Internal governance mechanisms and effective monitoring needed to ensure healthy operations of the financial sector

Zhou Xiaochuan, the governor of China's central bank, in response to widespread criticism of the large profits reaped by the country's banking sector, said at a news conference on Monday that changed economic cycles have contributed to the high but not exorbitant profit growth of domestic banks.

His remarks came just days after Wu Xiaoling, former deputy governor of the central bank and a deputy director of the Financial and Economic Committee of the National People's Congress, suggested that there are grounds for criticism as some unreasonable profit-making practices do exist within banks.

Although their viewpoints differ, one thing is certain, at a time when the risks of liquidity are growing in China's banking sector, the banks' huge profits will not be able to fend off the negative effects brought about by local government debts and mortgage loans.

According to a report released by China's Banking Regulatory Commission in February, the net profit of the country's commercial banks amounted to more than 1 trillion yuan ($164 billion) in 2011, increasing more than 36 percent year-on-year. In the first three quarters of 2011, 16 listed banks realized a profit of nearly 700 billion yuan, more than 40 percent of the total profit created by all the listed companies on the Shanghai and Shenzhen stock markets.

But despite the huge profits reaped by the banks, the Central Huijin Investment Ltd, a State-owned investment company, showed its concerns over the quality of financial assets on Feb 3. It announced that it would back up the Industrial and Commercial Bank of China, the China Construction Bank and the Bank of China in further lowering proportions of dividend shares. Huijin drastically increased its share holdings of the "Four Big Banks", which also include the Agricultural Bank of China, when China's stock market hit a record low in October.

The huge profits of domestic banks can be largely attributed to the rapid expansion of their newly added lending. Following the global financial crisis, domestic commercial banks loaned a total of 10 trillion yuan to boost the slumping economy. This expansion of credit brought considerable profit to the banking sector, which has resulted in a sharp contrast between their prosperity and the slowdown of the national economy.

The country has adopted a regulatory real estate policy aimed at stabilizing the sector's development and promoting the decline of housing prices. To this end, the country has encouraged banks to lower interest rates for first-time homebuyers to ward off a possible hard landing of the housing market. At the same time, the government is unyielding in pushing regulatory measures to stop the inflow of speculative funds from fueling housing prices. Policies have also been adopted to encourage the flow of bank funds to the real economy.

To fundamentally change the coexistence of huge bank profits and the deterioration of their asset quality, the country's supervisory department should adopt a prudent monitoring approach and try to curb the blind expansion of bank credit in a bid to prevent the ever-inflating bubbles from evolving into a financial crisis.

The enormous losses Japan's banks sustained following the busting of its housing market should be a cautionary lesson.

With China's financial resources mainly concentrated in the banking sector, fluctuations in the banking market will have a larger impact on the national economy than stock market fluctuations. Thus, the country should strengthen its governance of the banking sector. At the same time, a strict, prudent monitoring approach should be adopted to prevent over-monitoring or ill-timed loosening.

China should also try to push for the marketization of interest rates and introduce other financial reforms on the basis of improving the deposit insurance system and developing the securities market to promote healthy financial innovations. At the same time, it could open its financial market to qualified non-governmental and foreign capital at an appropriate time to promote market competition.

The author is vice-dean of the School of Economics at Fudan University.