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«Last Revised: January 24, 2012 Forthcoming, European Journal of Finance Abstract We examine the privatization process of the Industrial and ...»

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The IPO of Industrial and Commercial Bank of China and the ‘Chinese Model’

of Privatizing Large Financial Institutions*


Jun “QJ” Qian†

Franklin Allen

The Wharton School Carroll School of Management

University of Pennsylvania Boston College, WFIC & CAFR

allenf@wharton.upenn.edu qianju@bc.edu

Susan Chenyu Shan Mengxin Zhao

School of Economics and Finance School of Business The University of Hong Kong University of Alberta chenyush@wharton.upenn.edu  mengxin1@ualberta.ca Last Revised: January 24, 2012 Forthcoming, European Journal of Finance Abstract We examine the privatization process of the Industrial and Commercial Bank of China (ICBC), the largest bank in the world by market capitalization, and its dual IPOs in the Hong Kong and Shanghai Stock exchanges in 2006. The Chinese government retains majority equity ownership of ICBC while foreign institutional investors hold minority equity stakes. Other large financial institutions went through the same reform process and have similar, post-IPO ownership structures.

The largest Chinese banks, as a group, outperformed their counterparts from other emerging and developed markets before and during the 2007-2009 financial crisis. We argue that the ‘Chinese model’ of privatizing and managing large financial institutions can be advantageously used in other countries.

JEL Classifications: G2, G3, L1, Keywords: banks, IPO, privatization, non-performing loans, stock returns.


*  We wish to thank Edward Lee and Wenxuan Hou (editors) and two anonymous referees for helpful comments, Darien Huang for excellent research assistance, and Boston College, University of Alberta, University of Hong Kong, and the Wharton Financial Institutions Center for financial support. The authors are responsible for all the remaining errors.

† Corresponding author: Finance Department, Carroll School of Management, Boston College, MA 02467. Phone: 617- 552-3145, fax: 617-552-0431, E-mail: qianju@bc.edu.

I. Introduction Large financial institutions have been at the center of the 2007-2009 global financial crisis and the ongoing Euro Zone debt crisis. With perverse incentives, these ‘too big to fail’ institutions from developed countries took on excessive risks that were concealed from the public and regulators, and their downfall triggered the near collapse of the global financial system and led to massive welfare losses around the world. Even with substantial regulatory reforms such as the Dodd-Frank Act in the US, much debate remains on how to restrain these large institutions without excessive regulations that would discourage any risk-taking behavior, an essential part of all profitmaximizing corporations. 1 Effective monitoring of large financial institutions is of particular importance in emerging economies, since the banking sector plays a more important role in supporting economic growth than financial markets in most countries (e.g., Levine 2002). But this task can be a tall order in the developing world characterized by the lack of sophisticated institutional investors and underdeveloped markets and institutions.

In this paper we examine the privatization process of the Industrial and Commercial Bank of China (ICBC), the largest bank in the world in terms of market capitalization, and its dual initial public offerings (IPOs) in the Hong Kong Stock Exchange (HKSE) and Shanghai Stock Exchange (SHSE). ICBC’s largest shareholder is the Chinese government while foreign institutional investors hold minority stakes. Many other large financial institutions went through the same reform process and have similar ownership structures after the IPO. We find that the largest Chinese banks, as a group, outperformed large banks from other emerging and developed economies before, during and after the 2007-2009 crisis. Our conclusion is that the ‘Chinese model’ of privatizing large financial institutions can be advantageously used in other emerging countries, because it provides a balance between effective monitoring and maintaining the competitiveness of these institutions in the


1 See, e.g., Acharya et al (2010) on a review of the Dodd-Frank Act and regulations on financial institutions, and Johnson and Kwak (2011) on the adverse impact of the large financial institutions.

1   market place.

China’s intermediation sector has been dominated by a few large but inefficient financial institutions for many years. The four largest, state-owned commercial banks (“Big Four” banks) have nationwide networks of branches and control the majority of assets in the banking system.

Before the crisis, the most glaring problem of the banking sector had been high levels of nonperforming loans (NPLs), most of which accumulated in the ‘Big Four’ banks from poor lending decisions to state-owned enterprises (SOEs). Following the Asian Financial Crisis in 1997 and especially after China joined the World Trade Organization (WTO) in December 2001, a series of reforms began and focused on state-owned banks, with the goal of improving their efficiency—i.e., to make these banks behave more like profit-maximizing commercial banks and lower the level of NPLs.

A critical part of ICBC’s reform process was to strengthen its capital base and asset quality, and two steps were undertaken. First, China’s Ministry of Finance, through the establishment of a bank holding company – the Central Huijin Investment Company (Huijin hereafter), injected capital (e.g., government bonds and foreign currency reserves) into ICBC and other banks. Second, four asset management companies, established by the central government, assumed the NPLs of the Big Four banks. In particular, Huarong Asset Management Corporation took the bad loans that were transferred from ICBC’s balance sheet. ICBC’s legal status was changed from state-owned to a ‘joint-stock limited company’ in October 2005, with the Ministry of Finance and Huijin as promoters.

The next phase of the privatization process was to list the large banks on the Hong Kong Stock Exchange (HKSE), so that they would be subject to international banking accords (e.g., Basel II), disclosure requirements and governance mandates. Prior work has emphasized the benefits from improved corporate governance, since listing a domestic firm on an exchange located in more

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minority investors and reduce the agency costs of the controlling shareholders (e.g., Coffee, 1999, 2002; Stulz, 1999; Reese and Weisbach, 2002). On the other hand, the Chinese government, through various agencies, will retain majority ownership of all the banks while attracting foreign institutional investors as minority shareholders. ICBC’s IPOs, carried out simultaneously on the Shanghai Stock Exchange (SHSE) and HKSE on October 27, 2006, were successful—they raised a total of $22 billion, the largest amount of any IPO up to that point. From July 2010 onwards, all Big Four banks that were previously wholly state-owned have been corporations listed on HKSE. Other large financial institutions, including insurance companies, have gone through similar privatization process and are also listed on HKSE and domestic exchanges.

Next, we compare the performance of the largest five Chinese state-owned banks (Big Four plus the Industrial Bank of China) with other large, non-state-owned banks from China, the largest banks from emerging markets (both state-owned and non-state-owned) as well as the largest banks from developed countries over the period of 2006-2011. The five largest Chinese banks have improved their performance considerably as compared to the pre-IPO period and the upward trend continued during 2006-2011. As a group, these banks generate higher return on assets (ROA), returns on equity (ROE) and excess stock returns than all the other groups of banks from developed and emerging markets during the period.

We also look at two measures of risk-taking activities—Tier 1 capital ratio, a balance sheet measure, and the standard deviation of daily stock returns (on an annual basis), a market based measure. There is no significant difference, using either measure, between the five state-owned banks from China and other banks from developed and emerging markets during the sample period.

This indicates that the superior performance of the state-owned banks from China is not driven by less risk-taking during a period of global financial crisis. This also supports the view that majority

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of these banks relative to privately owned banks.

Overall, we conclude that the “Chinese model” of privatizing state-owned banks has been successful in improving efficiency. The main implication of our results is that such a model— partially privatizing large state-owned financial institutions and converting them into listed companies with a diverse investor base and the government retaining the majority stake—can be used in other emerging economies. Prior studies have emphasized the adverse effects of government ownership of banks—inefficiencies due to poor incentives and agency problems in the form of ‘tunneling’ by insiders and connected borrowers.2 We argue that the impact of the adverse effects can be significantly reduced if state-owned banks are listed on foreign exchanges and committed to enhancing minority shareholder protection and reducing agency costs. Moreover, as a publicly listed firm, profit maximization is part of their goals and these banks are also subject to international standards and face competition from other banks in the domestic and international sectors.

One of the key lessons from the 2007-2009 crisis is how to contain excessive risk-taking by large financial institutions. Risk-taking was justified as generating the highest possible returns to the shareholders; but excessive risk-taking by large institutions leads to higher systemic risk and more fragility. In this regard, the government, as the controlling shareholder of large financial institutions, can impose non-profit goals such as systemic stability (of the financial system) and ensure continued lending during recessions and crisis periods.3 In developing countries, legal and financial institutions are underdeveloped, and market-based forces such as institutional investors, who play a prominent role in the governance of listed firms in developed countries, are weak or nonexistent. In


2 With a cross-country sample La Porta et al. (2002) find government ownership of banks to be associated with less financial development. Sapienza (2004) shows inefficiencies in the lending process by state-owned banks in Italy, and Dinc (2005) shows the influence of political elections in the lending process in a sample of emerging markets.

3 Consistent with this argument, Beltratti and Stulz (2010) study an international panel of large banks and find that proshareholder boards are associated with higher (lower) performance before (during) the crisis, reflecting decisions that sought to maximize shareholder value but that did not perform as expected when the crisis hit.

4   such an environment, government and government-appointed officials are perhaps the only force that can rein in excessive risk-taking of large financial institutions; as long as these banks are competitive relative to non-state banks in the country/region, majority government ownership should not smother risk-taking. We also discuss how a government can enhance its presence in a banking sector dominated by privately owned banks. As observed during the crisis period, the government can obtain majority equity stakes of large banks in exchange for a capital injection, or acquire an entire financial institution in danger of collapsing.

Our paper extends the literature on privatizing state-owned companies. Prior research generally finds that (partial) privatization (in transition and developing economies) improves efficiency and performance.4 We show that listing state-owned banks in foreign exchanges is an important step in the privatization process, and that government ownership of listed banks has benefits, especially during crisis-prone periods and environments. Our paper also contributes to a growing literature examining China’s banking industry. In particular, Berger, Hasan and Zhou (2009) find that minority foreign ownership of the Big Four banks is associated with improved operating performance. We extend their analysis by showing that listing the Big Four banks on HKSE is another important step in reforming these banks and that these listed banks actually outperform large banks from emerging and developed markets during the 2007-2009 crisis period.

Section II of the paper provides background information on the China’s banking sector and documents the privatization process of ICBC and its dual IPOs. In Section III we compare the performance of the largest Chinese banks with majority state ownership with other large banks in the world. Finally, Section IV concludes.


4 For example, Bonin, Hasan and Wachtel (2005a, b) examine privatization of banks in Eastern European countries, and Serdar and Nandini (2011) examine the political influence of privatizing banks in India. See Megginson (2005) for a review of bank privatizations and Megginson and Netter (2001) for a review on privatization of all types of firms.

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