Lessons in lending

Lending losses in China highlight the need to improve credit, fraud and money-laundering risk management, which are receiving increasing attention from regulators, says Rohan Bedi

While banks and regulators in China are making moves to fight corruption and fraud in the country's financial markets, it is a slow and difficult process. Some changes have been made - the bankruptcy law passed in August is one example - but the widespread nature of the problem means improvements will not happen overnight.

China is the world's second largest bad loan market after Japan - in 2005, rating agency Standard & Poor's estimated that there was around $700 billion in bad loans in the country. Consumer loans are increasing in importance and accounted for some 10% of all outstanding bank loans in early 2005, of which mortgages represent 90%. On the face of it, non-performing residential mortgages do not seem to be a problem area and stood at 1.5% as of the end of 2005, as compared to the total industry problem loan ratio for China of 8.6%. However, recent mortgage lending scams have proved that this may be a deceptively low figure.

China is slowly addressing the significant issues of flawed credit-approval processes and lax risk controls - including the need for skilled and experienced staff in key lending and review positions - but the size and spread of the banking sector is a major impediment. The banking sector supervisor, the China Bank Regulatory Commission (CBRC), is making a strong effort to improve corporate governance and internal controls in banks. Recent fraud revelations show that better auditing and management reforms are helping detect fraud. Greater discretion in lending has been granted to introduce risk-based lending. The CBRC takes a positive approach to the development of credit derivatives and is encouraging banks to develop more risk-transfer and hedging tools.

Lending in China is percceptibly fraught with the risks of poor credit, fraud risk and the potential for money laundering. It is important to understand the historical context of lending in China. Historically, the 'big four' banks - the Industrial & Commercial Bank of China (ICBC), China Construction Bank (CCB), Bank of China (BoC) and Agricultural Bank of China - were used to implement government development policy and had little or no control over their borrowers or loan terms. The government approved borrowers and set identical loan rates for every borrower, regardless of risk. Hence, for decades, there was no market-orientated lending approach - credit analysis and risk management were not necessary and thus not performed. However, the fact that ICBC and BoC are now public companies should encourage a stricter approach for them.

Lending fraud also must be seen in the context of the perceivably corrupt lending climate. The country ranks 78th of 158 in anti-corruption organisation Transparency International's (TI) Corruption Perceptions Index in 2005, with a rank of 1 being the least corrupt. Similarly, TI's Bribe Payers' Index for 2006 highlights that Chinese exporters are perceived to be bribing abroad: China is the world's fourth largest exporter and ranks second to worst in the list of 30 countries.

Corruption also appears to be a problem among the big four banks. In 2005, 18,000 BoC employees and 40,000 CCB employees were disciplined for misappropriating funds and making unauthorised loans. Many senior executives were also involved, including the chairman of one of the banks, who was jailed.

Moreover, corruption in the Chinese judicial system causes problems in the enforcement of contracts and of legal judgments; reportedly, just 30-60% of judgments are enforced. Most unexecuted judgments are for either bank loan defaults or real estate judgments.

Beyond corruption

Lending in China has problems in addition to corruption, specifically with regard to mortgage fraud and money laundering. These include: property valuations are not as precise as in Hong Kong; it is generally difficult to prove collusion or overvaluation, making prosecution difficult; institutional obstacles and rivalries between financial and law-enforcement authorities continue to hamper financial law enforcement; and from a money-laundering perspective, the widespread use of cash in financial transactions and in deposits into bank accounts, creates vulnerabilities.

This is all changing slowly. Recent initiatives to control, for example, mortgage fraud include requirements to deposit property ownership certificates and the launch of a national credit-information system (covering individuals and corporate entities) in January - previously only Shanghai had a good database. However, reports suggest that data is not updated in a timely manner.

A new bankruptcy law passed in August will give creditors greater protection if a firm is bankrupt and will improve foreclosures, to an extent. Chinese banks are also strengthening management and cleaning up bad loans. The central bank now requires banks to make timely announcement of financial irregularities in order to tighten surveillance. The big four are looking at or actually adopting foreign banking procedures, including appointing loan-approval committees for important decisions to rein in top managers.

It is critical that confidence in the Chinese banking system is not eroded. Given the scale of the problem, regulators must strengthen conventional audit and independent review mechanisms first and also quickly move beyond these to adopt global best practices. Clearly, stronger controls on credit, fraud and money laundering are essential for controlling direct lending losses and also potential lending losses owing to asset forfeitures of criminal monies. Moreover, banks in China will face increased foreign competition from December, as required by China's accession to the World Trade Organisation. Eventually, China must adopt the Basel II capital adequacy framework, even if in a phased manner. This will undoubtedly add pressure on banks to introduce sound risk management systems.

Rohan Bedi is author of 'Money Laundering Controls and Prevention', published by PricewaterhouseCoopers Singapore, and senior anti-money-laundering implementation manager at an international bank. Website: www.rohanbedi.com. The opinions in this article are the author's own and do not represent the organisations he works for and is/was associated with.

Reference: US Federal Deposit Insurance Corp article, Nov 17, 2005 on China.

PRIORITIES FOR REFORM

Banks: Banks in China need to establish a comprehensive approach with regard to credit, fraud and money-laundering risk, beyond the basics of an effective organisation structure/segregation of duties.

Credit risk

- Specifically, for managing credit risk, new products launched in China (in Chinese), such as Moody's RiskAnalyst, enable lenders to make lending decisions using internal ratings and analysis of financial statement data based on International Financial Reporting Standards. Technologies such as this need to be adopted.

- Basel II aims to encourage the use of modern risk management techniques and systems in order to better manage risks. This will involve the collection and processing of a significant amount of historical-loss data and the ability to use advanced analytical models to assess and predict risks based on such data. This will also involve collecting and storing data on rating decisions, the rating history of borrowers and the probabilities of defaults associated with rating grades and ratings migration, in order to track the predictive power of the rating system.

- Rating agency Standard & Poor's says it is not just about software and modelling, but also about people knowing the business.

- Weaknesses in bank operating data on loans need to be addressed.

- Information sharing between branches and banks on bad loans needs looking at.

Mortgage fraud

- An effective programme that uses technology and databases is essential to check for documentation fraud.

- Stolen identities are used to deceive lenders into believing that mortgage loans are of good credit quality. Best practice is that a good identity theft detection programme incorporating technology is in place.

- From a more macro perspective, the reduction of paper-based account statements and cheques - and the proper development of secured online payments capabilities - will also reduce the potential for identity theft. The risk of phishing scams - identity theft through fake websites - will need separate management.

- Given the perceptibly widespread corruption in Chinese banks, controls on insider loan fraud are critical. Such controls would include: a comprehensive code of conduct, properly communicated and secure whistleblowing channels, proactive employment practices and an independent loan-review system.

- Proactive employment practices include comprehensive background checks and ongoing monitoring/detection.

- A know-your-third-party programme is key for establishing criteria to appoint and/or screen third parties - such as brokers, appraisers and lawyers - and periodically evaluate them. It should ensure the appraiser is independent of the borrowers and the brokers.

- Detailed monitoring procedures covering third-party fraud should cover the various stages of a loan application.

Anti-money laundering

- For anti-money-laundering (AML) purposes, the following are important: identification of beneficial ownership; monitoring of monies coming into and out of an account and for mortgages - the ownership history of a property and sales of a mortgaged property to offshore companies.

Training

- Also critical are credit, anti-fraud and AML training and an awareness programme, including a focus on the fact that loans serviced on time and which appear good could hide a money-laundering scam.

Regulators and industry bodies: Regulators and industry bodies should push banks to adopt the latest credit, anti-fraud and AML technology. Given the significant insider angle in fraud in China, supervisors must emphasise the importance of internal controls, internal audit and the creation of a culture that does not allow nepotism, nor exempts any person from the controls. Chinese authorities must also create better public records of 'bad guys' to ensure that searches of customer, third-party and employee names are meaningful.

The issue of poor business transparency - such as on adoption of international accounting standards by non-listed companies - also needs to be addressed.

Regulators and industry bodies must ensure that banks share information on material misrepresentation in mortgage loan applications. In the US, the US Mortgage Asset Research Institute offers such an industry service. Since fast-rising property values and low lending rates are a recipe for scams - as price rises can cover fraudulently inflated appraisals - regulators must also ensure banks have adequate data available for automated valuation models. These models seek to validate a property's value as determined by the appraiser and check for fraud red flags.

More broadly, creating an effective credit infrastructure and eradication of corruption in the judicial and banking systems are critical. China's 2006 AML bill takes effect on January 1 and includes corruption and financial fraud as predicate crimes for money laundering and reportedly spreads coverage beyond banks to law firms, accounting agents and businesses such as real estate.