The fragility of the domestic banking system has gradually been exposed in recent months.

In the recent "audit storm," the sector has become one of the major targets of criticism.

For example, a Guangdong private firm obtained more than 7 billion yuan (US$843.4 million) in bank loans through illegal means.

The National Audit Office revealed that from 2000 to 2002, the Jinzhou branch of the Bank of Communications in Liaoning Province, in collaboration with a local court, used fake documents to write off more than 200 million yuan (US$24 million) in bad loans from 175 local firms.

It seems the domestic financial system has a lot of problems, which will be exposed under further examination.

The current round of macroeconomic regulation further contributes to the surfacing of the problems.

In recent years, especially since last year, the banks have seen an exorbitantly high rate of loan extensions, which has cleaned up the appearance of their balance sheets. Their non-performing loan ratios have been lowered and their profit levels have generally risen to historic highs.

However, the newly extended loans have been granted during an economic boom. They are yet to stand the test once the economy cools.

Banks became reluctant recently to further grant loans and some firms have to resort to high-interest private borrowing to finance their business. This is, on the one hand, a result of tightened policies from the central government, which is determined to rein in the overheating economy; on the other hand, the intrinsic fragility of those banks make them cautious in lending.

The fragility also manifests itself in the structural imbalance of the country's financial system. Bank loans have taken up too large a part in the overall lendings of financial institutions.

A consensus has been reached among the central financial policy-makers on the establishment of a comprehensive, multi-layered financial market. Relevant central departments have taken initiatives to draft implementation policies. However, the marginalization of the stock market, a channel for direct financing, has not improved, and may have actually worsened.

Currently bank lending accounts for 90 per cent of domestic financing. If the burden of financing is mainly put on the shoulder of banks, they will face dangerous risks, especially given the poor credit environment and immature legal system.

The fragility of the banking sector has long been an issue. It is not the result of recent banking reforms, which only exposed the problems.

While adopting international banking standards to gauge the performance of domestic banks, we must bear in mind domestic banks have some unique features and constraints. To make the banks more capable, the source of their fragility must be discovered.

In the market economy, the financial enterprises are a major component of economic activities. They should operate and make decisions by themselves in accordance with changing market conditions.

However, many domestic banks do not have much autonomy in carrying out their banking businesses. Not only the State-owned, but also some share-holding banks, have to abide by higher authorities in making business decisions. The government has put those financial institutions under strict regulation, which creates conditions for rent-seeking activities.

Such regulations have led to some problems, an example of which is dual-track interest rates.

The official one-year lending rate of the banks is 5.31 per cent while that in the black market is as high as 20 per cent.

The result is a lack of access by common investors to bank loans. Some of them have to turn to the black market.

On the other hand, some people who have power can obtain bank loans. However, those who have access to bank loans sometimes just make use of the loopholes of the banks to grab State assets. They have worsened the situation in the weak banking sector.

Although in recent years the central government has written off the non-performing loans of the commercial banks several times, the amount of the bad loans has not seen a significant fall.

The solution lies in the ultimate market-oriented reform of the banking sector.

The governor of the People's Bank of China, the country's central bank, said recently that an elimination mechanism should be set up in the market economy. Financial enterprises should be allowed to exit from the market if they failed to compete in the market.

If the low-quality financial enterprises continue to operate in the market, they will constitute the biggest menace to the health of our financial system.

The fragility of domestic banking sector just lies in the current mechanism that financial institutions need not fear to be eliminated from the market even if they operate badly.

In this condition, how can the banks be motivated to improve their management and sharpen their competitive edge?

The mentality of some financial institutions is that the bigger they become, the safer they will be because the bankruptcy of big financial institutions will produce formidable social costs.

Such a mentality has made them more fragile.

(China Daily July 20, 2004)