Introduction
A growing domestic product and an increased stake in the management of the global economy have caused China to rise as a dominant economic player in the world. Consequently, many economic sectors in the country, such as the banking industry, have reported progress in scales and profitability on key performance indicators (Haasbroek & Gottwald 2017). However, competition from foreign banks threatens this trend (Park 2016; Min et al. 2018). A review of capital structure requirements is essential in making sure Chinese banks remain profitable.
Capital Structure Requirements of Chinaâs Commercial Banks
Many Chinese-based financial institutions use profitability as the main index for assessing performance. Their capital structures are also key tenets of their profitability scale, as mentioned in the agency and pecking order theories of finance (Haasbroek & Gottwald 2017). Their capital structures affect their profitability in two ways: governance and cost of capital (Haasbroek & Gottwald 2017). Similarly, their influences are reflected in major indices of profitability, such as the capital adequacy ratio and returns on investment (Haasbroek & Gottwald 2017).
The recent implementation of Basel II recommendations in the Chinese banking sector means that existing performance indices are assessed using global standards of financial management (Knaack 2017). For example, most banks are required to maintain a capital adequacy ratio higher than 8% (Knaack 2017). Similar recommendations from the adoption of Basel II recommendations have seen the percentage of equity capital in major Chinese banks reduce to a small fraction of the total capital cost (Rathnayake et al. 2019).
Given that the Chinese financial industry is debt-driven (as is the case with many other banks around the world), leverage is an important tool of financial performance analysis. This measure has an effect on the capital structure requirements of these financial institutions, but several researchers suggest that the strongest effects are felt on governance policies (Knaack 2017; Haasbroek & Gottwald 2017; Rathnayake et al. 2019).
Excerpts from the work of Rathnayake et al. (2019) suggest that the capital structure requirements of Chinaâs commercial banks are moderated by several factors, including economic conditions, social development goals and shareholder requirements. However, the âsocial goodâ that inspires growth in the financial system is perhaps one of the single most important attributes of the system (Lam 2015). This model of governance is guaranteed by the Chinese government, which owns and regulates the financial sector. The stateâs involvement in the countryâs financial system and its social focus means that Chinese banks operate in a complex system of interrelated functions (Park 2016; Min et al. 2018). This attribute also means that their capital structures are far more sophisticated than in many parts of Asia. Nonetheless, the link between capital structure and profitability in the country has encouraged regulators and banks to optimise capital structure requirements to improve their financial performance.
The Relationship between Capital Adequacy Ratio and Performance
The relationship between capital adequacy ratio and business performance of Chinese banks is not different from other countries around the world. For example, the need for capital adequacy in Chinese banks is rooted in need to maintain a steady flow of business capital. However, current regulations, the size of banks and prevalent economic conditions have been used to determine the capital adequacy ratio of most banks (Yazar 2015; Haasbroek & Gottwald 2017).
Recent changes in the law have forced Chinese banks to look for at least $260 billion in extra capital to satisfy current regulatory standards (Wildau & Jia 2019). Economic conditions have also influenced the relationship between capital adequacy ratio and performance in the financial sector. Particularly, recent attempts to improve the economy of China through increased lending have added to the capital needs of most banks (Wildau & Jia 2019). This development has been occasioned by an expansion of balance sheet requirements and the need to maximise performance sustainably (Wildau & Jia 2019).
Chinese Commercial banks are issuing securities to meet capital adequacy requirements by issuing common shares and convertible bonds. These instruments of equity management are aimed at raising capital in different tiers of liquidity mop-up, such as tier 1, core tier and tier 2 (Wildau & Jia 2019). A robust risk management model guarantees each tier of capital growth. Figure 1 below shows the loss-absorbing capacity of the four major Chinese banks relative to their capital adequacy ratios.
The loss-absorbing capacity imposed on Chinese commercial banks is a legal requirement to prevent them from experiencing significant financial shocks in the event of a serious financial crisis (Haasbroek & Gottwald 2017). This requirement stems from Basel III regulations, which require banks to finance themselves with a 4.5% common equity ratio, while assets are weighted on a select group of risk clusters (Wildau & Jia 2019). These regulations are not only applicable to Chinese banks but many others around the world because it is a global regulatory framework on bank capital management.
The Relationship between Capital Size and Performance
A review of the relationship between capital size and performance is essential in determining the core capital needed to promote the performance of commercial banks in China. A study by Liu, Alexander and Anwar (2018) suggests that there could be a strong linear relationship between capital size requirements and bank performance. Broadly, their findings suggest that banks should ensure their capital requirements are large enough to provide loans and meet all their primary and secondary financial obligations (Liu, Alexander & Anwar 2018).
Four major banks in China lead their peers in terms of capital size. They include the Industrial and Commercial Bank of China, China Construction Bank, Bank of China, and Agricultural Bank of China (Spross 2019). A broad analysis of the performance of these banks, vis-Ă -vis their capital size, shows the existence of a positive relationship between capital size and performance because the four major banks in China have consistently posted a positive financial performance (Liu, Alexander & Anwar 2018).
In addition, most western pieces of the literature suggest that the pace of growth achieved by Chinese banks, in terms of their capital size growth and performance, is impressive (Barth 2014; Min et al. 2018). The positive performance has been linked to the state-run, hybrid capitalist model adopted in China, which differs from the free market model used in many western countries (Barth 2014).
Relationship between Equity Concentration and Performance
A broad assessment of the relationship between equity concentration and performance draws attention to the ownership structure of most commercial banks in China. Anecdotal evidence shows that the most profitable and successful Chinese banks are state-owned and known to post a positive performance (Barth 2014; Min et al. 2018). Although the relationship between performance and equity concentration for joint-stock commercial banks and city commercial banks is still unclear, Chen and Wang (2015) say that joint-stock commercial banks have the highest economic efficiency of most banks in China. Differences in performance largely stem from the role of the government in dictating the operations of Chinese commercial banks. This strategy is unlike many western countries, which operate on a free-market economic principle (Park 2016; Min et al. 2018).
The high level of control exercised by the state on the Chinese financial sector is largely representative of the protection that Chinese commercial banks enjoy from poor or bad performance. Unlike Western governments, which are discouraged from interfering with the free market structure, the Chinese have more power over the national banking system than any other shareholder (Liu & Sun 2016).
Therefore, contrary to the operations of many commercial banks in western nations, which are privately owned and operate on the principle of profit-making, commercial banks in China are largely dictated by the wishes or interest of the government (Ahmed 2018). The equity structure or model adopted by these banks is largely rooted in a centralized planning framework where the government is the focal point of command (Friedman & Kuruvilla 2015).
Although there is a strong government backing to prevent commercial banks from the extreme financial implications of their operations, the institutions still have to operate profitably (Barth 2014). In other words, regardless of the composition of their equity structures, the banks need to ensure they have balanced their books and function as profitable institutions. Alternatively, smaller banks, which are privately controlled, are vulnerable to failure because they do not enjoy protection from the government, which has the option to print money to keep them operational (Knaack 2017; Haasbroek & Gottwald 2017; Rathnayake et al. 2019).
Summary
Overall, the findings of this review highlight the need to recognize that the capital adequacy ratios or capital size requirements of most Chinese banks are not only influenced by international best practice on the same (such as the Basel Regulations) but also internal policies and regulations that are supervised by the state agencies. Consequently, it is important to analyse the shareholding ratios of major stakeholders as well as the capital adequacy ratios to gain a deeper insight into the relationship between capital structure and business performance of Chinese commercial banks.
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