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China's Control Problem

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China's Control Problem

When it emerged last week that China Minsheng Banking Corp. had sold $436 million in suspect wealth-management products, fears rose of a collapse in the loosely regulated market for such products. It now looks like a more mundane case of forgery involving a branch manager. But that's not exactly reassuring: In fact, it suggests a different kind of systemic risk.

Internal controls -- such as auditing, document verification and risk management -- are part of the dull machinery of financial markets, which most people never notice. Yet such tedious tasks are vitally important. What can start as corner-cutting at one business unit can quickly spiral into a threat to the whole company and beyond.

In much of corporate China, weak internal controls are the norm. Banks are reluctant to spend money on database or compliance software. Forged corporate seals have been used to conduct billions of dollars in seemingly legitimate trading. Nearly 60 percent of Chinese executives say that unethical behavior is acceptable to keep a company going or to meet revenue targets. In short, investors and regulators have reason to worry.

And these worries aren't merely theoretical. Large thefts or losses from Chinese banks -- ranging up to $560 million, in one case -- happen with frightening regularity. What makes these cases so egregious isn't the sophistication and planning that goes into them but the relative ease with which employees walk out the door with stolen yuan in a briefcase. The thefts look less like mastermind plots from a heist movie than like a cartoon.

Many major firms impose few controls beyond what the person in charge says. I know of companies that accept hard-copy reports from regional managers with no auditing to verify information. The data is then entered by hand into basic spreadsheets used to oversee the whole operation. Although foreign investment banks typically store all employee communications conducted on company-issued phones and computers -- and often use artificial intelligence to verify compliance -- in China it remains strikingly common for people to list private e-mail addresses on their business cards.

Without precautions, this kind of thing could become a systemic problem. A bank executive sitting in an office without a strong IT system, risk-management software or internal auditing department relies solely on reports from provincial managers. When those managers have wide latitude in how they classify loans, and an incentive to downplay their non-performing loan ratios, it's quite likely that risks will be underestimated by the executives -- not to mention by regulators in faraway Beijing.

Worse, firms copy each other. If one bank gains a competitive advantage by creatively cutting corners -- and seems to get away with it -- others will catch on in rapid succession. The variety of financial companies suffering significant losses because of poor internal controls in recent years suggests that these aren't isolated incidents.

The good news is that internal controls matter to markets. Investors seem to be pricing Chinese bank stocks on the low side, expecting additional unpleasant surprises or remaining skeptical of the official story on non-performing loans. And smaller banks, less able to hide losses with lower loan-to-deposit ratios, are showing higher levels of stress than large ones.

Even so, China's regulators need to do more. For starters, they should require improved financial reporting and auditing. Every Chinese bank that sells shares in Hong Kong readily concedes that regulatory standards -- from loan classifications to accounting guidelines -- are different on the mainland. The problem at Minsheng was reportedly only detected when the head office got a phone tip, not through internal mechanisms designed to prevent mismanagement. If that's a problem at Minsheng, which is known for good management and technology, it's a safe bet that other banks are doing worse.

When Beijing instituted regulations on government travel not long ago, as part of an anti-corruption campaign, it quickly got things under control: Spending has risen by only 0.3 percent since 2011, and is budgeted to fall in 2017, thanks to improved internal controls. The same could happen in the private sector with better accounting and auditing standards. That would bring more transparency to China's markets. And transparency will set you free.

Source: Bloomberg

By Pathay Singh on 04/27/17