will often be social relationships as well, such as higher rates. If the pessimists are right, banks school connections could have serious problems as their net interest margins become squeezed. This could lead them, Direct government or Party influence. Some- like some Savings Loans in the US in the 1970s times an influential official will strongly urge a and 1980s, to take unreasonable risks to restore an loan to be made, essentially circumventing nor- acceptable level of profitability. It could also lead mal credit procedures. This is apparently less com- to a slowdown in loan growth, as banks'inter mon than in the past, and there is more likelihood nal capital generation slows and external capital of resistance, but it certainly still occurs today to sources find the banking industry less attractive. an extent that is hard to quantify. One reason it is hard to measure is because there are legal lim- Optimists believe the large banks will be consid on how strongly one can push a loan officer to erably more flexible and intelligent in their re make a specific loan, intended precisely to reduce sponses, and that the government and Party will the extent to which such pressure is exerted sensibly manage the process of change with an eye towards avoiding these potential problems Government and party leaders have recognized that it is too easy for large SOE's to acquire loans Bond markets are another source of credit fo and too hard for many smaller, purely private companies, particularly larger firms. However, firms to compete. As a result, leaders are encor the Chinese corporate bond market is smaller aging the banking sector to lend more to smaller and less sophisticated than in the US and Europe, firms and have also become more open to other and at present the banks are the largest holders avenues of credit provision, such as the informal of these corporate bonds. But, the corporate bond sector. One of the analytical debates about China market is growing rapidly. Net issuance of corpo is the extent to which the large banks will be able rate bonds increased by 65% in 2012, according to to change their behavior toward smaller firms. On the PBOC's figures on the size of various compo the one hand, Chinas leaders have proven adept nents of finance, and now represents about 16% of over the years at generating the changes that they net new credit. In addition to serving as compe wish to see. On the other hand, it is not clear that tion to the banks, and an alternative way for them the key incentives described above will change. to invest, the development of the corporate bond Some analysts also believe that the big banks sim- market may also take some pressure off the banks ply do not have the culture and systems necessary to act as a quasi-fiscal arm of the government. to lend successfully to small, private firms Chinese stock markets provide another source of There is also much analytical debate about the funding for businesses. However, there are sev sources of bank profit. Pessimists contend that the eral problems that hold these markets back from large banks are fat and happy, benefitting from a reaching their full potential. First, the markets combination of a ceiling on interest rates for de- are dominated by speculators to a far greater ex- posits, (their main source of funding), and credit tent than in Western nations. There are multiple quotas set by the Chinese central bank, which al- reasons for this, the most fundamental of which low banks to charge higher lending rates for those is that Chinese law, regulation and governance loans they do make. These government interest patterns considerably constrain the control that rates and credit quotas are becoming increasingly shareholders can exercise over management. and may even disappear, over time. Even These problems are now,they can be circumvented in various ways, publicly traded firms where the government owns such as through the use of certain"wealth man- a majority stake. Lacking the ability to influence gement"products that are deposit-like, but pay business choices and dividend levels, or to sell the The Chinese Financial System: An Introduction and Overview JOHN L. THORNTON CHINA CENTER AT BROOKINGSThe Chinese Financial System: An Introduction and Overview John L. Thornton China Center at BROOKINGS 4 will often be social relationships as well, such as school connections. Direct government or Party influence. Some￾times an influential official will strongly urge a loan to be made, essentially circumventing nor￾mal credit procedures. This is apparently less com￾mon than in the past, and there is more likelihood of resistance, but it certainly still occurs today to an extent that is hard to quantify. One reason it is hard to measure is because there are legal lim￾its on how strongly one can push a loan officer to make a specific loan, intended precisely to reduce the extent to which such pressure is exerted. Government and party leaders have recognized that it is too easy for large SOE’s to acquire loans and too hard for many smaller, purely private firms to compete. As a result, leaders are encour￾aging the banking sector to lend more to smaller firms and have also become more open to other avenues of credit provision, such as the informal sector. One of the analytical debates about China is the extent to which the large banks will be able to change their behavior toward smaller firms. On the one hand, China’s leaders have proven adept over the years at generating the changes that they wish to see. On the other hand, it is not clear that the key incentives described above will change. Some analysts also believe that the big banks sim￾ply do not have the culture and systems necessary to lend successfully to small, private firms. There is also much analytical debate about the sources of bank profit. Pessimists contend that the large banks are fat and happy, benefitting from a combination of a ceiling on interest rates for de￾posits, (their main source of funding), and credit quotas set by the Chinese central bank, which al￾low banks to charge higher lending rates for those loans they do make. These government interest rates and credit quotas are becoming increasingly flexible, and may even disappear, over time. Even now, they can be circumvented in various ways, such as through the use of certain “wealth man￾agement” products that are deposit-like, but pay higher rates. If the pessimists are right, banks could have serious problems as their net interest margins become squeezed. This could lead them, like some Savings & Loans in the US in the 1970s and 1980s, to take unreasonable risks to restore an acceptable level of profitability. It could also lead to a slowdown in loan growth, as banks’ inter￾nal capital generation slows and external capital sources find the banking industry less attractive. Optimists believe the large banks will be consid￾erably more flexible and intelligent in their re￾sponses, and that the government and Party will sensibly manage the process of change with an eye towards avoiding these potential problems. Bond markets are another source of credit for companies, particularly larger firms. However, the Chinese corporate bond market is smaller and less sophisticated than in the US and Europe, and at present the banks are the largest holders of these corporate bonds. But, the corporate bond market is growing rapidly. Net issuance of corpo￾rate bonds increased by 65% in 2012, according to the PBOC’s figures on the size of various compo￾nents of finance, and now represents about 16% of net new credit.4 In addition to serving as competi￾tion to the banks, and an alternative way for them to invest, the development of the corporate bond market may also take some pressure off the banks to act as a quasi-fiscal arm of the government. Chinese stock markets provide another source of funding for businesses. However, there are sev￾eral problems that hold these markets back from reaching their full potential. First, the markets are dominated by speculators to a far greater ex￾tent than in Western nations. There are multiple reasons for this, the most fundamental of which is that Chinese law, regulation and governance patterns considerably constrain the control that shareholders can exercise over management. These problems are exacerbated for the many publicly traded firms where the government owns a majority stake. Lacking the ability to influence business choices and dividend levels, or to sell the