Making Markets: The Untold Story of Chinese Banking and Why It Matters

Earlier this year, thousands of angry depositors stormed the Henan office of China’s central bank. The cause was a classic bank-run trigger: people were unable to retrieve their deposits. Two things about this protest were particularly noteworthy. First, it was directed at some of the less known Village and Township Banks 村镇银行 that rarely enter discussions of China’s financial system. Second, many of the depositor/protesters were from outside Henan province; a substantial number had travelled thousands of miles from Guangdong province to join the rally. Clearly, the banks in humble Henan province had managed to attract depositors nation-wide. Who were these village and township banks? How did they manage to draw deposits from so far afield? And why were they underregulated to the point of generating unrest?

What happened in Henan was hardly unique. Indeed, it could well be the beginning of a much bigger challenge that China’s new economic management team will have to grapple with carefully but resolutely into the future. The root cause of the Henan crisis lies in the kind of market that the Communist Party of China (CPC) has cultivated in the world’s largest banking system (the assets of which are equal to 40 percent of global GDP), particularly since the mid-1990s. I call it a ‘state-owned market system’. This market has a Leninist foundation, its organisation mirrors that of the Party-State, and the incentives for market competition go far beyond economic profits. It’s a system where market and administrative financial allocations co-exist, Party discipline and market discipline both matter, and profits and politics both reign in uneasy tandem.

The Grand Bargain

Most China watchers know that the country’s banking system is firmly controlled by the Party-State. Yet state control has not precluded market diversification and competition. The stereotypical view of Chinese banking, based on the situation of the early reform years, sees a system dominated by the Big Four banks: the Industrial & Commercial Bank of China, China Construction Bank, Bank of China, and Agricultural Bank of China. This picture is obsolete and analytically misleading. While the Big Four once controlled almost all banking assets in China, their asset share has now dwindled to less than twenty-five percent — a dramatic transformation.

What happened, though, was hardly a liberalisation of the sector. Private and foreign banks still play a negligible role in the Chinese system. Instead, underlying the shrinking market share of the Big Four is the proliferation of banks owned or controlled by lower-level governments, what I term ‘local state banks’ (e.g., Shanghai Bank, Beijing Bank, and Baoshang Bank). Since the mid-1990s, these banks have proliferated exponentially, numbering over 2,000 by the mid-2010s. While the Big Four remain the largest players in the system, in many localities they have lost their market dominance to the local state banks. [1]

The rise of the local state banks was never simply a story of market reform. Beijing did not allow local governments to enter banking so they could provide more support to underfunded private firms and small business owners. This privilege was the outcome of a ‘grand bargain’, a political quid pro quo.

Throughout the 1980s and early 1990s, a decentralised fiscal system incentivised China’s local governments to pursue economic development. Unlike the Mao era where all revenue had to be handed over to Beijing, local governments got to keep the rest after sharing with the central government a prescribed amount of taxes. However, by the early 1990s, localities were amassing almost 80 percent of the country’s total revenue. Beijing worried that this high degree of fiscal decentralisation could sow the seeds of political disintegration, as it was the case in former Yugoslavia. So the central government decided to take a large chunk of revenue away from the localities, i.e., recentralise. From 1993 to 1994, central share of revenue increased dramatically from around 20 percent to 55 percent. However, Beijing didn’t achieve it through a blunt administrative fiat. To keep localities happy and make sure they remained incentivised to pursue local development, the centre compensated them. It helped localities meet their responsibilities after recentralisation through fiscal transfers and tax returns, and permitted them to organise Local Government Financing Vehicle Companies (LGFVS) to borrow and sell land to real estate developers.

Less well-known is the most crucial component of Beijing’s offer: allowing local governments to enter banking. Beijing even promised to assist by transferring some central financial assets to help kick-start local banks. Vice Premier Zhu Rongji repeatedly highlighted the possibility of allowing localities to organise their own banks when negotiating the details of recentralisation with the localities.

Herein lies the fiscal-financial nexus of China’s banking market transformation. It explains why most of China’s local state banks appeared immediately after the 1994 fiscal recentralisation reform. Before 1998, local governments could veto the personnel appointments of local Big Four Banks’ branch managers; Premier Zhu Rongji brought this power to an end. Later, when Beijing sought to sever local government ties with the Big Four’s local branches, it gave the local state banks even more privileges, such as the authority to build branches outside their own cities and provinces.

Political Competition and Market Expansion

Localities ran with Beijing’s offer. But immediately upon entering the banking business, they faced an existential crisis: how to compete with local Big Four branches, which already had a sweeping presence across the country by the mid-1990s. Nevertheless, the local state banks took off quite fast. There were several factors behind their success, the most critical being local government support.

Local governments injected fiscal revenue into the new banks to get them going in the early years. They then coordinated with local state-owned enterprises and other government departments or work units to make enterprise deposits and set up payroll systems with the new banks. They also pressured wealthy local private businesses to borrow in advance, even when the firms had no need for funding, to beef up the banks’ balance sheets. And they pushed local religious organisations — ‘patriotic’ churches and temples — to deposit their donations in the new banks.

One reason local governments lend a strong helping hand is that they wish to have their cake and eat it too. This is a rational choice for all local governments in China, as they need financial resources to out-compete their peers. This is also the whole point of the central — local grand bargain: allowing localities sufficient financial wherewithal to grow and compete.

With strong local government support, the new banks aggressively expanded their turf and engaged in various market campaigns to grow their presence — for example, sending employees to residential compounds to sell bank products and services. Most importantly, they have been covertly raising deposit rates above central ceilings, such as handing out cash rewards proportional to the size of the customers’ deposits and keeping these transactions on separate books. [2]

The local state banks have also borrowed from central policies to further expand their market reach. For example, during the Hu-Wen administration, a top central priority was rural development, with Beijing encouraging the formation of more rural financial institutions. Numerous local state banks (which are mostly based in cities) seized the opportunity and applied for licences to set up Village and Township Banks. The trick was that many localities in fact ended up situating these so-called Village and Township Banks in urban areas to attract more customers; in recent years, they have also capitalised on fintech and collaborated with internet firms to reach potential customers nation-wide. In some cases, the centre has lost track of what these banks are doing, as happened in Henan province, because Village and Township Banks are usually not connected to the Central Clearing and Settlement System directly but only via the local state banks that created them.

Local governments’ aim is not to monopolise local financial resources but to aggrandise them. For one thing, in their localities, they don’t have the capacity to squeeze out the Big Four, whom ordinary Chinese still view as the most stable financial institutions. But more importantly, because local officials are like roving bandits who get transferred between localities every few years, they don’t even bother trying to monopolise, because their successors can free ride on their efforts.

That is why local governments have in fact played a crucial role in diversifying the local banking markets, by proactively inviting even more banks to enter their jurisdictions. They benefit from this open-door policy in two ways. On the one hand, new entrants usually have to sign deals with local governments that require them to make loans to designated local enterprises within a short period of time. On the other hand, by reducing the Big Four’s local market share, new entrants help boost ‘local financial development’ — which is included in upper-level governments’ evaluation criteria for local officials.

The rise of the local state banks unleashed ferocious competition in China’s state-owned banking market, with the result that the Big Four are no longer dominant. Setting aside Tibet, for every Chinese province, about 60–70 percent of banking assets and bank branches today are controlled by the local state banks. The city of Hangzhou, for example, had 671 bank branches and credit unions in 1990, but by 2015, this number had reached almost 5,000, only 38 percent of which belonged to the Big Four. [3]

So What?

What has the rise of local state banks meant for the Chinese economy? In short, it has created a state-owned banking market where a variety of state agents are engaged in market competition, and where the dynamism and dynamics of the markets change as the state’s priorities shift. When the constraints of state control and command were loosened, banks in China competed as any commercial banks would, albeit within the bounds of the Party-State. That said, things could change quickly when Beijing decided to tighten its regulatory and policy grip.

In 2014, Nicolas Lardy’s suggestively titled book Markets Over Mao debunked the myth that China’s banking system continues to discriminate against private borrowers. In fact, thanks to the proliferation of smaller regional banks, Lardy argues, the banking system as a whole has become highly competitive, and that, in turn, has helped non-state borrowers. [4]  Elsewhere, I have provided more systematic empirical evidence consistent with Lardy’s conjecture. But not all private borrowers are born equal or treated equally. It remains the case that politically connected firms have better access to bank loans and credit.

The most crucial outcome of intense bank competition has been an overconcentration of lending in the real estate sector, particularly by the local state banks. When the economy was still booming, it made sense for small, young banks to ride the rising housing tide —even embracing real estate firms as major shareholders to strengthen their balance sheets. It was the fastest way for the banks to expand. The downside of this expansion strategy, however, is now all too clear: the banks and real estate firms could sink together. This is exactly what happened to the Shengjing Bank and the Evergrande real estate company, once the bank’s biggest shareholder. As the real estate giant tottered, the bank also faltered and went through a radical restructuring to pre-empt a local banking crisis. More such events cancan be expected in the coming years.

Local governments had encouraged this enmeshment between local state banks and real estate firms: they needed a booming housing sector to extract land rents, and they needed local state banks to grow so they could rely on them when fiscal problems arose, as happened during the 2008–2009 Global Financial Crisis. We know that China muddled through that disaster by pumping money into the economy. Far less known is that the local state banks together, through their government financing vehicles, provided even more funding to local governments than the Big Four did.

The Regulatory Dilemma

So where were the regulators? Why didn’t they check the wild expansion of local state banks, especially their excessively cosy relationship with the real estate sector? The answer hearkens back to the central–local grand bargain. Besides its concrete policy concessions, Beijing also made clear that it would not meddle with how localities raised and spent money. So after the required taxes were submitted to the centre, all money-related matters could basically remain local ‘secrets’. And Beijing honoured its word.

This explains why, before Xi assumed power, China’s banking regulators essentially focused on the Big Four and left the local state banks untouched. The pre-Xi era was one of ‘great development’, in the words of one regulator I interviewed. No one really cared or dared to keep the local state banks in check. One municipal branch of the Banking Regulatory Commission tried in vain to remove a local state bank president in a north-eastern province in the early 2000s, but the city government fought successfully to protect him. [5] Notably, local Party secretaries and government bosses have proven much more powerful than the regulators.

After the stock market crash on 15 June 2015, President Xi did make a serious effort to ramp up regulatory pressure on the securities and banking markets. The number of punishments and warnings that central regulators issued to banks increased fifteen-fold between 2012 and 2020, reaching 5,290 in the first year of the global pandemic. Yet, as growth decelerated, China-US relations worsened, and the self-destructive dynamic zero-COVID policy continued, Beijing backed down, and the number of bank punishments shrank dramatically to below 3,000 in 2021.

The Future

What will happen to Chinese banking? This is a crucial question for the world to ponder, because it matters not just to China’s economy but to the world’s. Let’s assume the Communist Party will remain in power. When Xi eventually relaxes his zero-COVID policy, and the economy bounces back, we will see the return of significant regulatory pressure on the banks. There will be less intense competition among banks than before Xi took power. As the state strikes back, banks will again make more loans aligned with government policies, as they did in the early years of reform. The private sector will suffer as a result.

In the post-Xi era, presumably sometime after 2032, we might see the revival of a more dynamic state-owned banking market, but we should not expect any massive entry of private or foreign banks, as that would be inimical to Party rule. Nor should we expect large waves of central or local state bank failures. Problematic banks will continue to be merged with others or acquired by the central government, as has always been the case. In this state-owned market made by the Party, there will be no creative destruction, only creative re-organisation.


[1] Adam Yao Liu, Building Markets within Authoritarian Institutions: The Political Economy of Banking Development in China, doctoral dissertation, Stanford University, 2018.

[2] Ibid, p.96.

[3] From author’s dataset of China’s bank branches, collected from official statistics.

[4] Nicholas R. Lardy, Markets Over Mao: The Rise of Private Business in China, New York: Columbia University Press, 2014.

[5] Author interview, 2015.



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