Out of control

New concerns over risk management at Chinese banks

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02 Mar 2012
Week in China

Six years ago, Yantai Bank discovered that one of its branch managers had been lending the bank's money for personal gain. The rogue banker had grown his illicit side-business to Rmb500 million ($79.3 million), a significant sum for a city bank in Shandong.

But the banker did not get arrested, reports China Business. Instead he subsequently left the bank and went into business, becoming very wealthy.

His legacy was less happy for Yantai Bank which ran up bad debts as it tried to recover these unapproved loans. But perhaps worse was the moral hazard his example set for other staff. China Business concludes it almost certainly emboldened others at the bank, an institution with an asset base of Rmb34.8 billion.

"With such high profile irregularities occurring," an older bank employee confided to the newspaper, "other branch managers feel little fear [of breaching rules]."

So it was only a matter time until another Yantai banker started using company money for his own purposes. But this time, punitive action has been taken. Last month, branch manager Liu Weining was arrested in Zhejiang after a week on the run. He is now under investigation for diverting funds worth Rmb430 million for personal use.

This second fraud case puts Yantai Bank's internal controls back into the spotlight. Liu's lending was discovered not by routine checks on authorised lending levels but instead by the bank's human resources department.

How so? At the end of the year, head office policy is to compare the deposits held by each of the bank's local branches. The manager of the branch with the least amount of savers' cash is then replaced, and the new manager then conducts an audit of all the accounts handled by his predecessors.

With such high-profile irregularities occurring, other branch managers feel little fear [of breaching rules].

This year, Liu's branch came out bottom, so it wasn't long before he was found out. He then borrowed a further Rmb300,000 from friends and absconded. China Business calls the breach "staggering" and evidence of "internal management chaos" at Yantai Bank.

As the investigation is still underway, it is not clear what Liu did with the money that he embezzled. One line of enquiry is that he was involved in private lending (see WiC62 for more on this topic) and that he extended loans to private companies in Wenzhou.

Week in China has reported on dubious banking practices before.

Last year we wrote about a $227 million fraud at Qilu Bank (WiC91), another small commercial bank. These high profile cases highlight concerns about poor internal controls at the regional banks, something that is becoming an increased concern for the banking regulators.

One banking analyst speaking to Shanghai Securities News warned that the problem comes from the rapid growth of these local banks: "With the scale of the business growing, the controls will fall behind, so it is likely that incidents will occur."

But risk management is not only a concern for small city banks. Controls at larger banks are also attracting attention, with China Postal Savings Bank (CPSB) currently under scrutiny as its loan distribution network spreads.

Under the control of China Post Group Corporation, CPSB is a commercial retail bank with a focus on lending to small businesses outside of the major urban centres. It has more branches than any other bank in China (30,000 of them, usually located next to post offices), and it is China's seventh- largest bank in terms of assets and fourth-largest bank by deposit base.

CPSB is profitable, with net income in 2010 amounting to Rmb11.4 billion, which explains why a number of strategic investors have been looking to take a stake in the business. The Economic Observer reports that foreign banks have expressed interest but that CPSB's parent company would prefer to source investment from a large domestic financial institution.

Over the last four years, CPSB has extended loans of more than Rmb700 billion to small businesses and family-run companies, and it still has "plenty of room for lending," one of its executive told Century Weekly.

But the worry is that as the bank's loan network expands, risk management practices may fail to keep up. A few years ago, only 500 of the bank's county branches had been granted fuller loan approval power. That has since been expanded to 2,000 branches. Although there are clear advantages to ceding loan approvals to local decision makers – on-the-spot loan officers will be better aware of local conditions, for example – autonomous agents will also have greater freedom to make poor lending decisions too.
And, in the worst case, more opportunity to commit fraud.

Senior management is aware of the potential problems. "Transferring loan approval authority to lower levels is currently the biggest risk point [for the bank]," CPSB president Zhe Dapeng told Century Weekly. The bank says it is currently experimenting with new techniques for risk management, including the rotation of loan officers between branches in a regular cycle.

But as the situation at Yantai Bank revealed, problems with local branches aren't always exposed till it's far too late.

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