Traditional rural financial institutions, such as the Agricultural Bank of China and rural credit cooperatives, are all local branches of larger financial institutions. The authorities or higher-level branches appoint senior management, set policy or commercial objectives, and help to resolve financial difficulties. This kind of top-down setup usually carries high cost and high risk, limiting the institutions’ incentive to meet the financial demands of small and medium-sized enterprises and farming households and limiting financial supply in rural areas.
In the poorer rural areas in the central and western regions of the PRC, moreover, financial institutions either are unsustainable because of policy lending or channel funds out of rural areas for commercial purposes. Since the restructuring of the state-owned commercial banks in the 1990s, large banks have been relieved of policy lending tasks. To increase profit, they now target urban areas and medium-sized and large enterprises and have been withdrawing from rural areas.
Improving financial services for small and medium-sized enterprises and farming households requires investment in local financial services. In this regard, the opening of the rural financial market is more about reinventing incentive systems and promoting local financial institutions than about inviting the return of state-owned commercial banks or restructuring rural credit cooperatives hindered by large volumes of nonperforming loans.
Localized rural financial entities can leverage their information advantage for rapid expansion.
The nurturing of localized rural finance should begin by legalizing informal finance. Non-deposit-taking informal finance providers can be transformed into new rural financial organizations, and deposit-taking informal financial service providers should register as formal financial institutions and be subject to prudential supervision.
Localized financial entities, likely to be cooperatives, should be developed in a bottom-up manner to meet local demands using local money. In this way, new rural financial organizations can better meet diverse local demand through flexible services. This kind of financial entity will blend and grow with the local economy. As their scale increases, they may either be transformed into commercial entities or remain as cooperatives.
The core advantage of small and medium-sized rural financial entities is that they can use “soft information” to ensure lending safety. Soft information is difficult to quantify. It comprises intangible assets rather than legally binding restraints and includes, among other things, interpersonal kinship and trade relationships, borrower work capability, borrower experience and reputation, peer pressure, and competition among related parties. Such information represents an alternative to financial statements, tangible collateral and guaranty, and so forth. The localization of new rural financial entities is a prerequisite for using the soft information inherent in all social and economic activities. More importantly, such soft information carries low cost.
Rural credit shops and microcredit entities may present more vitality for future rural finance development. These entities have close links with existing agricultural organizations such as production cooperatives or specialized farmers’ organizations, which helps them to better understand farmers’ financial demands, production capabilities, and systems. Such understanding can serve as a replacement for collateral and is the key to identifying suitable borrowers and ensuring loan repayment.
Successful financial models ought to carry distinctive local features, but their innovative and broad institutional arrangements must be capable of replication across regions. If small rural financial entities can develop a profitable credit model, then the credit demands of labor-intensive small enterprises and business can be better met, agricultural productivity can be enhanced, and farmers’ income can be increased. This kind of finance model surely will be trusted by farmers and therefore can be widely replicated.
The development of new rural financial institutions also can help attract commercial banks back to rural areas. Relatively large commercial banks can make wholesale loans to small financial entities with sound performance and credit, and such wholesale lending can be commercially viable and profitable. Moreover, by using small financial entities as agents for credit and asset management, commercial banks can recover part of their lost market share. Meanwhile, with their information advantage and support from large commercial banks, small rural financial institutions will develop sustainably.
Effective supervision of localized rural financial entities requires both innovation and effective communication between government and market.
New rural financial institutions will require different supervisory measures than commercial banks, and the objective of supervisory innovation is to balance financial stability with efficiency. The guidelines for microcredit lending companies—issued jointly by the China Banking Regulatory Commission and the People’s Bank of China—introduced three revolutionary breakthroughs in rural financial supervision.
First, the guidelines introduced layered supervision, which allows provincial authorities such as the Microcredit Lending Company Supervision Bureau and the Office of Finance to supervise if they agree to be responsible for lending companies’ risks. This is a major breakthrough in financial supervision in the PRC and it will promote supervisory diversification, competition, and financial innovation.
Second, the guidelines allow microcredit lending companies to borrow from up to two commercial banks. This not only will present commercial banks with wholesale lending opportunities but also will enable them to participate in rural finance. Moreover, the wholesale banks will join provincial supervisory authorities in overseeing microcredit lending companies, which will help to reinforce market discipline among such companies.
Third, the guidelines allow microcredit lending companies with superior credit records to apply to become deposit-taking village banks. This provides incentives and gives lending companies the ability to transform into local, privately owned banks. Equally important, as the wholesaler to the lending companies and, later, as a shareholder in the village banks, wholesale banks can assist in this transformation. This will support the integration of rural and urban finance.
Other changes also are required. For instance, the capital adequacy ratio requirement for new rural financial entities needs to be upgraded. The major difference between lending companies and credit shops or village banks lies in their respective capital adequacy ratios. The capital adequacy ratio requirement for lending companies is 100%; the ratio for credit shops or village banks depends on credit risk. Following the establishment of an entity, a capital adequacy ratio of 50% or higher can ensure that part of the founders’ own money is used for lending. If an entity becomes commercially viable, such a requirement can be relaxed to the level of commercial banks. Higher capital adequacy ratio requirements, combined with timely bankruptcy mechanisms, can effectively mitigate a financial entity’s operational risks.
Moreover, small financial entities should be allowed a higher deposit rate ceiling to enhance their competitiveness. Small financial entities carry higher risks, and the depositors in such entities should receive a risk premium. Only when these small entities offer higher deposit interest rates can they compete against other commercial banks in the deposit market.
Finally, government policy lending targets should be met through commercially sustainable means. If the government intends to provide low-cost support for agricultural production, it should provide the relevant small financial entities or banks with fiscal subsidies or reduce lending risks by providing agriculture insurance. Such institutions will survive and be sustainable only when commercial viability is guaranteed.
In all, the ultimate goal in opening the rural financial market is to meet diverse financial demand and to mitigate financial risk by enhancing competition and improving the efficiency of the financial system. We genuinely hope that the opening of the rural financial market will be a harbinger of future financial market opening throughout the PRC.
Justin Yifu Lin
Senior Vice President and Chief Economist
World Bank
Introduction