An Examination of the Chinese Banking System: Scale Economies, Cost Efficiency, Profitability and Financial Stability Modelling

This thesis is a timely and warranted examination of the scale and performance of the Chinese banking system for the years 2005 to 2015. Firstly, in light of the policy debate over “too big to fail”, we examine evidence on the scale economies of banks, as well as technological change, to inspect whether industry consolidation is a rational objective for the larger banks in China to continue their asset growth. Secondly, utilising Stochastic Frontier Analysis, we construct a stochastic frontier cost function to examine the evolution of cost efficiency in the banking sector. Thirdly, considering the intense restructuring of banks over the study observation period, we explore the underlying variables that explain the profitability of Chinese banks. Finally, the driving factors that affect the resilience of Chinese banks are evaluated with the aim of maintaining the financial stability of the banking system. During 2005 to 2015, significant economies of scale are found for large Chinese banks, driven by cost savings rather than by “too big to fail” considerations. Actually, greater cost economies are achieved by banks with lower credit risk, higher liquidity and “too big to fail” status. Therefore, recent policy recommendations that imply a limiting of bank size will place economic costs on large banks in China in the form of forgone scale economies. In addition, the technological progress that has been shaping the Chinese market provides justification for bank consolidation. We also observe that neglecting the costs of financial risks in the estimation can increase scale efficiency estimates for Chinese banks. Overall, Chinese banks exploited higher levels of cost efficiency before the global financial crisis; thereafter, cost efficiency decreased. It is evident that stronger economic growth, lower inflation and exchange rate appreciation are able to improve the cost efficiency performance of Chinese banks. Linking cost efficiency to the profitability and financial stability of Chinese banks, we find that banks need to acquire superior risk management skills to realise greater cost efficiency with the aim of boosting bank profits. Nevertheless, a higher level of cost efficiency appears to hinder the solvency of banks through cost skimping behaviours. The involvement of Chinese banks in shadow banking activities enhances the stability of banks to a very limited extent, and banks need to improve their competency to manage the associated costs in order to realise the profit-increasing effects of shadow banking operations. Asset growth and the utilisation of short-term wholesale funds are shown to strengthen banks’ profit-generating ability and assist banks to become more stable. The Basel III capital requirements are seen to have affected the profitability and stability of “too big to fail” banks and “not too big to fail” banks differently. Moreover, banks’ profitability is benefiting from a macroeconomic environment that features stronger economic growth, reduced inflation and a lower interbank offered rate; exogenous threats that weaken the resilience of Chinese banks mainly take the form of fluctuations in the interbank offered rate and exchange rate