The smaller banks, all based in East China, plan to map out a road to turning their marginal loss-yielding financial institutions into an efficient larger financial institution.

Under a long-planned deal, the 17 city commercial banks - headquartered in 17 prefectural cities in the East China provinces of Anhui, Henan, Jiangsu and Shandong - will be reshaped into a large bank called the Huaihai Bank over three to four years.

Lu Minfeng, president of the Huai'an City Commercial Bank, told Business Weekly late last week that "the merger will be implemented gradually, beginning from business co-operation and resulting in restructuring."

Lu's bank is based in Jiangsu Province and has 2.6 billion yuan (US$314 million) in assets.

A public flotation on the stock market is also being considered after the complete restructuring and many market watchers see a listing as the best way to shore up competitiveness in a tough market.

The proposed Huaihai Bank would have 40 billion yuan (US$4.8 billion) in assets, much more than the de facto threshold of 10 billion yuan (US$1.2 billion) required by the China Securities Regulatory Commission for a bank's IPO (initial public offering) .

As one of the major initiators of the plan, Lu told Business Weekly that the move would make the 17 banks front runners ahead of dozens of their counterparts in hinterland areas to shore up their competitiveness following China's World Trade Organization entry last December.

"We believe that cross-(provincial) border line-ups are the most practical way for us to better survive in the market and enhance our performance," said Lu.

The Chinese mainland is currently home to 111 city commercial banks but most of them do not make a profit and struggle to survive in a fierce market dogged by limited size, backward technology and poor management.

However, on the other side of the coin is the possibility of launching more city banks in smaller cities to cope with the rapidly growing demand for finance on the part of China's ever more numerous small companies.

Justine Lin, a renowned economic expert at Peking University, said: "Smaller banks should play a major role in financing the growth of China's small and medium-sized firms in the future."

The restructuring of smaller banks has become another major issue facing the industry's watchdog as it tries to iron out possible financial risks but most of the securities commission's efforts are currently concentrated on reform of the giant banks, billed as the backbone of China's banking system.

"We believe that there are solid bases to back up the planned merger," Lu told Business Weekly, referring to the smaller banks' geographical and cultural proximity and similar size and asset quality.

Most of the 17 smaller banks have good-quality assets.

"The merger will cover eight to 10 companies first and then be expanded to all the 17," said Lu.

He said the initial stage of co-operation will help the firms share resources, lower their costs and improve efficiency.

A few city commercial banks in coastal areas and hub cities have already linked up with foreign rivals through stake takeovers, a step that could prop up their position in the market.

These smaller banks include the Nanjing City Commercial Bank and Xi'an City Commercial Bank. A prime example is the Bank of Shanghai, a front runner in China's financial reform The Hongkong and Shanghai Banking Corp, the International Financial Corp and Shanghai Commercial Bank - all overseas-based banks - bought a combined 18 per cent stake in it.

Despite being under different administrative control in the four provinces, the 17 banks are very similar in asset quality, services offered, management expertise and cultural background.

"We have gathered twice to discuss the plan and a consensus has built up that the marriage is the best way for us to survive against the fierce competition," said Lu, adding that a detailed plan will be drafted by the end of the year.

"But, currently, the plan has not been forwarded to the central bank for approval," added Lu. However, he said he is very optimistic that the People's Bank of China will encourage such a merger given that the central bank has already mapped out many policies to spur the reform of the Chinese banking sector.

"The new bank will be a big step for China to reshape its marginal smaller financial institutions in the inner regions," said Lu.

Smaller banks are designed to finance the country's millions of emerging small and medium-sized companies.

Lai Xiaofeng, director of the Banking Supervision Department with the People's Bank of China, told a high-profile seminar held in Tianjin by the People's Bank of China on the development of city commercial banks in late September that the country encourages smaller commercial banks to strengthen their co-operation in various ways, including capital restructuring and mergers of branches and other outlets.

"But the marriages will be market-oriented voluntary reform rather than government-dominated matchmaking games," said Lai, who also vowed that the central government will take action to help smaller banks in general reduce their non-performing assets to below 10 per cent within five years.

According to the central bank's rules, 15 per cent of the smaller banks' stakes can be sold to foreign partners. Chinese institutional investors can buy the same percentage stake but the ceiling is 5 per cent for Chinese private investors.

China's commercial banking system is currently composed of four major groups of institutions - four State-owned large commercial banks, 10 shareholding banks, 111 city commercial banks and over 3,000 urban and rural credit co-operatives.

But, dogged by limited size and funding, most of the 111 city commercial banks are loss-yielding or on the brink of bankruptcy as most of them have a capital adequacy ratio that is under the 8 per cent internationally accepted warning level.

With total assets of 964.5 billion yuan (US$116.5 billion), city commercial banks accounts for less than 6 per cent of the country's total bank assets, dominated by the "Big Four" State-owned banks.

However, many market watchers do not share Lu's optimism about the planned merger.

Pressure will come from local governments.

Many of the smaller banks are not run like Western-style companies according to a profit-driven model but are seen by the local governments as sources of finance for State firms.

(Business Weekly November 26, 2002)