The International Finance Corporation's mission is to find promising private sector investments and introduce them to international corporate and accounting standards. In China, the IFC has invested in two majority privately owned banks. But only half their loans go to private companies. Karin Finkelston explains.

FinanceAsia: Some analysts say that China's position as the second largest FDI recipient in the world is related to a state-owned banking system that fails to effectively distribute capital. Is this why your most high profile investments in China have been in majority privately-owned banks?

Finkelston: Clearly, many private companies aren't getting the finance they need because of problems with the state-controlled banking system. By investing in private banks, which we define as having less than 50% government ownership, we hope to create a bigger multiplier effect than by investing in individual private companies. Our investments are also very much aimed at introducing international bank management systems and safeguards. For example, the two banks we have invested in have capital adequacy ratios in excess of the Basel standard of 8% and use International Accounting Standards.

How do you define the private sector and how large is it?

The private sector is quite hard to define. But if you include agriculture, the non-state sector amounts to over 50% of GDP, or around 33% excluding agriculture. The foreign invested sector accounts for over 6% of the private sector.

Did you look at China Minsheng Banking Corporation, which prides itself on being the most private among China's banks?

Yes. We started by doing technical assistance work to improve standards at Minsheng and some of the city commercial banks in Shanghai and Beijing. As our search progressed, Bank of Shanghai seemed increasingly willing to accept IFC ideas about international accounting standards and transparency. At the time, Minsheng Bank was preoccupied with its upcoming domestic IPO, which took place in 2000. After Minsheng listed it couldn't take new investment for a year according to the regulations. Bank of Shanghai, on the hand, recognized it was in danger of being squeezed between the state banks and the coming foreign banks. In 1999, we took a 6% stake and based on the money we had invested, encouraged them to shift to international style audits, governance and management.

For example, we put a very strong person on the board who re-fashioned the board along international standards, with an audit committee and a compensation committee answering to the board. Traditionally, these are within the power of the president. So it's quite new that he allowed the board to have more power to allow the bank to conform increasingly to international standards. The People's Bank of China (the central bank) now sees BoS as a model for the banking sector.

IFC investments have also given a new lease of life to the city commercial banks, many of which had been closed down. They are extremely small compared to the big four state banks, but they can be potentially more nimble, and being neighborhood banks they are also more able to focus on local companies.

So you followed the same reasoning when investing in Nanjing City Commercial Bank?

Yes, we bought a 15% stake in Nanjing City Commercial Bank last autumn. They are really focused on local businesses in Nanjing. So at the same time as introducing international banking standards to China, we are also enabling money to be directed to small to medium enterprises.

What accounting issues did you encounter?

It was very important to translate the financial data we were given into IAS terms. One of the justifications in the developed countries for having just a handful of accounting firms was that uniform standards could be imposed and the players regulated, although that model has shown some weaknesses! In China we encountered a large variety of different accounting methods.

The investment of HSBC in Bank of Shanghai indicates that they like what you made out of BoS. But to what extent is BoS private?

More than 50% of the shares are owned by individuals and private companies. That's mainly due to its history of being a conglomeration of (failed) local credit cooperatives: a lot of people in the neighbourhood owned them. The largest shareholder is the city of Shanghai. The city of Nanjing is also the largest single shareholder of Nanjing City Commercial Bank. Both the banks are making money, although it's a difficult sector to be in.

What are the obstacles?

For a start, there's a revenue tax on top of a profit tax. Pulling money straight off the top line makes it difficult to build capital. However, the revenue tax used to be 8% but it's now dropped to 5% and we hope it will drop further.

What is the justification for the revenue tax?

It may have something to do with tax collection. It's much simpler for the government to tax revenue rather than to tax profit. The final profit figure could ultimately by distorted and reduced by lots of accounting issues which the government doesn't have time to investigate. But the revenue tax makes life difficult for the banks to accumulate earnings and thus build capital. Bank of Shanghai has been very good at accumulating capital, and has managed its dividends - which can also drain a bank's capital - carefully.

Have you been able to influence the bank's lending practices?

Yes, we've pushed them to look at the private sector. Not entirely, of course. The bank also lends to infrastructure projects in and to the city of Shanghai, which is a very good credit. It's an interesting issue, because many of the private sector companies are risky, but the banks can't adjust their interest rates when lending to higher-risk companies. That's because the PBOC sets all the interest rates, from deposit rates to lending rates. The banks can then charge plus or minus 30% of the official rate. Overall, about half the loans of BoS go to small to medium enterprises. The credit allocation mechanism is flawed in China by the lack of interest rate flexibility and you can see that in the relatively low ratio of loans to deposits. Chinese banks are short of the mechanisms to compensate for more risky credits.

Why did you choose Nanjing City Commercial Bank? I haven't heard of Nanjing as a private sector hotspot.

It's not as high profile as around Zhejiang or Shanghai, but there are a lot of private sector companies in Jiangsu province, of which Nanjing is the capital. We wanted to export the BoS model to a more challenging environment. It's a kind of pilot. We look at certain factors such as population density and average incomes. It was also important that the management understood the issues. We are not satisfied with China standards, we push for international standards. And Nanjing City Commercial Bank was willing to meet those criteria. It also has a very profitable treasury operation, and good management.

Your stake of 15% is much higher than your stake in BoS. How did that come about?

Our stake in BoS went up to 7% after the bank did a share issue, following HSBC's investment. The decision for a bigger stake in NCCB had to go the State Council, but basically there's a recognition of our role in helping to improve the Chinese financial sector and that we are not here just to make money.

The value of your stake in BoS must have gone up after HSBC's investment. Making profitable investments is an important part of your goal?

Yes. However, we have made no profits until we've exited!

How do you estimate the price you pay for your stakes?

We look at multiples of IAS book value. We don't relate it to the Chinese book values or stock market price/earnings ratios. And we translate all the figures they give us into international accounting standards.

Is 7% in BoS enough to ensure that you can impose your reforms?

The investment is made based on our conditions. They could turn around and refuse. But BoS, for example, has seen the benefit of accepting IFC conditions, since HSBC is now involved as well. In fact, we're getting a lot of interest from other local banks who have now seen the benefit of having the IFC as a partner. Following international standards such as those set by the IFC will enable banks to be much better placed for facing foreign competition.