Performance and risk in the Chinese regional ranking sector: a meta-frontier approach

This thesis examines the performance and risk of Chinese commercial banks, with a focus on the Chinese regional commercial banking sector from 2005 to 2015. To that end, cost efficiency, scale economies and loan loss provisioning practices are investigated. We begin our analysis by classifying Chinese provinces into three regions using a novel hybrid hierarchical and k-means clustering method based on provincial macroeconomic conditions. We then estimate pooled and individual cost frontiers, and we test whether Chinese regional commercial banks operate under different technologies. Our likelihood test results reject the common technology assumption in favour of technology heterogeneity. Building on the latter, we adopt a stochastic meta-frontier method to estimate a country meta-frontier that envelops regional frontiers. We find that cost efficiency for regional banks mainly stems from technological gaps between regional frontiers and the country meta-frontier. These gaps can be narrowed through increased foreign bank presence, increased banking sector competition and acceleration in regional urbanisation. Banks in the North-eastern and Coastal regions of China are found to be the most cost-efficient, while banks in the Inland region are found to be the least cost-efficient. In addition, we expand our analysis, and we obtain economies of scale from both the individual frontiers and the meta-frontier. Our comparison suggests that banks in the Inland area would operate at the optimal size if they adopt the meta-frontier technology, while regional banks in the core financial centres would start to enjoy economies of scale when they adopt the meta-frontier technology. We also find that investment banking activities, higher liquidity ratio, and lower credit risk would contribute to economies of scale, while banks’ profitability from traditional lending activities does not seem to impact scale economies. After examining the performance of Chinese regional commercial banks, we focus on loan loss provision practices of the Chinese banking system using a series of system Generalized Methods of Moments dynamic panel data regressions developed by Arellano and Bover (1995) and Blundell and Bond (1998). Overall, we find that Chinese banks are generally backwards-looking in terms of provisioning, and there is strong evidence of income-smoothing. Furthermore, we find that Chinese banks engage more intensively in income-smoothing during the 2007-2008 global financial crisis, in line with the arguments of Curcio et al. (2016) and El Wood (2012) that stress that adverse financial conditions might incentivise bank managers to lower perceived risk of stakeholders and signal bank resilience by reducing earnings volatility. We also find that loan loss provisions mainly signal an expense rather than financial strength to investors. The higher level of loan loss provisions is also linked to lower cost efficiencies derived from the meta-frontier, supporting Berger and DeYoung’s (1997) “bad management” hypothesis. Finally, following Beatty and Liao (2014), we first estimate the discretional component of loan loss provisions by obtaining residuals from regressions of loan loss provisions on their non-discretionary elements and following Jin et al. (2018), we estimate an equation of determination of discretionary loan loss provisions. We find consistent results that reliance on retail (core) deposits has a positive impact on the quality of reported earnings as banks with more reliance on core deposits for funding tend to engage less in discretional use of loan loss provisions. This thesis contributes to the literature methodologically and empirically and highlights several important policy implications. Firstly, banks in different regions in China are found to operate under different technologies, and higher cost efficiencies can be achieved by narrowing the technological gaps between the regional frontiers and the country’s meta-frontier. This thesis suggests that this can be achieved by encouraging more competition, more foreign bank presence in the banking sector and advancement of urbanisation to narrow the technological gaps while encouraging better bank management via better capital adequacy and lower levels of non-performing loans. With respect to size effects, our findings stress the importance of optimal technology adoption for banks operating in economic centres. In terms of bank loan loss provisioning in China, a dynamic, forward-looking counter-cyclical loan loss provisioning method may be beneficial to avoid its cyclical nature that amplifies credit shortages during economic crises. Furthermore, our findings that banks engage more in income-smoothing during a crisis period should encourage regulators to monitor more closely bank accounting information during times of economic and financial stress. As banks’ earnings quality is positively driven by retail deposits, regulators should also pay more attention to regulating banks that rely heavily on wholesale funding in order to enhance market discipline