The development of commercial banks of China

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Background

The development of commercial banks of China

The banking system in China began from 1949 when People‟s Bank of China (PBOC) was established. Before 1978, the Chinese financial system followed a mono-bank system where banks were part of an executive agency. After then banking reforms had been the central subject in China‟s transformation from a command economy in to a market-oriented economy (Chen et al. 2005). There were three steps of the reform of banking system. First step was from 1979 to 1988, which focused on changing the structure and function of banking system, and PBOC released its functions into four specialized state-owned banks⁴ (Chen et al. 2005). In that period, PBOC changed its role to central bank, and a supervision organization. Second step was from 1988 to1994, which established three specialist policy banks ⁵. This reform aimed to separate the policy banks and commercial banks. The policies after 1994 can be regarded as the third step. During this period, marketization of commercial banks was gradually improved. With Central Bank law published at 1995, banking legislation was then in accord with the provisions of the Basel Committee on Banking Supervision (Chen et al. 2005). Chen et al. (2005) also point out that the separation between policy banks and commercial banks was far from complete commercial banks system of China that commercial banks had to followed policy from PBOC such as lending to the local government regardless of return.

 Interest rate liberalizing progress in China

China has already made substantial progress in liberalizing its financial markets, and it s interest rates in particular (Tarhan et al., 2009). The idea of interest marketization was proposed in 1993, but no progress had been made until 1995. In the year of 1996, interbank market was built and China interbank offered rate (Chibor) was opened. In the following year, government established interbank bond market, and liberalized interbank repo rate. In 2000, governments liberalized foreign lending rates, and in the year of 2004, ceiling on all lending rates has been removed. In the year of 2006, because of the subtle influence of Chibor to the financial market, the government opened the Shanghai interbank market and hoped Shanghai interbank offered rate (Shibor) can be the benchmark interest. The pricing mechanism of Shibor⁶ which is similar to the Libor, can help the internationalization progress of financial market in China, and develop the interest rate liberalization.
The liberalizing of interest rate was largely developed the banking system. Liberalizing the deposit rate allows banks an additional channel to compete for deposits, and therefore funds their lending operations (Tarhan et al., 2009). After the year 2007, the trading volume in interbank market grew sharply that interbank market trading volume of overnight interbank offered rate⁷ was 8030.5 billion Yuan in the year 2007, and this number in 2014 reached 29498.3 billion Yuan which was more than 3 times to the number in 2007⁸.

The role of Shibor

Benchmark interest plays a leading role in the interest rate system, which will not only influence the monetary policy, but also is the basis pricing elements in derivative products in financial market (Fang and Hua, 2009). It has been 9 years since Shibor was introduced by government for the first time. So many researchers in China pointed out that Shibor can be the benchmark interest in their study (Fang and Hua, 2009, Shi and Gao 2012, Peng and lu, 2010, Xiang and Li, 2014). However, there was a great debate in the literature on if Shibor can take the role of benchmark interest after 2007. The major topic of the debate was which rate (interbank offered rate or interbank repo rate) could be the benchmark rate in China. Figure 2.1 shows that the relationship of Shibor, Chibor and Repor that overnight Shibor and overnight Repor is influenced by each other, and change in overnight Shibor influenced the overnight Chibor, and overnight Chibor will not be influenced by overnight Repor. And 1 week Shibor will influence the both 1 week Repor and 1 week Chibor, and 1 week Repor independent of each other (Fang and Hua, 2009, Xiang and Li, 2014). Xiang and Li (2014) also pointed that the price of Shibor reflects the liquidity of financial market and quoted by 18 commercial banks, which are high level credit rating banks that consist of state owned commercial banks, joint -equity commercial banks, city banks and foreign commercial banks. PBOC (People‟s Bank of China) signed 1670 billion Swaps, based on Shibor in 2008. So Shibor gradually influenced the price of financial products, and other interest rates.

Theoretical framework

Interest risk is one of the relative market risks, which is measured by a benchmark interest rate index (Jorion, 2007). The recent growth of interest risk management industry can be traced back to 1970s, due to the increased volatility of financial markets (Jorion, 2007). Controlled by the governments, the volatility of interest rate was relatively stable before 1970s. Since then as the progress of interest rate liberalization, many researchers pay attention to the interest rate risk management. Interest rate risk plays a role whenever agents are choosing between assets of different maturities, and poses an important problem for banks that take in short-term funds and financial long-term investment (Martin Hellwig, 1993). Martin Hellwig (1993) also points out that interest rate risk is insufficiently diversified.
Regulator has responded to increasing financial disasters that required banks and other institutions to carry enough capital to provide a buffer against unexpected losses (Jorion, 2007). The landmark Basel Capital Accord of 1988 was the first step to banks risk measurement, but it was only against credit risk, not concerned about other financial risks such as market risk, liquidity risk and operational risk. This agreement then was modified and amended to includ the market risks-interest risk in 1996. The Basel Ⅱ Accord was finalized in 2004 and implemented in 2006, which minimized the capital requirements with the regulation for at least 8% of capital in risk-weighted assets, expanded role for bank regulators, and emphasized market discipline which helped the banks to enhance their business safety and encouraged banks to publish information about their exposure risks.

Interest rate “gap” management

Mark and Chiristiopher (1984) invented a model to measure the bank interest rate sensitivity and they found that cross-sectional variation in the interest rate sensitivity measure is significantly related to the maturity mismatch of the bank assets and liabilities. In the year of 1985, Brewer introduced the interest “gap” management in which the interest income is less than interest expense, to unexpected changes in market interest rates. Banks have recognized the importance of gap management in reducing interest rate risk, achieving acceptable bank performance, and controlling size of gaps is an important function of bank funds management, and he found that the size of the gap has a major impact on the volatility (Brewer, 1985). But interest “gap” management only concerns the value in the balance sheets and ignore the change of value over time, so researchers measured many other methods and regarded interest “gap” management basic assistant method.

Duration method

Macaulay (1938)⁹ first introduced duration method to deal with the relationship between the fixed income portfolio and the interest rate in order to measure the sensitivity of risk value of portfolio to interest rate volatility. Regardless restrictions in Macaulay duration method, researchers improved the duration method in the following years. Brewer (1985) compared different methods of interest “gap” management to found out that duration gap model is more efficient than other gap models. The difference between duration analysis and modified duration analysis is that the duration of a financial instrument is the weighted average matured of the instrument‟s total cash flow in present value terms, and modified duration can be viewed as an elasticity that estimates the percentage change in the value of an instrument for each percentage point change in market interest rates (Houpt and Embersit, 1991). Gloria (2004) pointed out that the current research on duration models offer of a succession of new models that generally use the traditional model as the only benchmark, and he tested if there are significant differences between the models. He gives the suggestion that it will get a better result when risk factors are less than three.

VaR methods

Jorion (2007) gave the definition of VaR: VaR summarized the worst loss over a target horizon that will not be exceeded with a given level of confidence. VaR method can be traced back to Markowitz‟s (1952) and in 1993, the report of G-30¹⁰ “Derivatives: Practices and principles” first access financial risks with VaR. J.P Morgan ¹¹ introducing RiskMetrics which is a new risk management system to calculate market risks. Basel Commission allowed banks to use VaR method to calculate the risk in 1994. The potential for gains and losses can attribute to two sources, one is exposures and the other is the movements in the risk factors (Jorion, 2007). There are many approaches of VaR to measure the market index risk, and each of them has their advantage and disadvantages.

Acknowledgements
Abstract 
1 Introduction 
1.1 Purpose
1.2 Research questions
1.3 Method
2 Background 
2.1 The development of commercial banks of China
2.2 Interest rate liberalizing progress in China
2.3 The role of Shibor
3 Theoretical framework 
3.1 Interest rate “gap” management
3.2 Duration method
3.3 VaR methods
4 Empirical framework 
4.1 Parameter VaR
4.2 Models measuring for conditional variance
4.3 Forecast VaR model
4.4 The residual distribution
4.5 Back-testing of VaR
4.6 Data description
4.7 Methodology
5 Diagnostic tests .
5.1 Normality test
5.2 Stationary test
5.3 Autocorrelation test
5.4 Conditional heteroscedasticity test
6 Empirical result 
6.1 Result of GARCH family models
6.2 Result of VaR
6.3 Forecast VaR.
7 Conclusion 
References
Appendix
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Interest risk in Inter-bank market in China based on VaR model