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Integration of Commercial Banking between Taiwan and China after MOU
Dr. Hong-Jen Abraham Lin
Department of Finance and Business Management
Brooklyn College of the City University of New York
Abstract
This article reviews the literature of efficiency analysis of commercial banks in Taiwan and China. Furthermore, based on the experience of geographic deregulation in the European continent and the US, the author depicts a picture of the integration in future.
From the perspectives cost and profit efficiencies derived by the existing empirical studies, the author has found that scale economy is not the motivation for Taiwanese and Chinese banks to expand. No evidence implies that the acquisitions of banks help major banks in either Taiwan or China improve cost and profit efficiencies. In the experience of China, the gain from improved cost efficiency is mainly caused by minor foreign ownership and outside monitoring. Furthermore, the banking markets in European Union and most of the states of the US are monopolistic competitive after deregulations and integration. Thus, the banking markets of Taiwan and China are expected to be monopolistic competitive after integration.
Henceforth, when the banking industry is monopolistic competitive and the equity market is well developed, Quality of services or relationship is the key to success for the integration of the banking industry across strait.
1. Introduction
1.1 Background
China is the one of the fastest growing economies worldwide and the first choice for Taiwanese foreign direct investments. By the end of 2008, Taiwan invested $47.66 billion in China. Major industries between Taiwan and China have integrated or become horizontally and vertically connected. Nevertheless, no such integration exists in the banking industry because of regulatory and political issues.
After Taiwan and China joined the WTO (World Trade Organization) in 2001 and China promised open banking and insurance markets in 2006, major Western banks have invested shares in major Chinese state-owned banks (see details in Hong et al. 2009, and Kuan, Yang, and Huang, 2009). Taiwan banks may also grasp this opportunity to expand their business in China, whereas China can demonstrate its economic power in Taiwan by establishing its banking branches.
The promise of opening financial markets was fulfilled in the Memorandum of Understanding (MOU) and the Economic Cooperation Framework Agreement (ECFA) between Taiwan and China. The MOU was signed on November 16, 2009, and became valid on January 16, 2010. The MOU and ECFA further integrate financial markets between Taiwan and China. Within three to five years after ECFA and MOU, Taiwan and China will open their banking and insurance markets to each other to establish cross-border branches.
1.2 The Perspective of Banks from Taiwan
Banks in Taiwan have experienced intense competition for more than a decade. From 1990 to 2001, the number of banks increased from 24 to 53, and the return on equity was reduced by a margin of 29.28 % to 5.5 % (Lieu et al., 2005). Lin, Lin, and Mohanty (2009) studied 24 Taiwan publicly traded banks and found high cost efficiency to accompany low profit efficiency for the whole industry. Homogeneous products and price-cut competitions among banks may cause the reasons behind this phenomenon. These banks did not have strong markets outside of Taiwan, and most compete primarily in the Taiwan domestic market.
After opening its doors to banks in other countries, will China be an opportunity or a threat to Taiwan banks? Hong and Zheng (2009) compared and showed that Taiwanese bank branches in Mainland China profited more than their counterparts in Taiwan did. The opportunity for banks in Taiwan to expand to China may increase in the future. Lu et al. (2005) stated that Chinese banks are still in favor of lending loans to state-owned enterprises. Numerous small- and medium-sized businesses in China cannot obtain sufficient funding because of this biased policy, and rely on funds from underground finance or family borrowings for their capital investments and working capital. This could be the other market for Taiwan banks in China if Taiwan banks cooperate with experienced local players.
Banks in China will establish branches in Taiwan to serve more tourists and investors from China to Taiwan. Will China banks in Taiwan become a threat to Taiwan banks? Answering this question requires a discussion from China’s perspective.
1.3 The Perspective of Banks from China
Hsu (2008) compared financial reforms in China and those in Taiwan and concluded that the experience in Taiwan may help future banking development in China. Particularly after MOU and ECFA, the foreseeable cooperation of financial institutions and communications across the Taiwan Strait will become more convenient and less costly. Financial institutions such as credit unions in China may learn from Taiwan on reforms in local and underground finance. China may not learn this type of knowledge and practical experience from major foreign bankers.
1.4 The Structure of This Article
This paper reviews literature on commercial banking in China and Taiwan and analyzes strengths and weaknesses using two different approaches: 1) efficiency analysis and 2) strategic analysis. Efficiency analysis includes cost efficiency, profit efficiency, scale economy, and scope economy of the banking industry. The analysis is based on industrial organization tools. Strategic analysis incorporates the threat or opportunity for Taiwan banks, how they can face the “giant” Big Four in China, and where the benefit lies for this banking cooperation or integration. According to the above research and analysis, this work draws conclusions, addresses possible implications, and indicates directions for future studies.
The remainder of this paper is organized as follows. Section 2 analyzes the existing literature on scale economy, scope economy, efficiency, and productivity. Section 3 summarizes the strategic approaches of relationship banking, e-banking, and consumer banking. Section 4 reviews the history and literature of geographic integration of the banking industry in the US and Europe. Finally, Section 5 concludes the findings above.
2. Efficiency Analysis
This section explores the strengths and weakness of banks in China and Taiwan from an industrial organization perspective, mainly efficiency analysis. The concepts include scale economy, scope economy, cost and profit efficiencies, and information and communication technology (ICT) and productivity.
2.1 Scale Economy
The measure of scale economy indicates the existence of scale economy. The indicator used by Jagtiani et al. (1995) measures economy of scale. If a company operates at the level of increasing return to scale, this indicator is greater than one. If it operates at the constant return to scale or decreasing return to scale, the Jagtiani indicator is equal to or smaller than one. The existence of scale economy also means that as output increases, the average cost per unit of output decreases. That is, the more a bank produces, the more it saves per unit of output.
Traditionally, the output variables of commercial banking have included financial investments, demand deposits (if demand deposit is not available, use total deposits), and total loans, according to the intermediary approach. Following this tradition and the method of Jagtiani et al. (1995), Taiwan banks fall in the range of constant return to scale (Huang, Chen, and Chen, 2007; Huang , Chang, and Chiu, 2009; Lin, Lin, and Mohanty, 2009; and Fu and Heffernan, 2007). Lieu et al. (2008) found that Taiwan banks are in the range of increasing return to scale. Most researchers and practitioners observe no scale economy (that is, constant return to scale or decreasing return to scale) in the banking market in Taiwan. In other words, enlarging the size of a commercial bank does not lower the average cost.
2.2 Scope Economy
Willig (1979) estimated the scope economy for multiproduct firms. This methodology appropriately applies to the field of banking. Scope economy means that the wider variety of products a bank sells, the more it saves on the average cost per product. For instance, bank holding companies (or universal banking in the U.K.) that include both commercial banking and investment banking may enjoy a scope economy. The concept of “bankassurance” that incorporates or merges both banking products and insurance products into one financial institution is another example.
Based on the method of Willig (1979), the estimations by Lin and Lin (2009) and Lin, Lin and Mohanty, (2009), and Yao et al. (2007) support the existence of scope economy. Fu and Heffernan (2008) indicated that joint stock banks enjoy a higher scope economy. In practice, Taiwan’s second financial reform moved toward the bank holding company system to increase scope economy in banking.
2.3 Cost and Profit Efficiencies
This subsection discusses and summarizes the literature of cost and profit efficiencies in banking based upon Data Envelopment Analysis (DEA) or the stochastic frontier approach. Various methodologies are not the focal point; instead, only the insights and implications from the empirical literature are highlighted and compared.
Lin, Lin, and Mohanty (2009) indicated that Taiwan publicly traded banks were more cost-efficient than their Chinese counterparts before 2000. Taiwan banks were featured with higher transparency and better regulation than their Chinese counterparts. Kumbhakar and Wang (2007) found that joint-stock banks in China are more efficient and productive than state-owned ones.
Fu and Heffernan (2007) indicated that joint stock banks in China enjoy higher cost efficiency. Shen and Lu (2008) also posited that joint stock and city commercial banks in China are most profitable; and following Wu, Chen and Lin (2007), the return on assets for partial foreign-owned banks is higher. Yao, Jiang, and Feng (2007) stated that non-state banks were 8 to 18 % more efficient than state banks. Berger, Hasan, and Zhou (2008) estimated China bank efficiencies and found that the Big Four are the least profit-efficient, and foreign ownership significantly improves efficiency. In summary, although various papers have explored efficiencies from diverse angles, joint-stock banks are the most profitable or efficient among all types of banks.
Lieu et al. (2005) investigated cost efficiency and off-balance sheet activities and found that old banks have better accessibility to off-balance sheet transactions and thus their cost efficiency is higher. Liang et al. (2008) related non-performing loans to operational efficiency of banks in Taiwan. Lin, Lin, and Mohanty (2009) studied bank efficiencies from 1995 to 1999 and estimated higher cost efficiencies for old banks. Their findings indicated that newly established banks operated at a lower efficiency level than old banks did. The main reason why old banks in Taiwan operate efficiently is market monitoring. That is, most government-owned banks are partially publicly traded in the Taiwan Stock Exchange and become transparent to the market. Hence, they also make efforts toward minimizing cost (or maximizing profit) by following the market mechanism.
2.4 Information and Communication Technology and Productivity
The constant return to scale and the existence of scope economy in commercial banking may be ascribed to intensive use of information and communication technology (ICT). More than two decades ago, most bank information technology centered on the mainframe computer system. In a bank, the most common IT structure includes many terminals linking to a mainframe computer (a centralized computing system). A bank operating on this type of system may not own massive extra capacity to manage more transactions because all transactions rely on the main frame.
One personal computer can currently handle more transactions and difficult tasks than a mainframe of twenty years ago. A bank operating on this “distributional computation” system owns extra capacity to handle more products and transactions. The average cost per product or per unit of output is also extremely low. Therefore, the use of ICT and e-commerce models has shifted and reshaped cost and profit frontiers worldwide (Lin and Lin, 2009).
Banks in Taiwan and China have also transitioned to ICT systems. After decentralizing the ICT system and lowering the cost per computer, the ICT cost of a small bank may not differ from that of a big bank. The ICT system capacity for a bank has grown sufficiently to handle multi-product businesses easily. The computing system transition explains why there is no scale economy and justifies the existence of scope economy in Taiwan and China.
2.5 Summary and Implications
The literature review indicates that most studies conclude that there is no scale economy in China and Taiwan, but a scope economy. This implies that further development of multi-product businesses such as universal banking, bank holding companies, or “bankassurance” will help banks acquire more scope economy. Large size will not automatically reduce the average cost of bank outputs. The concept of “too-big-to-fail” is only a myth if a big bank does not own any strength other than its size. This coincides with the phenomena of the 1990’s economic downturn in Japan and the 2008-2009 financial crises in the U.S.
Minor foreign ownership helps enhance bank efficiency in China. According to the features of Taiwan banks such as governance, management, market monitoring, transparency, and comparatively solid regulation, Taiwan banks are foreign to China in practice. It is expected that Taiwan banks that enter the China market and acquire shares of China banks will improve cost efficiency of banks in China in future.
Even though Taiwan has gained higher efficiency, its strength is gradually fading after increasingly more Western and Japanese banks have entered the China market. Long-standing political issues have closed the door of cooperation between Taiwan and China for decades. This has led to delayed involvement of Taiwan in China’s financial markets following Taiwan’s long history of direct investment in China.
3. Strategic Analyses
This session includes various strategic analyses including e-banking, relationship banking, consumer banking and bank regulations.
3.1 E-Banking
China has more Internet users than any other country worldwide. As of 2009, 384 million persons use Internet in China, including some urban and rural labor workers. A large web population implies huge e-banking potential.
Taiwan development using Internet technologies and applying e-commerce models has preceded China, and is thus more advanced in e banking.
The demand for loans is strong and the supply is short in the loan market in China, particularly in regions where very few financial institutions can effectively outreach enterprises. In some rural areas, only agricultural credit unions exist and operate following government policies. Whenever the government tightens money supplies, limited funding flows to urban areas and fast growing rural or village enterprises suffer from insufficient funding. E-banking brokers in China try to match the asymmetric demand and supply of funds.