According to data released by the China Banking and Insurance Regulatory Commission (CBIRC), commercial banks realized a cumulative net profit of RMB 1 trillion in the first half of 2020, down 9.4% year-on-year. By institution, the net profit of large commercial banks (state-owned banks) in the first half of the year fell by 12%, joint-stock banks fell by 8%, urban commercial banks fell by 2%, and rural commercial banks fell by 11%. In the meantime, the non-performing loan ratio of commercial banks was 1.94%, up 0.03 percentage points from the end of last quarter, while the provision coverage ratio was 182.4%, down 0.80 percentage points from the end of the previous quarter. CBIRC officials said the banking industry is expected to dispose of RMB 3.4 trillion of non-performing loans in 2020, compared with only RMB 2.3 trillion in 2019. The disposition of non-performing loans in 2021 will be more intense due to the pandemic.

There is no doubt that the impact of the pandemic will lead to a deterioration in the quality of bank assets. However, the deterioration of bad debts in the banking sector did not occur only after the outbreak of the COVID-19 pandemic. It is a problem that has accumulated over the years, especially the signs of systematic financial risk emerging in some parts of the country, which are particularly alarming.

On July 20, the Central Commission for Discipline Inspection (CCDI) website revealed that Zhang Anshun, former party secretary and director of the Shanxi Supervision Bureau of the China Banking Regulatory Commission (CBRC), was under disciplinary and supervisory investigation for suspected serious violations of discipline and law. On July 19, Jing Hui, former secretary of the Party committee and director of Shanxi Provincial-Local Financial Supervision and Administration Bureau (Provincial Government Financial Office), was investigated for serious violations of discipline and law. In addition to the downfall of the main person in charge of the financial supervision department, four heads of Shanxi Rural Credit Cooperatives Union with assets of more than RMB 1 trillion were also investigated, including the former secretary of the Party committee, the former deputy secretary of the Party committee, the chairman, and the vice-chairman.

It is worth noting that the period when the above-mentioned financial officials were in power was the period when the Deyu Agriculture Corp heavily invested in the banks, making the banks the sources of funds of this Shanxi company in the capital markets. According to China Newsweek, since 2013, Deyu have taken stakes in two local urban commercial banks, including Jinzhong Bank and Yangquan Commercial Bank, and at least eight local rural commercial banks. Deyu has bought so many shares in banks that locals nicknamed the owner of the entreprise as the "bank governor". While this "governor" was powerful, he left the banks with huge bad debts and roiled Shanxi's financial system. The scale of Deyu's multi-line manipulation of listed companies often amounted to billions of yuan, and the local commercial banks it has invested in become "money-funding machines" that it controlled. "Deyu doesn't have many assets, and it's impossible for it to take down several listed companies at the same time without the backing of financial institutions," according to sources.

This issue of local financial risk in Shanxi Province is related to the corporate governance loophole in the banks. A former director of Yangquan Commercial Bank said, "In the past, the powers of the board of directors, the board of supervisors and the management level were separated, and each had its own duties. The board of directors proposed the plan, the management was responsible for implementation, and the board of supervisors supervised it. Later on, it has changed. The party committee had the final say in lending, and when signatures are needed, a party committee meeting is called." When the former chairman was in office, loans over RMB 10 million needed to be discussed by the board of directors. However, the succeeding chairman kicked out all the directors who disagreed with him. Due to out-of-control governance, Yangquan Commercial Bank became an ATM for the Deyu. As reported by Caixin, by the end of September 2019, Yangquan Commercial Bank had actual non-performing assets of RMB 5.417 billion, with a non-performing ratio of 25.24%, a provision coverage ratio of 16.02%, a capital adequacy ratio of -5.52%, and a capital gap of RMB 5.215 billion.

The risk problem of banks has much to do with corporate governance. After the restructuring of domestic small and medium-sized banks in China, there are widespread problems such as equity structure to be optimized and shareholder management is not standardized enough. First, the problem of missing owners has long existed, while insider control and major shareholder offside exist simultaneously. Second, the qualifications of some banks' shareholders do not meet the requirements, there are problems such as equity entrustment, changes in the bank's shareholders have not been reported for approval according to the provisions. Third, the shareholders' capital contribution is not true, there is a false capital contribution from the shareholders to the bank, the source of funds is unknown, the non-ownership funds were used to acquire banks' stakes, and even bank funds are used for internal circulation. These problems are common in many of the banks in which Deyu has stakes in.

The former governor of the People's Bank of China, Zhou Xiaochuan, once pointed out when talking about the financial risks of private enterprises, that there are many reasons for the emergence of risks, but the problem of corporate governance is an important one, and the lack of corporate governance leads to the aggravation of financial risks. According to Zhou, the most prominent feature of these companies' "brute expansion" is their high leverage. The primary cause of such high leverage is to increase leverage by issuing bonds and borrowing from financial institutions, and many of them use financial institutions under their control to conduct related transactions. The second cause is bogus capital. In the extraordinarily rapid expansion of enterprises, most of the capital is bogus, illegal, and disguised, not the real capital. The financial risk quickly magnifies with the bogus capital and amplified leverage.

The causes of these risk problems are not complicated. It is worth asking: Why did the problems that led to financial risk persist? What are the reasons behind the uncontrolled corporate governance of domestic enterprises and banks? In our view, in addition to fluctuations in market operations, there are two key issues that cannot be ignored:

The first is corruption. The combination of power and money gives rise to a malformed political and business environment, which creates all kinds of gray areas in capital control. Take the aforementioned Deyu as an example, according to people in the Shanxi capital markets, "Deyu could not have bought into so many banks without its deep background. It is impossible for banks not to know the risks of these shareholders, and no one would dare to lend money without the approval of the authorities." On June 18, 2020, Lou Yangsheng, secretary of Shanxi Provincial Party Committee, said at a conference on financial reform in Shanxi: "We must combine risk prevention and control with financial anti-corruption, seriously investigate and deal with the corruption behind the risks, and resolutely dig out the "pests" in the financial sector." Corruption has spread from the industrial sector to the financial sector and has begun to create regional financial risks.

The second is the weakening and lack of rules in the market economy. The market economy is essentially an economy of rules, it is the economy of rule of law and credit economy. Since the 18^th National Congress of the Communist Party of China (CPC), China has attached great importance to anti-corruption, strengthened intra-party governance, and "purified" the political atmosphere. However, objectively speaking, China has not made progress commensurate with anti-corruption in the improvement and reform of the market economy system. Due to the great changes in the international and domestic situation in recent years, the market-oriented reform of the domestic market system even shows signs of weakening in some fields and to some extent. For example, the Third Plenary Session of the 18^th National Congress of the Communist Party of China (CPC) proposed to "let the market play a decisive role in the allocation of resources". This is an exciting idea, but it has been less effective in practice since then. In some places and in some areas, market rules are being ignored or even set against politics.

In the future, under the pressure of the external geopolitical and geo-economic environment, China will focus on promoting the "inner circulation" and taking into account both of the external, i.e. international, and domestic circulations. In particular, China needs to be vigilant to guard against the two signs of this shift: One is to pursue closed-door development, believing that "national strength" and "independent innovation" can accomplish everything. The other is the non-market economy, which ignores the rules and requirements of the market economy and advocates "state capitalism" or even a planned economy.

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