however, effectively identify the practice of some borrowers who obtain new loans to pay off existing ones.

However, the five category classification measurement adopted internationally, based on the possibility of being able to recall loans, is a way to more accurately identify risks.

The NPL ratio by the four State-owned commercial banks in 2002, when set against the international measurement of five category classification, was 4.7 percentage points higher than that measured according to the Chinese four category classification.

Although all the commercial banks in China had adopted the international standard by 2002, they continue, to a large extent, to follow the domestic standard.

The structure of new loans, which focus on medium and long-term lending and which for the most part are channeled into infrastructure, massive companies and real estate, also render the domestic measurement unable to accurately assess the level of risks.

In Shanghai, the level of new loans issued by financial institutions had reached 11.3 billion yuan (US$1.4 billion) by April this year, of which 8.1 billion yuan (US$975 million) were medium and long-term loans, and accounted for 71.4 percent of the total.

However, the existing loan structure makes it difficult for banks to properly identify risks.

As a result, the claim by State-owned banks that the NPL ratio of their new loans since 2000 was less than 0.5 percent and the NPL ratio for individual consumption loans was less than 0.4 percent has been met with scepticism.

To address existing problems, banks must adopt a scientific and uniform approach to measuring loan risks.

The method of discount cash flow, which compares the current price with the book value of the loans, could identify the level of risks the loans will be subjected to. The supervisory authorities should sort out and inspect the NPLs to make the figures more accurate.

With the aim of improving loan standards, China's banking industry has established a scientific decision-making mechanism when it comes to offering loans. This has enhanced the transparency of credit evaluation and effectively curbed corruption.

The establishment of the China Banking Regulatory Commission will make supervision of banking industry more professional.

The author is a senior researcher with the International Financial Research Institute

(China Daily June 30, 2003)