China's Banking Strategic Transformation Empirical Research

Around 2005, many Chinese banks announced transformation plans to change their original capital-consuming business model. This paper investigates the transformation process and the associated performance effect with bank-level data over the period of 2001-2008. I employ five accounting-based variables to measure the transformation activities, i.e. functional diversification, retail banking business, and risk management capability. I find that all the variables of interest, except the LLP-to-asset ratio, move in the predicted direction, i.e. higher non-interest income share, lower loan-to-asset ratio, heavier retail banking intensity, and better risk management capability. The LLP-to-asset ratio would have moved downward if Chinese banks did not change their provision recognition policy. These developments hold for both the overall sample and the sub-samples by bank ownership, and it is evident that Chinese lenders have implemented their transformation plans.Regression analysis is then performed to investigate the relationship between bank performance and transformation activities. First, I find a significantly negative relationship between profitability and functional diversification intensity. Non-interest activities may generate revenue with less regulatory capital, but the evidence suggests that it is a less profitable business. Second, higher retail loan ratio is found to be significantly associated with higher bank returns. Possible explanations for the positive relationship are better utilization of branch network and regulatory capital arbitrage. Finally, there is significant evidence showing that risk management capability is positively associated with bank profitability.