Introduction/Background
In 1912, the Bank of China (BOC) became the country’s central bank. By 2006, it was listed on the Hong Kong stock exchange and the Shanghai stock exchange, becoming the first central bank to do so. Central Huijin Investment Limited is the major shareholder of the bank, owning 67 percent. This company is in turn owned by the People’s Republic of China. BOC has substantial overseas operations in places such as Hong Kong, New York and London. BOC is governed by a Board of Directors consisting of 15 people. BOC is one of the Big Four state owned commercial banks and does not receive hardly any competition outside of these other three banks, but does have a high threat of fraud due to poor risk controls. In China, financial development is led by economic growth, and bank loans have had very little effect on this growth. BOC stays in business because it is run by the government, which will not let it fail. In 2001, the BOC was subjected to greater transparency and greater foreign competition due to China’s decision to join the World Trade Organization (WTO). These new requirements uncovered many instances of fraud that have been previously undiscovered.
One of these fraud schemes was led by Xu Chaofan, a former branch manager, who stole over $400 million from the bank. He also worked with two other managers to steal an additional $80 million after he became a regional manager. The group set up fake companies to invest in BOC and hide the stolen funds. Some money was used to buy apartments for the perpetrators, while the rest was invested in a variety of financial instruments. These large transfers went unnoticed because of poor supervision, non-performing loans and accounting gimmicks. When better controlled audits became required by the WTO, the fraud was discovered and the thieves fled the country.
As mentioned, one of the main contributors to this fraudulent activity was the rise of non-performing loans. A non-performing loan is loan that is in default, or close to being in default, which means that the legal obligations of the loan cannot be met. State-owned banks were under tight control of government, which allowed for large amounts of lending to occur before China joined the WTO. Much of this lending was defaulted on and non-performing loans made up about 25% of all loans by state-owned banks. Private-owned banks were not as liberal with lending, so non-performing loans were not nearly as big of a problem for these banks (Schneider, 2013).
Several techniques can be used to reduce the amount of non-performing loans that must be reported by the BOC. In the late 1990s, the Chinese government chose to create four asset management companies to accept these loans from the banks. The asset management companies would then translate the non-performing loans into assets that could be sold to investors. By turning the loans into assets, there was no obligation to the Chinese government to report non-performing loans as well as no risk that the government would lose money by giving out loans that it knew it might not receive back (IFLR, 2003).
Another viable technique that the Chinese government could have used would have been to proactively investigate any potential factors that might cause a loan to become non-performing. China has not created an individual credit system that it could use to analyze the probability that a loan will be repaid, but it can use several other criteria, including academic degrees, jobs, titles, and housing conditions to assess the likelihood of repayment (IFLR, 2003).
The bank could have also required that the borrowers submit regular financial information to provide assurance that he or she is still in good standing. If the bank feels that the person’s financial situation is weakening, it could have required that the loan be repaid immediately. If these intermediate checks are not successful in detecting a possible inability to repay the loan and the