By Didier Cossin & Abraham Lu
Since its dual IPOs in 2007, the Industrial and Commercial Bank of China Limited (ICBC), one of the largest commercial banks in China, has received a multitude of best governance awards adding to its global reputation. As recently as June 1999, however, international institutions and analysts broadly considered ICBC as “technically bankrupt” with the nonperforming loan (NPL) ratio reaching 47.59 percent. ICBC drastically improved through a governance transformation with the united effort of the government, the management team, and its employees. The transformation path had four steps: internal restructure, ownership reform, governance overhaul, and public IPOs. With each step, corporate governance became more sophisticated and comprehensive.
The ICBC’s governance system has four tiers: shareholders’ general meeting, board of directors, board of supervisors and senior management. The board of directors itself is composed of three distinct groups, the executive directors, the full-time non-executive directors, and the part-time independent directors. This structure is designed to provide effective checks and balances within the board. The board of supervisors monitors the performance of the directors and senior management members who are not on board. There are two additional components of the governance system: the party committee which plays an important role in the system and the party disciplinary commission which provides thorough monitoring from the top to the bottom. ICBC’s unique, sophisticated and rich governance system provides potential lessons and perhaps some inspiration for western and emerging markets. In what follows, we trace those lessons.
Chinese banks as country strategic and the political will to transform them
The banking reform of the past 30 years is a snapshot of China’s reform, a process filled with trial and error while exploring new paths for development. In 1979, Deng Xiaoping forged ahead with plans for a banking reform; the objective was to transform “banks into real banks.” After that, China’s banking sector has experienced many institutional changes, but the transformation has been largely unsuccessful.
In 1997, the average of the capital adequacy ratio (CAR) of the Big Four1 was only 3.5 percent and they were burdened by the NPLs and large losses. The banking sector had experienced tremendous difficulties and was described as “a ticking time bomb,” which would eventually lead to an implosion of the country’s economic system. The WTO entry added further urgency. When China joined the WTO in 2001, the country promised that the geographic and customer restrictions on foreign banks would be gradually removed. Full access was to be granted after December 11, 2006. However, the ailing banking system could not cope with the intensified domestic competition.
In 2000, China initiated the banking governance reform and Premier Wen Jiabao identified such critical reform as a Must-Win Battle, vowing to transform the state-owned commercial banks (SOCBs). The leadership had demonstrated the highest level of political commitment necessary to enforce corporate governance and processes. The banking governance reform was carefully deliberated at the highest level and a new corporate governance structure was implemented bank by bank, step by step. In 2010, the last of the Big Four – ABC – went public, which marked the completion of the Big Four’s historical transformation into public shareholding commercial banks. ICBC’s governance implementation showed many details of the inner works of the corporate governance transformation.
Downsizing and debt restructure at ICBC
ICBC did not fully lean on the government. Before the state-restructuring plan was approved, ICBC had been working on the transformation for some years. The number of employees decreased from 570,000 in 1996 to below 360,000 in 2005, and the number of branches was cut by more than half to around 20,000. A new business model was introduced and the asset structure was changed. Such great effort helped raise operating profit fivefold between 2000 and 2004 and decrease the cost/income ratio to 40.71 percent in 2005, about 21.5 percent less than in 2000.
Later, the government helped with the reform, and ICBC itself tackled the most difficult issues such as capital adequacy and debt restructuring. Given the size of the bank and the outstanding NPLs, most people believed that transforming ICBC would be extremely costly. However, ICBC was able to write off a large portion of NPLs with its operating profit and, as a result, the capital injection from the state was much smaller than expected. In addition, through a restructuring fund established with the Ministry of Finance (MOF), the RMB 246 billion worth NPLs equivalent amount would be paid off in installments with the future income tax ICBC would generate and the future dividends to the MOF. In March 2010, the restructuring fund was cleared, which meant part of the restructuring cost was paid off by ICBC itself. After the financial restructuring was completed, ICBC went three further steps to improve governance: shareholding reform, governance overhaul and public listing.
The shareholding diversification reform was a historical stride forward compared to the state sole ownership of the past. Before 2005, ICBC was fully financed by the state through the MOF. The poor governance structure, both insider control issues and agency problems, were related to the state ownership. To improve corporate governance in the banking sector, the state had to relinquish part of the ownership to non-state investors in exchange for more efficient monitoring. Non-state investors would bring in management expertise and the required management staff to generate returns and to best serve shareholders’ interests. The market for bank managers would be more competitive. As a result of this shift, agency problems such as abuse of power and corruption would decrease and efficiency would likely increase.
In December 2003, the State Council set up Central Huijin Investment Ltd. (Huijin), an investment vehicle to represent the state’s interest in the country’s financial sector. Huijin was merged into China Investment Corporation (CIC), China’s sovereign wealth fund, when CIC was established in 2007. A new regime of corporate governance including the boards of directors and supervisors would guide the company and select management. Under this new governance structure, the government, as represented by Huijin, should only influence the management decisions at SOCBs through votes at shareholders’ meetings and directorial and supervisory board participation as defined in the law.
On October 28, 2005, ICBC was restructured to a joint-stock limited company, with the MOF and Huijin each holding 50 percent. In January, 2006, ICBC brought in Goldman Sachs, Allianz and American Express as strategic investors. On October 27, 2007, ICBC further diversified its ownership through simultaneous IPOs in Hong Kong and Shanghai. In doing so, state-ownership was diversified systematically and, concomitantly, corporate governance improved.
Along with the shareholding reform, ICBC constituted new articles of association, elected the board of directors and board of supervisors, hired senior management and established standard corporate governance structure. An efficient decision-making, execution, operation and supervision mechanism was also established.
The ICBC’s governance system
In the four-tier governance system, the shareholder meeting has the ultimate power to select directors and supervisors, decide their compensation, and decide on the operational policy, financing, investment, and dividend plans. A company might have several interim shareholder meetings in a year to decide on key issues such as major investments and acquisition, changes in operation policies and procedures, share issuance, debt issuance, among others.
The board of directors is composed of the executive directors, the full-time non-executive directors, and the part-time independent directors; all elected by shareholders. Similar to the system of the UK or the USA, the non-executive directors and independent directors are expected to outnumber executive directors and hold key posts, including audit and compensation committees. Under the direction of the board of directors, the senior management team executes strategy and is responsible for its daily operation and management activities.
To balance the power of directors, a board of supervisors was established alongside that of directors to exercise checks on the management team and board of directors. In a four-tier system, a board of supervisors shall be composed of representatives of the shareholders (full-time), and of the staff, workers and external professionals (part-time). Initially, the new corporate governance system was not mandatory for the state-owned enterprises (SOEs) and banks. The 1999 amendment to the Company Law specifically required the state-owned entities to set up supervisory boards as a mechanism to safeguard state assets.
Unlike the supervisory board in Germany, which makes major business decisions, the supervisory board in China does not have the same ex ante and ex post strategic decision-making power. Its main function is ex post and in-between control: examining the financial affairs, supervising the acts of the directors and senior managers, and making sure laws and regulations concerned with corporate governance are strictly followed.
Board practices, internal checks and balances
The board of directors is the decision-making organ, bearing responsibility to the shareholders assembly. In 2005, ICBC chose to have 13 directors: four executive directors, six full-time non-executive directors from Huijin and the MOF (all six dedicated fulltime to ICBC), and three part-time independent directors. In 2007, the bank added three more part-time independent directors. The ICBC board listens to diverse opinions, it engages in balanced discussions in the boardroom, which constitutes effective checks and balances within the board.
The six part-time independent directors do not represent any single shareholder and they are designated to make objective judgments and express unbiased views independently. Among the part-time independent directors, we found overseas banking professionals, academics, and regulators. As one part-time independent director at ICBC commented on the selection, this structure is optimal with very diverse angles looking at all possible available alternatives. With only one type of part-time independent directors, either banking professionals, academics, or regulators, the views would be rather narrow and possibly biased. Thus, the ICBC independent director framework is crucial for a balanced and efficient board.
In China or elsewhere, beyond the structures, a true governance culture seems to be a key driver of governance success. In particular, behavioural drivers of governance effectiveness include independence, integrity, equal participation, mutual respect, openness and constructive dissent as well as personal engagement.
The bank dictates that the executive directors from the senior management team, who are considered as insiders, should not exceed one-third of all directors. Being members of the board, the senior management team and the party committee simultaneously, executive directors have multiple roles and responsibilities. The multiple roles distinguish executive directors from the other directors as they link the board, the management and the party committee. Executive directors are involved in important decision-making processes in board meetings, and on the management and execution side, they periodically report to the board about operating activities, provide the board with complete, accurate and timely information so that all members are fully aware of the bank’s operations.
Regarding the level of detail in the board meeting, Mr. Jiang Jianqing, board chairman of ICBC, strives to have a more balanced discussion in the boardroom. An over-detailed board might neglect long-term or macro issues. Board members in a western board focus more on macro issues, long-term strategies that have fundamental impacts on the company. It’s hard to judge which model is more effective and ICBC determines to have a balance of the two models.
The six full-time non-executive directors sit on the board to represent the largest shareholders: Huijin and the MOF. The full-time non-executive directors come from diverse backgrounds such as the People’s Bank of China (PBC), the China Securities Regulatory Commission (CSRC), the China Banking Regulatory Commission (CBRC), or the Financial Affairs Leading Small Group of the Communist Party of China (CPC). Some of the non-executive directors were recruited in the market. The non-executive directors usually had no financial and banking experience, but had extensive experience working in various government agencies that were directly involved in steering the country’s economic reform. Those directors received training and subsequently underwent examinations in order to be qualified. When a non-executive directorship becomes open at major banks, candidates are be shortlisted and selected.
Through the board committees, the three groups of directors openly voice opinions on the nomination, compensation, strategy, operational policy, financing, investment, and dividend plans. In the Anglo-American corporate governance model, shareholders, both institutional and individual, do not behave like owners. They are reluctant to monitor corporations and they are passive while attending shareholder general meetings (Monks, 2011)2. At ICBC, the full-time non-executive directors do behave like owners and they behave proactively in terms of exercising their rights as shareholders.
The full-time non-executive directors seem to be highly influential in many cases. For example, ICBC arranged to pay off the restructuring cost with dividend, so the full-time non-executive directors carry the most weight in deciding the dividend policy. In terms of compensation, the directors have different opinions. Some part-time independent directors at ICBC indicated that based on the performance of ICBC itself, the management should be paid more. Apparently, the full-time non-executive directors have different views. Though they admit that the pay level of senior management at ICBC is significantly lower by international standards, in a developing country like China, the pay is adequate as the average income level is significantly lower.
The relationship among the three groups of directors is dynamic. Executive directors bring operational details to the board which help other directors who are not familiar with banking issues; full-time non-executive directors, as shareholder representatives, exercise owner’s rights and influence management decisions; part-time independent directors represent professionals from diverse backgrounds, focusing on risk management, strategy and direction issues. No single group dominates the board discussions; each group is independent to check on other groups; and each group contributes to the decision-making at the highest level. This practice largely avoids the abuse of power by any individual group. To put it shortly, ICBC’s board practices reflect the four dimensions of an effective board: the right people with focus and dedication, correct structures and processes, quality information architecture and productive board dynamics.
Key stakeholder control
In German banks, key stakeholder groups such as employees, influence the corporate decision-making through the board of supervisors. In the Anglo-American model, no formal stakeholder control mechanism exists, which might lead to governance failure (Blair, 1995)3. At ICBC, the supervisors inspect and supervise the performance of directors and senior management, the financial activities, and audits.
By attending the shareholder meetings and the board meetings as nonvoting delegates, the board of supervisors also reviews the performance of the members of the board of directors and the members of senior management. The review focuses on different categories including work attitude, behaviour, duty-fulfilling capacity and contribution, among others.
In general, supervisors have full authority and the highest level of access to information or materials. They carry out periodic inspections on risk management, internal control, or related party transactions, and if necessary, require detailed explanations to dig deeper into any suspicious issues. Supervisors normally require four to five briefings by the external auditors on financial status such as asset situation, loss allocation, asset quality, risk exposure or any other operational issues. Supervisors might also question the process of a decision, for example, who and why signed off a particular decision.
The retiring and leaving directors, presidents and other senior management members go through an auditing process by the board of supervisors. Any issues against the law and regulatory requirements would be brought to the management team and the board of directors through deliberated motions. If the board of supervisors is to fail in its duty of supervising and inspection, it would be summoned to hearings by CBRC.
Outsiders often question that the board of supervisors has an unclear role and undefined authority. The supervisory board has a role to monitor the board and the board members. In the western board, you don’t have such an organization. In the western corporate governance system, board members sometimes are hired by the CEOs, so they all have to say yes to the CEO. In contrast, the supervisory board in China has to provide checks and balances by law.
Management incentives, power and culture
Bankers at ICBC are among the lowest paid of world bankers. Chairman Jiang, for example, made USD 234,700 in 2008. That was less than two percent of the USD 19.6 million awarded to Jamie Dimon, CEO of JPMorgan Chase. Top Chinese bankers are party members who were recruited when they were young for their merits and ethical behaviors. Through their careers, they were trained to pursue noble causes, even if sometimes this meant some self-sacrifice. In any case, there was no pay for performance although thorough evaluation systems allowed career paths to reward the most effective individuals.
Top managers with excessive power are not tolerated. On the contrary, top managers’ decisions, power, or status are closely monitored by the board of supervisors, which prevent managers from making self-enriching decision. They are responsible for the daily operation and management activities under the board of the directors, which sets the views on long-term goals and risk management.
Senior managers could be promoted beyond what a bank could possibly offer. For example, a top executive could become a governor running a province or a regulator supervising an industry. The opportunities are rampant, and can always provide career advancement as incentives for performance. To many senior managers, the value of career advancement may far exceed higher pay. But it would be naive to believe that higher positions come easily. The competition is fierce and senior managers have to demonstrate their management capability, impeccable ethical merits and networking skills.
Senior managers are also tightly controlled. Internal controls include the full-time non-executive directors, the part-time independent directors on the board, the board of supervisors, the party committee, and the party disciplinary commissions. Criminal charges such as taking bribes and abusing power could lead to confiscation of possessions and the death penalty.
Strong regulation and comprehensive monitoring
At ICBC, Chairman Jiang synergistically serves as party secretary and chairman of the board of directors. Chairman Jiang proposed that the party committee should fully support the board of directors and the management in decision-making, lawful operation and efficient execution. The party committee should not replace the board of directors, management team and intervene operation activities. The directors who were also party members should express opinions as directors at the board’s meetings. Through this consultation and participation process, the party committee became a key stakeholder in the bank.
The communist party at ICBC exercises the party discipline, including the detection of corruption and financial irregularities committed by party members. According to the company law, local party committees were assigned the rights to “supervise Party cadres and any other personnel to ensure that they strictly abide by the state laws and administrative disciplines, strictly observe the state’s financial and economic regulations and personnel system, and refrain from encroaching on the interests of the state, the collectives and the masses.” The party disciplinary commissions operate at different levels of the bank, increase the number of controllers, and provide thorough monitoring. Such party monitoring prevents misbehaviour by managers and employees at all levels, and tends to improve corporate governance.
Unlike the deregulation and self-regulation in the finance industry in the West, China has a supervisory body, the CBRC, and strict rules governing the banking industry. Through on-site examination and off-site surveillance of the banking institutions, CBRC punishes rule-breaking behaviours and financial crimes. Regulatory mechanisms from PBC, the Hong Kong Stock Exchange (SEHK) and the Shanghai Stock Exchange (SSE) add more external control.
Dual IPOs and adequate market discipline
The Anglo-American corporate governance model relies on the market to monitor and discipline corporate misbehaviour. Although a large body of research claims that the market-oriented approach is behind governance failures, the approach has positive elements such as more regulators, more disciplines, and it is better focused on shareholder value creation and long-term profit maximization. For ICBC, therefore, going public was the last step to distance itself from political interference and political ties with the SOEs.
In October 2006, ICBC had simultaneous IPOs on the SEHK and the SSE respectively. With 76 times oversubscription, ICBC’s Hong Kong IPO retail tranche attracted the largest amount of orders ever. Given such strong interest, ICBC priced its shares at the top end of the range specified in its prospectus. ICBC sold 35.39 billion “H” shares in Hong Kong and 13 billion “A” shares in Shanghai. After the bank exercised the over-allotment option in November 2006, ICBC raised USD 21.9 billion, making it the world’s biggest IPO at the time.
The dual IPOs diversified investors further. By introducing new investors, ICBC strengthened its objective of maximizing return and change its service culture. By listing on the SEHK and SSE separately, the bank was required to operate by international standards, which brought in international auditors, added compliance rules, and offered more protection of minority shareholders. The public monitoring and outside control by international investors reduced risk, improved CAR, brand value, and market value. Further information disclosure pushed the bank to reform its report system and internal control. With more disclosure and transparency, ICBC opened the door for international expansion and cooperation.
The market-approach, however, could not solve all the problems. Some negative effects, such as short-term profit maximization, excessive risk-taking, or information asymmetry can lead to governance failures. For ICBC, therefore, transforming itself from a state-owned to a publicly listed bank was an added measure to monitor the status of its governance and an effective way to further improve its governance practices.
China’s banking reform has been a continuous process. Without downsizing, debt restructures, and capability building in the past, ICBC would not be restructured to a joint-stock limited company. Without joint-stock restructure and going public, ICBC would not get rid of historical NPLs and build a modern corporate governance structure and system. Without continuous reforms and innovation as a public company, history (bad loans) might repeat itself, as governance should be continuously improved. As an old Chinese saying goes, the arduous task of corporate governance improvement is still an uphill journey.
Lessons for Western and Emerging Markets
The Chinese corporate governance model is complex, deeply rooted in the country’s legal, cultural, social, political and historical environments. Corporate governance reform is path dependent: the right governance has to take into account the identity of the legal and regulatory framework, culture, custom, norm, society, and organizational structures. In particular, the political economy of China, a socialist market economy with Chinese characteristics, faced unique challenges; thus, governance reforms had to be implemented with careful design and enforcement. As a result, China’s corporate governance system presents different features from those that dominate in other regions. The current corporate governance system in China has unique features that cannot be categorized simply as the German governance model or the Anglo-American corporate governance model or any other model. The system was developed from the Chinese institutional environment.
China’s legal system has been impacted by the Continental law system, so it is no surprise to find the existence of a board of supervisors as in Germany. In addition, the banks were previously solely owned by the state, thus shareholder representatives sit on the board and exercise shareholder rights. The Communist Party Committee previously ran all the SOEs; now it remains as a latent part of the governance structure, which constitutes a potential threat to the adequate implementation of the governance system. Senior managers were traditionally limited with power and money, and they are not permitted to have excess control in the new system either. Evidently, the roles of each stakeholder are different from those of western systems, which confirmed the notion that there is no “one size fits all” solution to the corporate governance issues. Notwithstanding such peculiarities, there are elements in the Chinese governance system that, when adapted to reflect local characteristics, could be employed to improve governance elsewhere.
ICBC’s governance reform, for example, showed that the Chinese largest shareholders are not silent and that they are active at exercising shareholder rights. However, shareholders, as represented by the full-time non-executive directors are checked and balanced by other directors, such as the executive directors and the part-time independent directors within the board. The constitution of three classes of directors and the presence of dedicated full time non-executive directors is a rich governance solution to a complex institution in transformation. The board strives to have balanced discussions and listen to more diverse voices when making decisions. The balance is largely dependent on the chairman’s ability which might be distorted in a different setting.
The combination of a board of directors (with power not that dissimilar to that of a western board of directors) and a board of supervisors (which meets less often but still oversees the overall functioning of the board of directors as well as supervises the institution overall) is also an enrichment of checks and balances. The institutional arrangements present less opportunity for CEOs (or chairmen) to dominate the board than in the West. The performance of all the members of the board of directors and members of senior management team is reviewed by the board of supervisors without exception. Full time non-executive directors are also assessed by their own organization (such as Huijin or MOF). The party committee and its disciplinary commissions operate at various levels of the bank which provides thorough monitoring from the top to the bottom. The party monitoring prevents misbehaviours by lower level managers and tends to improve corporate governance.
The pay to top management is not linked to stock price, which largely avoids the short-term profit maximization pitfalls. The incentives are different as senior managers could be promoted outside of the banking industry to become governors or to equivalent positions. In short, the career advancement opportunities provide incentives for performance. This is centrally organized by the Central Organization Department (COD), a de facto HR department for the Party.
An effective corporate governance model must integrate adequate market discipline. By listing on the SEHK and SSE separately, ICBC was regulated by overseas and domestic regulators. The bank had to follow international standards, more compliance rules, more monitoring and increase outside control. Further information disclosure pushed the bank to reform its report system, internal control, and mechanisms to interact with more diverse shareholders.
To conclude, corporate governance is not static and is not context-free: it evolves when the nature of business changes and should adapt to the context. If the traditional borrowing and lending business shrinks, the bank would have to change its business structure focusing on net fee and commission income. When ICBC grows its business outside of China, the governance system will likely evolve as well. The board discussions, for example, would likely focus on different issues and it could be necessary to recruit board members with a different set of skills or backgrounds.
About the Authors
Didier Cossin is Professor of Finance and Governance at IMD Business School, Switzerland; he is the Director of IMD Global Board Center and has extensive experience working with boards around the world.
Abraham Lu is a Research Fellow at IMD.
1. Industrial and Commercial Bank of China Limited (ICBC), China Construction Bank (CCB), Bank of China (BOC), and Agricultural Bank of China (ABC)
2. Monks, Robert, 2011, “A review of corporate governance in UK banks and other financial industry entities: the role of institutional shareholders”, in William Sun, Jim Stewart, David Pollard (eds.), Corporate Governance and the Global Financial Crisis: International Perspectives. Cambridge: Cambridge University Press.
3. Blair, Margaret, 1995, Ownership and Control: Rethinking Corporate Governance for the Twenty-First Century. Washington, DC: Brookings Institution Press.[/ms-protect-content]