How Tomorrow Group's Baoshang Bank Failed
Head of takeover team and senior Chinese central bank official published an exhaustive account with damning details.
On May 24, 2019, China’s banking regulators announced a takeover of the lender Baoshang Bank, its first such move in 20 years. The takeover, due to what the People's Bank of China described as the bank having been used as an “ATM” with “serious credit risks”, sent shock waves across China's banking system - borrowing costs rocketing overnight, forcing the PBOC to inject up to 200 billion yuan in liquidity, private estimates quoted by Reuters showed.
Baoshang, based in the small but resource-rich city of Baotou, Inner Mongolia, was also part of the financial empire of the mysterious Tomorrow Group, which only added to outside interest.
Over a year later, Zhou Xuedong, a senior official with the Chinese central bank and head of the takeover team at Baoshang, published a 5,000-character article in a magazine of the central bank that is also available on the central bank’s official account on WeChat, revealing details around the takeover and lessons to be learned from Baoshang's failure.
The article is newsworthy in a number of ways. Firstly, it is an authoritative, exclusive revelation of the exact troubles at Baoshang and how it came into a problem. Secondly, its ruthless exposé with some detailed numbers was really something to read. Thirdly, it sheds rare light on the workings of Tomorrow Group - still a source of interest and mystery for many. Fourthly, Zhou's analysis and reflections offer a unique window into how China's central bank looks at and deals with a bank failure at a time of increasing financial volatility including defaults.
Below is a translation of Zhou’s article - not a verbatim one - with some minor editing and explanations. The few <> are mine, as some of the terms are quite technical. The highlights in bold are also mine.
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中小银行金融风险主要源于公司治理失灵——从接管包商银行看中小银行公司治理的关键
作者｜周学东「包商银行接管组组长」
Financial risks of small and medium-sized banks mainly stem from corporate governance failures: key reflections from the takeover of Baoshang Bank
By Zhou Xuedong, Head of Takeover Team at Baoshang Bank
On May 24, 2019, Baoshang Bank was jointly taken over by the People's Bank of China (PBOC) and the China Banking and Insurance Regulatory Commission (CBIRC) due to serious credit risks. This is a major event in the history of China's financial development, which reflects a bitter lesson of corporate governance failure and should act as a wake-up call. The root cause behind the risks of many small and medium-sized banks lies in the failure of corporate governance, as well as the related financial corruption and crimes.
In December 2015, Baoshang Bank said in a disclosure associated with a debt issuance that, as of June 30, 2015, it had a "non-performing loan ratio of 1.60%, a provisioning coverage ratio <ratio of provisioning to gross non-performing assets, indicating the extent of funds a bank has kept aside to cover loan losses> of 168.86%, a capital adequacy ratio <a percentage of a bank's capital to its risk> of 10.82%," and "equity of $24.3 billion”.
However, only a year and a half later, when in May 2017 a special task force began to explore the cases related to the Tomorrow Group, it was found that the majority shareholder <Tomorrow Group> of Baoshang Bank had appropriated from the bank a cumulative total of 150 billion yuan since 2005, upon which the annual interest was much as ten billion yuan.
The majority shareholder has consistently failed to pay both the interest and the principle, and the severity of insolvency was beyond imagination! It is inconceivable where the key metrics disclosed in the disclosure above came from! For the next two years (since May 2017), Tomorrow Group and Bashing Bank exhausted all means to save the bank and raised funds to prevent a bank run, until it was taken over in May 2019.
After that, the takeover team dealt with the financial risks in accordance with market principles and rule of law. Funded by China’s Deposit Insurance Fund, the takeover team gave ample protection to the legitimate rights and interests of all creditors, especially the nearly 5 million depositors, 200,000 customers in personal wealth management, and 30,000 small and medium-sized enterprises. The takeover always adhered to the prevention of moral hazard, resolutely break the "rigid payment" and the “faith in license” <both of which refer to the widely-assumed implicit guarantee by the Chinese authorities at the last resort>.
In June 2019, in order to get all the facts in Baoshang, the takeover team hired third-party professional services to thoroughly investigate its assets and liabilities. The result confirmed the existence of a huge insolvency risk - without the rescue of public funds, the general creditors would each only have been able to get 500,000 yuan from the bank.
In September 2019, the reform and restructuring of Baoshang Bank were officially launched, but the market-based restructuring could not proceed due to the huge loss and a lack of investor participation. In order to ensure Baoshang's financial services would not be interrupted, the takeover team drew from international experience and practices, and, based on existing domestic rules, decided to set up a new bank to acquire and take over Baoshang Bank.
On April 30, 2020, Mengshang Bank was officially established and opened for business. On the same day, the takeover team of Baoshang Bank announced that Baoshang Bank would transfer its relevant business, assets, and liabilities to Monshang Bank and Huishang Bank (which took over Baoshang’s 4 branches outside Inner Mongolia) respectively. China's Deposit Insurance Fund provided financial support to Mengshang Bank and Huishang Bank, to share the impairment losses of Baoshang and facilitate the takeover, as well as ensure the continuous operation of Baoshang's financial services.
Baoshang's risks are rooted in the overall failure of its corporate governance - the most striking feature being it has everything that a corporate governance structure demands - shareholders‘ meetings, a Board of Directors, a Supervisory Board, the Management, and all the rules and regulations. However, in reality, that’s only in form, and two major problems in corporate governance remain in Baoshang: "majority shareholder control" and "insider control" at the same time. Those, coupled with local "regulatory capture" and corruption, led to dysfunctional corporate governance and provided breeding ground and lenient environment for all kinds of illegal and fraudulent behavior.
The leadership of the Communist Party of China in Baoshang is lacking, with the person in charge of the Party Committee of Baoshang becoming subordinate to the majority shareholder and evolving into an insider controller and the role of the Party Committee and its discipline watchdog seriously weakened to a showpiece.
Formerly known as Baotou Commercial Bank, which was established in 1998, it was renamed as Baoshang Bank in 2007. The bank then set up four out-of-region branches in Beijing, Shenzhen, Chengdu, and Ningbo from 2008 to 2011 under rapid expansion. Li Zhenxi served as the head of the bank since 2002, and as Secretary of the Party Committee and Chairman of the Board since 2008. - 11 years until 2019, when Baoshang Bank was taken over.
According to multiple reports to the takeover team, in a considerable period of time before the takeover, Baoshang was basically run by Li alone, despite that Li since 2014 no longer served as Party secretary. Li practically commanded every major organization within the bank, becoming the de facto insider controller and an agent of the majority shareholder.
The takeover team found that for a long time, the Baoshang Bank's Party Committee was virtually non-existent, and the so-called "core role of the Party" <the standard requirement in China> had long been replaced by the "core role of the Chairman of the Board". For example, Baoshang's major decision-making didn't need to go through the Party Committee’s collective discussion <as Chinese rules require>. The disciplinary watchdog of the Party Committee was also dysfunctional.
The major shareholder of Baoshang manipulated the shareholders' meeting, interfered with the bank's normal operation, and engaged in tunneling <transferring resources out of the bank for its own benefit>.
Due to the domination of Tomorrow Group among shareholders, Baoshang's shareholders' meeting was just a farce. There are 79 institutional shareholders of Baoshang Bank which collectively holds 97.05% of all shares, in which 35 institutional shareholders with 89.27% of all shares clearly belonging to Tomorrow Group. Due to the concentration of the shares, it is easy for the major shareholder to manipulate shareholders’ meeting. Since 2005, Tomorrow Group, through many related-party transactions, guarantees, and appropriation of funds, has been severely encroaching on the bank. In the 15 years from 2005 to 2019, Tomorrow Group, through 347 loans by 209 newly-resisted shell companies, appropriated 156 billion yuan from Baoshang, and all of them became non-performing loans.
The Board of Directors was in form only, lacking a comprehensive and effective risk management system. The risk management and control function simply failed, as everything was decided by the Chairman of the Board personally.
For a long time, the Board of Directors of Baoshang has been virtually non-existent and the operation mechanism of the Board has been a mere decoration. There was a culture of zero risk control and non-compliance. Although Baoshang's Board of Directors set up nine special committees, since 2011, Baoshang made inappropriate decisions on related-party transactions through the Related-Party Transaction Control Committee, Business Operations Committee, and other committees. The Board became complicit and conducive to Tomorrow Group's tunneling. A significant number of the Board's 13 directors listed in the December 2015 disclosure did not take part in decision making, nor did they object to major inappropriate decisions, and some of them were willingly “bought”.
As for the Risk Management Committee established under the Board, it did not substantially exercise its duties, and the various risk control positions existed in name only, with no internal control constraints from top to bottom, and the functions of the risk management department were completely weakened.
The various departments of Baoshang often used the confidentiality of its business information as an excuse to hinder audits, making it difficult for the internal audit department to perform its duties. Tomorrow Group and Baoshang's Chairman designated their own businesses in Baoshang as "special" and kept out any internal audit on confidentiality grounds. Also, problems that were identified in audits were left unattended.
<According to Chinese laws, there needs to be a Supervisory Board, made up by elected persons from the shareholder meeting and the employees, as well as appointed from outside the bank, supposedly acting as a watchdog.>
The Supervisory Board failed with insufficient professionalism and a lack of independence. All along, the Supervisory Board has been a showcase, and its inspection and supervision did not work. Among the seven members of the Supervisory Board (one appointed by shareholders, four chosen as representatives of employees and two from outside the bank), the four supervisors supposedly representing employees are in fact members of the middle to senior Management, and their dual identity makes them largely subordinate to the Board or Management. Some members do not have the necessary knowledge or skills, and none of them had a financial background. As a result, the Supervisory Board became not responsible to the bank, nor to overall shareholders especially small and medium-sized shareholders, but was subservient to the majority shareholder, the Board of Directors, and the Management, ultimately becoming their collaborator.
The Management overrode the checks and balances of the bank’s corporate governance, replacing rules and regulations with decisions from individual leaders or their collective decision-making.
Baoshang’s Management not only illegally assisted the major shareholder to appropriate huge sums of money but also registered various entities for their own to take out loans from the bank, which all basically went non-performing - by the time of the takeover, 98% of the related-party loans derived from this way went bad. Decision-making on performance evaluations, salary adjustments, sourcing, personnel appointment was based on relationships and personal preferences of leaders of the bank, overriding the mechanism of internal governance.
Failure of outside supervision was also rampant, with banking regulators colluding with Baoshang insiders. There was severe "regulatory capture”. Top officials at the Inner Mongolia branch of China Banking Regulatory Commission were willingly “captured" by Bashang. Some of them not only took bribes, but also intervened in such internal affairs of the bank as personnel appointments, contract awarding; some even defrauded Baoshang in huge loans via companies under their control, and some used their own law firms to extract high legal fees from Baoshang. In such a chaotic operating environment, the risk management system and internal control mechanisms of the bank were completely inadequate. The “pay via expenses” <employees claim illicit expenses as a form of wages> has almost become a routine.
It can be said that Baoshang was not brought down in one day, or by one person. Besides the failure of corporate governance, its culture is also to blame for the failure.
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From Baoshang's failure and the cost inferred, risks of banks especially those with some systematic importance have big externalities <could cause big problems for its counterparties in the financial world>. I <Zhou Xuedong, of the central bank> believe that, in the corporate governance of financial enterprises, the following three points are most critical:
1. Give full play to the leading role of the Party, as well as carefully choose the Secretary of the Party Committee and the Chairman of the Board.
An important reason for the significant credit risks of Baoshangwas that the Party Committee did not play any role and the Secretary of the Party Committee abandoned his duties and "voluntarily surrendered". In retrospect, a sound corporate governance structure must unify the strengthening of the Party's leadership, i.e. "the leadership of the Party Secretary" and the improvement of corporate governance, i.e. "the leadership of the Chairman”. It should be emphasized to let the Party leadership truly play a central role through the "leadership of the Party Committee Secretary" and the "leadership of the Chairman".
Party leadership and corporate governance are not contradictory: one of the objectives of the Party Committee is also to ensure that the bank operates first and foremost in a law-abiding and compliant manner, to improve the quality of the bank's assets and market competitiveness, and to run the bank well, which is fully consistent with the objectives of corporate governance; and Party leadership is also reflected in the fact that Party organizations at all levels require their members to be more law-abiding and ethical than the average employee. It can be argued that none of the Party Committee's requirements for Party members on the Board of Directors, Supervisory Board, or at the Management level are detrimental to the Bank's legitimate interests. The Party Committee also needs to pay attention to and address the banks' excessive pursuit of short-term interests at the expense of long-term development. In other words, it is also an important responsibility of the Party Committee to eliminate negative externalities, maintain financial stability, and balance corporate interests with the interests of society and the public.
2. Establish an effective equity structure with checks and balances, rationalize and diversify the equity structure, and improve the effectiveness of corporate governance.
A good shareholding structure is the basis for good corporate governance of banks. Over-concentration or over-diversification of the shareholding structure is not conducive to the formation of a good governance structure. The failure of internal checks and balances among shareholders is an important reason for Baoshang’s failure. Small and medium-sized banks can actively explore the best options for optimizing their shareholding structure by combining regional characteristics with their own reality to overcome over-concentrated or over-dispersed shareholding structures. It’s important to fundamentally enable checks and balances and improve the effectiveness of corporate governance by diversifying shareholders and giving full play to the democratic decision-making role of the shareholders’ meeting.
3. Strengthen external supervision, improve information disclosure mechanisms, cultivate a sound corporate governance culture for banks, and improve transparency.
External supervision should be enforced mainly in two areas. The first is prudential supervision <which requires financial firms to maintain sufficient capital and have adequate risk controls in place>.
In particular, external regulators <govt authorities> should implement penetrating supervision <through the surface to see the essence of financial business and behavior, such as the source of funds, intermediate links and eventually to penetrate the link, in accordance with the "substance over the form of” principle> to identify invisible shareholders and entrusted shareholdings <"dummy" shareholding>, so as to detect, as early as possible, of shareholding dominance and insider control and curb the attempts of the Management or private shareholders to hollow out the banks.
Baoshang was a typical example of being dominated by one major shareholder. In two recent cases of significant banking problems, the Bank of Jinzhou and Hengfeng Bank, before their restructurings, were under typical "insider control”.
The second is information disclosure. Accounting information distortion must be resolved through external audits, information disclosures, and external supervision. In the future, the possibility of regulators directly hiring accountants, auditors, lawyers and other professional services to examine banks should be explored, where the examination is paid for by and responsible to the regulators. That could be one way to solve the problem of auditors being paid off by banks and colluding in frauds.
In addition, the establishment of a mechanism with good incentives and the cultivation of excellent corporate culture are the basis for the effective operation of corporate governance. Enditem