Walking into any of the big domestic Chinese banks these days, you might not notice much difference between them and their foreign counterparts from the US or Europe. Most branches in the larger cities have gotten a new look, with polished marble floors, noticeably shorter queues and service that has taken on Western characteristics of orderliness and speed.

But until just a few years ago, Chinese banks were seen as inefficient at best; rather than helping consumers turn savings into investments, they were, to a large extent, instruments of the state used to funnel money into state-owned enterprises with soft loan terms, and sometimes into the pockets of management. This stigma transferred over into the investment world, where the big banks were tagged as "dead ducks" and viewed by many to be unworthy investments because of the deadweight of non-performing loans, bloated staff lists and inefficient business practices.

But this past October saw China Construction Bank (CCB) become the first of the big four Chinese banks to list on a foreign stock exchange, with a US$9 billion listing supported by the Bank of America. Predicted is that at least two of the three remaining big four state-owned banks - Bank of China (BoC), Industrial and Commercial Bank of China (ICBC) and Agricultural Bank of China (ABC) - as well as some smaller commercial banks, will follow suit with their own listings by the end of this year.

These listings come on the tail end of nearly five years of foreign investment into the domestic banking sector spurred on by China's accession to the WTO in 2001. This December marks the deadline for authorities to open up the banking sector under WTO-stipulated accession agreements, allowing foreign banks to operate more competitively within the domestic banking sector, and likely, giving Chinese banks a run for their money.

For all intents and purposes, the substantive improvements visible at the branches of the big state-owned banks are physical manifestations of a massive clean up that has been undertaken in the last several years. Such transformation has certainly sparked the interest of investors worldwide, with a total investment of US$19.03 billion having been made in the Chinese banking sector as of last month, not including funds raised during initial public offerings (IPOs).

Share acquisitions have come from some of the most formidable global players, including Citigroup, Goldman Sachs and Singaporean Temasek Holdings, showing that the spruce-up has done more than just make a trip to the bank here more pleasant - it has changed the face the Chinese banking sector shows to the world.

Glitch in the system

All this is good news, but the wound hasn't healed just yet. Foreign investment may have helped inject fresh capital and Western management expertise into the struggling enterprises, but the big four are still facing major problems.

Last year saw the resignation of CCB chairman Zhang Enzhao after bribery allegations, and Chinese state media recently reported that the China Banking Regulatory Commission (CBRC) disciplined nearly 7,000 bank officials in 2005 alone for illegal actions or financial crimes, according to BusinessWeek. The culmination of a 13-year-long scandal involving two Bank of China (BoC) managers put corruption in the international spotlight recently when the two were indicted by a federal grand jury in Las Vegas for defrauding BoC of more than US$485 million and laundering it in Vegas casinos. Although the chances of such a thing happening these days in the mainland banking sector are presumably slim, such evidence - even remote - clearly marks the boundary between emerging market and internationally competitive player.

Further stunting growth in the domestic market is the mountain of bad debt and NPLs, the value of which continues to ebb and flow. After a series of government bailouts, the condition had seemed to be on the mend. But Chinese lenders are now facing yet another wave of NPLs due to a recent buildup of credit in the real estate sector. According to Ernst & Young, the volume of outstanding real estate loans - both construction and home mortgage loans - between 2002 and the first quarter of 2005, increased 40 percent, while "official" real estate loans more than doubled.

But these, seemingly, are short-term problems to be snuffed out in due course with liberalisation and modernisation of systems and the sector. Sustainable, long-term growth is what the authorities need now be focusing on, and nowhere is that more important than in China's burgeoning credit market.

China has historically been a largely cash-based society, but a recent report by McKinsey & Company forecasts that by 2013, China's consumer credit market, including credit loans, home loans and other personal loans, will account for about 14 percent of profits - a 10 percent jump from present levels. The biggest challenge will be maintaining control of that rise without a modern system for tracking credit information.

"One of the key issues that the banks all need to work on is developing their ability to collect enormous amounts of data on consumers," says Nick Harrison, senior vice-president of Lloyds TSB, which entered the China banking market earlier this year. "It's a nation of savers, and they're going to move forward in terms of buying cars and houses, but the banks need to be behind the scenes accurately profiling who they can and can't lend money to. That's one of the most important things they have to learn."

Although there is a national credit organisation - the National Credit Administration Bureau - and some smaller consumer credit information systems scattered throughout China's cities and provinces, there is certainly no equal to what an Equifax or Experian offers in the US.

Shanghai probably has the most efficient system under the Shanghai Credit Information Services Co (SCIS), which utilizes data from 15 participating domestic banks and telecom and energy companies to assess the creditworthiness of the 3.7 million records currently in its database.

But with targets gearing towards a 400- to 500-million-strong middle class market by the year 2015, it won't be an easy stretch from here to there. "It takes decades to build up a database," says Harrison. "It's taken us [Lloyds TSB] an enormous amount of time, post-Second World War, with credit profiling and credit scoring our customer base to be able to do that confidently."

Digging out

It's a deep hole, but it is one the Chinese banking sector can climb out of, and with relative ease. This gap in the consumer credit market, on the one hand, presents a huge opportunity for foreign banks if their Chinese counterparts don't get it together in time; but on the other, it points to a place where foreign investors can play an increasingly important role in the transfer of skills.

"The introduction of foreign strategic investors (FSIs) is meant to help accelerate the credit practices of these banks," says Simon Ho, Co-head of Asia Financial Research at ABN AMRO. "It's a big government policy initiative to restructure and reform the state-owned banks, and introducing FSIs, and also market listings, for these banks is part of that process." But it is very much a long-term process, and Ho says we shouldn't look to the first-round WTO deadline this December for any real change.

"You have 15,000 branches in these big state-owned banks, and they have a lot of issues - very decentralized management, and obviously controlled by the state central government. You shouldn't expect things to change overnight ... but the whole direction is clear: everyone wants to get better, to improve. It's going to get a lot more competitive."

Stock market listings will be of further help to banks in writing off bad debts, but they will be even more valuable in terms of instilling confidence in other would-be investors and bringing the Chinese sector on par with international standards.

"Assuming it goes well and according to plan, it will certainly create more confidence with foreign investment," says Lloyds' Harrison. "I think it's nothing other than a positive to our business [foreign bank business in China] in terms of garnering interest and confidence from my bosses in London."

Harrison also agrees that FSIs and IPOs are an important component to growth in the domestic market. For example, in the challenge to build up the credit system, foreign banks can offer a wealth of expertise on how to cull and manage massive amounts of information, and experience in foreign markets is knowledge that can be brought back home.

"Lloyds has built up enormous links in the UK, and we have an enormous amount of data on both customers and prospective customers that allows us very quickly to profile individuals and decide whether or not we want to lend them money and what the likelihood of repayment is if we do." According to Harrison, this will be one of the most important ways for the Chinese banking sector to maintain sustainable control of a nation of savers that is quickly becoming a nation of spenders.

Fear of takeover

The government's strategy to open up the market by allowing FSIs to take hold of bits and pieces - and in many cases, chunks - of the bigger banks, has not been well received all around, however. Critics say that share acquisitions, especially the older purchases, are undervalued and merely a slapdash attempt to save the institutions from financial ruin, without considering the long-term effects opening up will have on the market.

ABN's Ho explains that earlier sales may have been at lower-than-normal prices, but only because at that early stage there were no benchmarks set. "I don't think they're selling it on the cheap," says Ho, adding that he, in fact, believes the markets may have gone too far now in valuing the banks. "Who would have imagined these are worth three-and-a-half times book value today? And without them, would you be getting these price levels now, as well as the confidence?"

According to Ho, there are real, sound reasons for the relinquishing of stakes - controlled stakes - in the major banks. "They're introducing a foreign strategic investor so they can bring in the technology, the know-how from overseas or international best practices," says Ho. "There's skills and knowledge transfer, and it also helps them in terms of credibility when they go to the market and do an IPO, because they can say 'Look, Bank of America has confidence in us, so there.'"

But will foreign investors ever be able to gain a controlling stake in one of the big four, as many Hu-Wen critics fear? "It's not on the cards at all," insists Ho. "They're not giving up any control; they get some capital, they get some money, and it's basically a source of knowledge and skills that helps them to list."

Banking on reform

Chamber policy recommendations from the 2005 Position Paper

As China's banking sector becomes more mature, foreign banks are increasingly demanding greater access to the market, and not just in the form of buying portions of the four main state-owned banks. European banks, the most represented group of foreign financial institutions in China, are keen to step up cooperation with regulating administrations the China Banking Regulatory Commission (CBRC) and China Securities Regulatory Commission (CSRC) and help along improvement in such areas as risk management and corporate governance, in which the Chinese system still lags and European banks excel.

In some ways, foreign banks are finding it more difficult to operate in China today than before WTO accession; foreign financial institutions' market share dropped from 2 percent to 1.4 percent between 2001 and 2004. In the Chamber's 2005 Position Paper the Banking and Securities Working Group made the following recommendations:

- Reduce capital requirements for foreign banks and abolish the current 30 percent mandatory working capital deposit earlier than the December 11, 2006 deadline.

- Eliminate the current 70/30 deposit ratio and calculate liquidity and other ratios through means more in line with international standards.

- Allow onshore foreign currency loans to be converted into renminbi, and charge only that foreign collateral converted to renminbi towards banks' foreign debt quotas.

- Allow foreign banks to issue guarantees to secure renminbi loans by Chinese banks to encourage more foreign direct investment in China's less developed areas.

- Abolish the waiting period (currently three years) for foreign bank branches to apply for renminbi licenses, starting from 2007.

- Let foreign financial institutions to take majority stakes in joint ventures on the mainland.

- Coordinate the authorisation of equity- and commodity-linked capital guarantee products, and treat them as off-balance-sheet business.

- Treat regulations of state administrations such as SAFE as inapplicable to equity-, index- and commodity-linked products, as is the case for insurance policies.