MINISTRY OF EDUCATION OF THE REPUBLIC OF BELARUS

STATE EDUCATIONAL INSTITUTION "SCHOOL OF BUSINESS OF BELARUSIAN STATE UNIVERSITY"

Chair of Innovative Management

Sun Zizheng

ANALYSIS OF IMPACT OF INTEREST RATE LIBERALIZATION ON ’S COMMERCIAL

Master`s thesis

specialty 1-26 80 04 "Management" (profile "Financial Management")

Supervisor: Darakhovich Siarhei

Admitted to Master’s thesis defense on "___" ______2021 Head of Chair of Innovative Management Ph.D., Associate professor ______Alena A. Poddubskaya

Minsk, 2021 CONTENTS

GENERAL CHARACTERISTICS OF THE WORK ...... 3 INTRODUCTION ...... 4 CHAPTER 1 THEORETICAL FOUNDATIONS FOR UNDERSTANDING THE CONCEPT OF INTEREST RATE LIBERALISATION ...... 6 1.1 Definition of the interest rate and its different types ...... 6 1.1.1 Definition of the interest rate ...... 6 1.1.2 Types of interest rates ...... 6 1.2 The Importance and content of interest rate liberalization ...... 8 1.2.1 Importance of interest rate liberalization ...... 8 1.2.2 The content of interest rate liberalization ...... 9 1.3 International experience of interest rate liberalization...... 11 1.4 The development and current situation of interest rate liberalization in China 14 1.4.1 Obstacles of China's Interest Rate Liberalization Reform ...... 16 CHAPTER 2 ANALYSIS OF CHINA’S BANKING SYSTEM ...... 18 2.1 China’s banking system and the People’s of China ...... 18 2.2 Big Four Banks...... 21 2.3 State-owned, joint-stock, and city commercial banks ...... 23 2.4 The role of Chinese commercial banks in the banking sector ...... 24 2.5 Foreign banks ...... 26 CHAPTER 3 ANALYSIS OF IMPACT OF INTEREST RATE LIBERALIZATION ON CHINA’S COMMERCIAL BANK ...... 29 3.1 The influence mechanism of the liberalization of interest rate on commercial banks ...... 29 3.2 Specific impacts on banks of different sizes ...... 32 3.3 The impact of interest rate liberalization on new products, new business and margin structure in commercial banks ...... 33 3.4 Analysis of impact of interest rate liberalization on China’s commercial banks ...... 34 3.5 Countermeasures in the context of interest rate liberalization ...... 40 CONCLUSIONS ...... 44 REFERENCES ...... 46 APPENDIX ...... 49

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GENERAL CHARACTERISTICS OF THE WORK

Master's thesis on the topic: 51 pages, 2 figure, 6 tables, 40 sources. Keywords: COMMERCIAL BANK; INTEREST RATE LIBERALIZATION; INTERMEDIATE BUSINESS. The object of the research: commercial banks as the most important element of the Chinese banking sector. The subject of the research: internationalization of the commercial banks in China in the context of interest rate liberalization. Aim of my research is to reveal the impact of interest rate liberalization on China’s commercial banks. Research objectives: 1. To consider the concept of interest rate liberalization; 2. To analyze the development and current situation of interest rate liberalization in China; 3. To reveal negative and positive impacts of interest rate liberalization on the development and current situation of interest rate liberalization in China; 4. To consider countermeasures in the context of interest rate liberalization

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INTRODUCTION

For all countries or regions, interest rate liberalization is of great significance to the economy, and this reform will have a huge impact on the whole financial market. Financial liberalization can bring many benefits. Since capital and risk can be better priced, liberalization can improve investment allocation and efficiency. Banks that are more efficient and better at assessing risks will gain a larger market share. Credit support to sectors with poor financial services in the past will also increase. The range of financial products will be expanded, and enterprises and households will be able to better manage risks and obtain opportunities for diversified asset selection. However, if the timing of implementation is not ripe, financial liberalization may also expose the weaknesses of the financial sector, damage the termination of activities and cause economic fluctuations. The liberalization of interest rates refers to the process in which various economic entities in a market economy independently determine the level and structure of interest rates. In essence, it is a process in which the market mechanism gradually plays a role in determining interest rates, thereby continuously optimizing capital flow and allocation. In China, the liberalization of interest rates is an important part of the reform of the socialist economic system. Opening up the interest rate transmission mechanism and integrating the dual-track interest rate determination mechanism is the main task of my country's interest rate liberalization.Embarking on interest rate liberalization reforms nearly two decades ago, China has made significant progress in the past few years, but has yet to take the final and most critical step: removing deposit rate ceilings in order to reach full interest rate liberalization. China’s policymakers have adopted a cautious approach towards the timing and sequencing of the liberalization to minimize disruptions to the stability of the financial system. Despite the slow pace of reform, policymakers have placed a high priority on liberalizing interest rates. Market participants anticipate full liberalization within the next decade to improve the allocation of financial resources and facilitate the rebalancing of the Chinese economy. As for commercial banks, similarly no matter which country or region, it is also an important member of the financial system. It directly participates in the entire market economic activities and connects the implementation path of monetary policy. It is a very important financial institution, and it has great influence on any economic system. Significantly, it is very important for controlling the development process of the market economy, the flow of social capital, and the implementation of relevant national economic policies. Many scholars try to study the effects of reformation from the perspective of buyer sides. Regarding the impact of interest rate liberalization on commercial banks,

4 three scholars, Ba Shusong, Yan Min, and Wang Yuexiang(2013) gave a very specific and thorough analysis and explanation in the "Analysis of the Impact of my country’s Interest Rate Liberalization on Commercial Banks". They concluded that the profit model depending on high interest margin cannot be sustained, in which circumstance capital pressure is increasing and pricing power needs to be enhanced.[1] Jin Lingling, Zhu Yuanqian and Ba Shusong(2012), in the “International Experience and Enlightenment from the Impact of Interest Rate Liberalization on Commercial Banks”, mentioned the changes of global interest rates and the spread of deposits and loans, and analyzed the trend of the spread of deposits and loans. It can be concluded that interest rate liberalization will affects the deposits-loans surplus of banks, and this profit model is unsustainable, indicating that a new profit model is needed.[3] In reference to foreign experience, Xiao Xinrong and Wu Yonggang(2011) published the "Impact of American Interest Rate Liberalization Reform on the Banking Industry". It can be concluded that for China’s late start, the experience of foreign developed economies is of great significance to the development of China’s interest rate liberalization.[2] Regarding risks and problems, in the "Challenges and Responses to Commercial Banks from the Liberalization of Interest Rates", Li Hongjin(2015) analyzed the problems faced by commercial banks such as the reduction of deposit-loan margins and the pricing power of commercial banks due to the liberalization of interest rates, and believed that loan interest rates would rise However, the deposit-loan gap will still shrink, and interest rate fluctuations will increase credit risk and liquidity risk.[7] To sum up, there are different opinions on the topic of the impact of interest rate liberalization on commercial banks. This paper aims to analyze the impact of interest rate liberalization on commercial banks through different factors. Starting from the emergence and development status of interest rate liberalization, the paper then discusses the position of commercial banks in it. As China started later with this process, there are a lot of advanced experience to learn from. Therefore, the paper compares foreign progress for reference. The paper also analyzes and summarizes what changes commercial banks will face due to interest rate liberalization and puts forward relevant countermeasures. The findings of the research can be used in the process of preparation for lectures and practical classes on such topics as “Interest Rate Liberalisation”, “Chinese commercial banks”. Findings of the research can also enrich the general theory of the interest rate liberalization and its impact on bank system.

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CHAPTER 1 THEORETICAL FOUNDATIONS FOR UNDERSTANDING THE CONCEPT OF INTEREST RATE LIBERALISATION

1.1 Definition of the interest rate and its different types

1.1.1 Definition of the interest rate

Interest rate refers to the ratio of the amount of interest to the amount of borrowed funds (principal) in a certain period of time. Interest rate is the main factor that determines the level of capital cost of a company, and it is also a decisive factor for corporate financing and investment. Research on the financial environment must pay attention to the current interest rate and its changing trend.[36] The interest rate is one of the most important elements of commercial, credit or investment contracts.

1.1.2 Types of interest rates

In financial analysis, the interest rate is used not only as a tool for increasing the amount of debt, but also in a broader sense - as a measure of the profitability of any financial, credit. Investment or commercial activity. The interest rate used in the process of increasing or discounting the value of cash (estimating its future and present value) is classified according to the following main characteristics. 1. According to the form of estimating the value of money in time [8, p. 928]: cumulative interest rate - cumulative interest rate refers to the sum of interest paid during the validity period of the loan or within a certain period of time. discount rate (discount rate) - the discount rate refers to the interest rate used in discounted cash flow analysis to determine the present value of future cash flows, which consider the time value of money. 2. On the stability of the interest rate value [21, p. 145]: fixed rate -- characterized by a constant value during all calculation periods; floating (variable) rate-is characterized by its regularly revised level by agreement of the parties in the context of individual intervals of the general accrual period. This revision is due to changes in the average rate of interest in the financial

6 market (or in its individual segments), changes in the rate of inflation, and other conditions. 3. On accrual of a certain annual amount of interest [21, p. 147]: periodic rate - it may differ in the level of the annual payment period and the duration of each interval, such as monthly payment and quarterly payment. effective annual rate – it refers to the annual interest rate compounded once a year that can produce the same result when calculating interest based on the given periodic interest rate and the number of compounding times per year. 4. According to the formation conditions [29, p. 168]: the base rate- the base rate is a universal reference interest rate in the financial market, and other interest rates or financial asset prices can be determined based on this interest rate. Generally speaking, the interest rate of Treasury bonds is the most suitable as the base rate. the arbitrage rate- the interest rate calculated by financial institutions according to the characteristics of the base rate and loan items after the base rate is determined. 5. According to the financing period[21, p. 147]: long term rate - refers to the interest rate of various financial assets with a financing period of more than one year. short term rate - refers to the interest rate of various financial assets with a financing period of less than one year. 6. According to the purpose of loans: interest rates on commercial real estates, consumer mortgages’ loans. Consumer mortgages are a type of loan from a bank or lender to help you finance the purchase of a home. Commercial real estate loans lend business owners a sum of money to invest in their business. Business loans can be used for a wide variety of business-related expenses, from new equipment to hiring and beyond. Interest rates for consumer mortgages are typically lower than commercial real estate loans. A business loan will likely carry a higher interest rate, depending on the amount borrowed and term, among other factors. [9, p. 940]. 7. Rates on term deposits of the population and companies. The interest rate of time deposit refers to the rate of return that the bank pays to the depositor for the time deposit. If the company and the bank do not sign a deposit agreement, the deposit interest rate for the company and the individual is the same. If the company has signed a deposit agreement with a bank (such as the Industrial and Commercial ), it will be calculated according to the agreed deposit interest rate. Agreement deposits are extended on the basis of the original unit demand deposits. The agreement deposit accounts are closely related to their corresponding demand deposit accounts. After the deposits in the demand deposit accounts exceed 7 the agreed limit, the part exceeding the limit can enjoy the agreement deposit interest rate. Deposit interest rates are closely related to other currencies and stock market interest rates. 8. Interest rates on debt securities (bonds, savings (deposit) certificates, bills of exchange, commercial securities, notes, etc). Refer to the interest rates of the capital market. In debt securities, there is a % rate at which the borrower - issuer of the security borrows money. These rates are also very diverse, the coupon on multi-year bonds, the interest rate on bills and savings certificates, and the yield to maturity. Coupon rates show the percentage profit to the nominal value of the bonds. The yield to maturity shows the percentage profit, taking into account the market value of the bonds and the re-investment of the coupon income received [11, p. 59].

1.2 The Importance and content of interest rate liberalization

Interest rate liberalization means that interest rates are determined by the market factors rather than being set by the regulators. Through market competition mechanisms, financial institutions are allowed to set the price interest rates independently. Therefore, interest rate liberalization refers to the monetary authorities fully or partially out of the direct control of interest rates, which is determined by the market main body independent interest rates, interest rates in the market capital supply and demand in accordance with the law of value under the influence of spontaneous market behaviors. Under the market-oriented interest rate system, lending and deposit rates are decided by the financial institutions. The structure of interest rates is adjusted spontaneously according to the law of value which is determined by market supply and demand, but not directly decided by the central bank. However, the central bank will set a benchmark interest rate, which is usually based on the benchmark interest rate, and the money market interest rate is the intermediary, which determines the interest rate of the deposit and loan by market supply and demand.

1.2.1 Importance of interest rate liberalization

The use of interest rate controls is a common policy challenge for developing economies including China. International experience suggests that interest rate controls 8 usually lead to inefficient allocation of financial resources. In an inflationary environment, interest rate controls frequently result in near-zero or negative real interest rates. Distorted interest rates serve as a hidden tax on savers and a subsidy for borrowers, which encourage leverage and lead to unproductive use of credit. Not surprisingly, interest rate controls are often associated with high levels of nonperforming loans and frequent recapitalization of banks.[3, p.56] The growing global consensus among policymakers is that interest rates need to be determined by market forces. Starting in the late 1970s, a wave of interest rate liberalization reforms swept the developing world. By the mid-2000s, many developing countries had successfully liberalized bank lending and deposit rates. A liberalized interest rate environment generally leads to more efficient allocation of financial resources, widens credit access for previously underserved sectors (especially small businesses), and promotes more sustainable economic growth [22, p. 38]. By committing to interest rate liberalization reform, Chinese policymakers hope to ensure that interest rates play a fundamental role in effective resource allocation. Government officials have stressed the importance of allowing banks more autonomy in pricing products and services, providing households with more diversified investment choices, and letting market forces determine risk premiums. In addition, the PBOC expects that interest rate liberalization would facilitate the smooth, effective transmission of monetary policy. These expectations are largely in line with the benefits that interest rate liberalization delivered to other countries in the past. It should be noted that despite these expected benefits, the actual implementation of such reforms may bring risks to a country's financial system and economy. As Mehran and Laurens concluded, “interest rate liberalization may not produce the expected benefits if the timing, pace and sequencing are off” [14, p. 23]. They argue that successful reform often depends on macro-economic and financial stability in countries, conditions of the banking and state enterprise sectors, and central bank capabilities. When implemented too rapidly, interest rate liberalization almost always results in heightened volatility in interest rates and capital outflows and subsequently, bank failures. On the other hand, too slow a pace in implementation may cause new distortions to emerge.

1.2.2 The content of interest rate liberalization

1. Liberalization of interest rate transmission. Interbank lending rate can accurately reflect the short-term capital supply and demand situation. It is one of the most representative interest rates in financial markets. Therefore, it is the main content

9 of interest rate liberalization that the rate of inter-bank lending rate is the criterion of interest rate liberalization. 2. Liberalization of interest rate management. The monetary authorities' control of interest rate is indirect, which cannot be used directly to control market interest rate. The central bank has indirectly affected interest rates, can use three major policy tools, namely open market operations, legal deposit reserve, rediscount rate to indirect adjusting interest rates, and to guide market interest rates. 3. Liberalization of interest rate structure. In the process of financial transactions, each participant has full autonomy on the choice of number of structures, the flexible way to meet various needs from both sides of the transaction. This played a significant role in the formation of the market equilibrium interest rate. 4. Liberalization of interest rate decision. The most important content of interest rate liberalization is that financial institutions have pricing power for their financial products, which mainly refers to the pricing of deposit and loan by commercial banks. [35, p. 163]. To sum up, interest rate liberalization is regarded as a dimension of financial liberalization in developed countries, and the corresponding research is incorporated into the general framework of financial liberalization. In contrast, the discussion of the interest rate liberalization in China is more abundant and comprehensive.. The impact of interest rate liberalization on banks has been mainly studied in two aspects. One is to study the impact of interest rate liberalization on bank loan pricing and spreads. The other is to study the impact of interest rate liberalization on bank risk. First, on the impact of interest rate liberalization on bank loan pricing and spreads, Feyzioglu T. discussed the impact of interest rate liberalization on bank lending rates through building a banking monopoly competition model. In the model, interest rate on both deposits and loans exist are regulated. Interbank market lending rate is controlled by the central bank. Interest rate liberalization leads to the rise of interbank lending rate, which further results in the rise of loan interest rate [6, p. 25]. However, the above conclusions have not been agreed by others. Porter and Xu showed that the cancellation of deposit rate will lead to the decline of interbank lending rate [16, p. 89]. He and Wang pointed out that the effect of loosening deposit rate on loan rate is uncertain, depending on the competition between banks and the degree of capital account openness. Ji L. set up a two-track interest rate model and studied the equilibrium with the upper limit of the deposit interest rate by means of parameter calibration and nonlinear optimization. The study showed that the loosening of the upper limit significantly increased the deposit rate and significantly reduced the loan rate. Li analyzed the impact of interest rate liberalization on bank spreads based on data of more than 20 countries and regions and showed that after the interest rate liberalization had finished, deposit and loan rates and real interest rates of most 10 countries rise but not necessarily narrow the nominal spread, net interest margin may even further expand [13, p. 105]. For the impact of interest rates liberalization on bank risk, Diaz-Alejandro(1987) studied the process of financial liberalization in Latin American countries and the financial crisis along with it. The results showed that financial liberalization might cause moral hazard of banks, and even lead to banking crisis.[37, p. 4] Based on panel data of cross countries, some literature found that there is a positive correlation between the financial liberalization and banking crisis [11, p. 10]. While others showed that the correlation between financial liberalization and bank crisis was not significant. Zhang specify the year dummy variable of 2004 as the proxy variable of interest rate liberalization and studied bank risk behavior under the background of interest rate liberalization based on data of 14 banks from 1998 to 2010 [11, p. 12]. The empirical results showed that the influence of interest rate liberalization on bank credit risk is not significant but might enhance the bank's business risk. To sum up, the existing literature has reached a consensus on the role and impact of bank liquidity creation and began to explore the factors that influence bank liquidity creation.

1.3 International experience of interest rate liberalization

In 1970s, the disadvantages of interest rate control became increasingly exposed. Under the guidance of financial deepening theory, a wave of financial liberalization with interest rate market as the core has been launched. "Progressive" interest rate liberalization is represented by the United States, and , and "radical" interest rate liberalization is represented by Latin America. Seven representative countries including the United States, , , Japan, Thailand, Chile and Uruguay are selected as the research objects. In order to ensure the systematic and scientific approach of research on the effect of interest rate liberalization reform in these seven countries, it is analyzed by sorting out the time points and landmark events of interest rate liberalization and opening (See Table 1.1).[5]

Table 1.1 - The open schedule and landmark events of interest rate liberalization in various countries

Nation Year Landmark event USA 1986 Successfully abolished the “Q regulations” that regulates deposit interest rates 11

UK 1971 Introduced financial reform and scraped the interest-rate agreement AUS 1981 Canceled the direct controls on deposit and loan interest rates JPN 1994 Liberalized liberalization of deposit and loan interest rates and completely liberalized the interest rates control THA 1989 Commercial bank's one-year deposit interest rate cap was lifted CHI 1975 Eliminated all interest rate controls URY 1794 Raised the legal interest rate cap on deposits and loans Note- Source: author’s elaboration on the basis of [5]

The changes of GDP growth rate before and after interest rate liberalization: By comparing the changes of GDP growth rate before and after interest rate liberalization in seven countries, there are three points to followed from the Table 1.2. Firstly, after interest rate liberalization, the GDP growth rate shows a downward trend in the overall stability with a good performance, such as United States, Britain, Japan and Thailand. America's GDP growth rate tends to be stable. Interest rate presents a modest rise at first, then begins to decline, and the average GDP growth rate for five years before and after the liberalization of interest rate are 3.36% and 2.64% respectively, which has reduced 21%. Besides, Britain's GDP rate is relatively slow, but it decline a little after interest rate liberalization. Although the GDP growth rate of Thailand has been declining since the interest rate liberalization, it remains stable at about 8%.[4, p. 24] Secondly, after interest rate liberalization, GDP growth rate fluctuates, such as Australia and Uruguay. Australia's GDP growth rate decreases from 3.35% to -2.23%. But after interest rate liberalization, it has increases to 5.23% in the fourth year and decreases to 3.93% in the fifth year, showing a small wavy change. Uruguay's GDP growth rate increases to 6.09% after the reform, decreases to 1.46% from 6.09% in the second year, and recovers to 6.19% from 1.46% in the third year. Thirdly, after interest rate liberalization, GDP growth rate increases significantly, such as Chile. Interest rate liberalization has injected new vitality into Chile's GDP growth. In the five years after interest rate liberalization, the GDP growth rate has increased by 400% compared with that of the previous five years [5, p. 27].

Table 1.2- National GDP growth with situation before and after the liberalization of interest rate (percentage)

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Note: 0 year is the year of interest rate liberalization; for the -i years before opening; for the -i years after opening ( i= 1,2,3,4,5); The inflation rate by the GDP deflator measures. Source: World bank database.

Due to the different conditions of these countries, there are significantly different effects of interest rate liberalization reform in various countries. Developed countries, represented by the United States, Britain, Australia and Japan, have carried out interest rate liberalization reform in a “gradual” mode. The overall economic situation is in a stable status, and interest rate liberalization reform has achieved good results and success. Most developing countries in Latin America, represented by Chile and Uruguay, adopts "radical" market-oriented reform of interest rate, which has a great impact on macro economy and faulty effect on reform. It can be seen that the effect of a country's interest rate liberalization reform is closely related to the macroeconomic conditions in the reform period, especially the stability of macroeconomic operation and the degree of financial development.[4,5] Lessons learned from the experiences of interest rate liberalization in various countries. 1. Interest rate liberalization needs a stable external environment. Interest rate liberalization reform is easy to succeed under stable macroeconomic environment. When macro environment is stable, government can response to requirement of financial regulation's changes calmly, which do not meet the requirements of real economic development and respond reasonably, so that the reform has a higher opportunity to success. 2. Relevant supporting regulatory policies should be improved. The reform of interest rate liberalization should enable market players to have ability to price capital freely, so as to promote effective allocation of resources and highquality economic growth, rather than simply deregulate interest rate control. Therefore, the base for fully liberalizing interest rate control is mature financial market. At the same time, according to the reform experience of various countries, in a stable economic situation, regulators can monitor financial system closely and establish suitable regulatory system based on recent condition. 3. Supportive policies should be timely and appropriate. The more reasonable supportive policies at the right time is the foundation of further reform. Based on these successful experiences of United States, Japan and South Korea, the key point is that the government proposes supporting policies timely according to the actual needs of market subjects.[4,5]

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1.4 The development and current situation of interest rate liberalization in China

With the development of social economy, the disadvantages of interest rate control are becoming more and more prominent. Therefore, the United States, Japan, South Korea and other countries have abolished interest rate controls. It has been proved by practice that the implementation of these policies has played a positive role in promoting economic development. Taking South Korea as an example, to correct the overinvestment in heavy and chemical industries and distortions created by the strong protectionist policies in the 1970s, the government had respect for the market mechanism and competition and as a result limited government intervention. The import liberalization ratio rose from 68.6 percent in 1979 to 91.6 percent in 1986. The average nominal tariff rate for all commodities declined from 35.7 percent in 1978 to 18.1 percent by 1988.[38, p. 248] At present, the interest rate liberalization in China is taking lessons from the successful experience of these countries. According to the unified deployment of the Communist Party of China (CPC) central committee and the state council, the overall train of thought of China's market-oriented interest rate reform is to loosen monetary market interest rates and bond market interest rates, in turn advance deposit, loan interest rate liberalization [27, p. 46]. On January 3, 1996, the People's Bank of China established the national unified inter-bank lending market, which formed a unified inter-bank lending rate nationwide. On June 1, the liberalization of China's inter-bank lending market interest rate opened the prelude to the market-oriented reform of interest rates determined by both lenders and borrowers based on market supply and demand, laying a solid foundation for future reforms. [27, p. 46] In June 1997, the interbank bond market was officially launched, and bond repurchase, and coupon trading interest rates were released. [27, p. 46] In March 1998, the People’s Bank of China reformed rediscount rate and the formation mechanism of discount rate, liberalized the discount rate and the discount rate, thus basically realized the interest rate liberalization of money market. [27, p. 46] In September 2000, the People's Bank of China released the interest rate on foreign currency deposit and loan and realized the reform of the interest rate liberalization of foreign currency deposit and loan in China. [27, p. 46] In April 2003, the Chinese chemical group enterprise bonds were issued by market-based pricing, which marked the basic realization of interest rate liberalization in China's bond market. [27, p. 46] In 2004, the central people's bank raised its benchmark interest rate, while opening up the ceiling on lending rates and a floor for deposit rates. But since then, the 14 deposit and lending interest rate liberalization in our country basically at a standstill, until June 7, 2012, when the People's Bank of China lowered the benchmark deposit and lending interest rates, and allows for the first time deposit interest rates could rise to 1.1 times the benchmark interest rate, restart the marked the liberalization of interest rate in our country. [27, p. 46] On July 20, 2013, the Central Bank decided to fully liberalize the lending rate of financial institutions and cancel the lower limit of lending rates, which marked the completion of the liberalization of China's loan interest rate. Through long and unremitting efforts, China's interest rate liberalization has achieved remarkable achievements so far (Figure 1.1). [27, p. 46]

Figure 1.1 China’s path to interest rate liberalization Note- Source: author’s elaboration on the basis of [27]

The inter-bank lending market, inter-bank bond market, discount, rediscount, discount market and other currency markets, with financial bond market, corporate bond market, treasury bond market and other bond markets have basically achieved interest rate liberalization. For the liberalization of deposit and loan interest rate, China’s basic idea is "first foreign currency, later local currency; First loan, later deposit; First long, big, later short, small ". At present, the interest rate liberalization of foreign currency is basically in place, the loan interest rate floor is cancelled, the basic trend towards liberalization, the remaining main task is to reform the interest rate liberalization. Regarding the deposit and loan interest rates, China has completely liberalized the upper limit of RMB loan interest rate and deposit interest rate of financial institutions since 2004. In 2013, the lower limit of loan interest rate and control on bill discount interest rates were basically abolished, and the control on loan interest rate of financial institutions was fully relaxed. These steps marked the basic realization of China's loan interest rate liberalization.

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For currency market interest rate liberalization, the interest rate liberalization in China's money market is progressing smoothly. It has mainly gone through three stages of interbank lending rate liberalization, bond market interest rate liberalization and Shanghai Interbank Offered Rate (Shibor in short) as the benchmark interest rate in the money market which construct the market interest rate system [26, p. 15]. Last but not the least, in aspect of central bank interest system, the central bank's control of interest rates has gradually changed from direct to indirect in China's interest rate liberalization reform, such as open market operations. Through the central bank and designated dealers to conduct securities and foreign exchange transactions, the realization of the monetary policy control objectives has played a positive role in regulating the money supply, regulating the liquidity level of commercial banks, and guiding the trend of money market interest rates.

1.4.1 Obstacles of China's Interest Rate Liberalization Reform

1. The market interest rate self-discipline pricing mechanism has implicit control. Theoretically, China has liberalized the upper limit of deposit and loan interest rates and basically completed the market-oriented reform of interest rates. However, in practice, China has established a three-level self-regulatory mechanism for interest rate pricing at the national, provincial and municipal levels, which still provides guidance for pricing schemes of small and medium-sized financial institutions with weak independent pricing ability. To some extent, the interest rate ceiling is still affected by the self-discipline mechanism of the industry. [21, p.30] 2. China's benchmark interest rate formation mechanism is not standardized. Currently, Shanghai interbank offered rate is mainly adopted as the benchmark interest rate in China with 16 quotation Banks with high credit rating participating in the quotation. However, the rating of quotation institutions is not completely equal, and the market segmentation and SHIBOR are greatly affected by the Repo rate, which cannot reflect the real price of capital. Because interest rates transmission mechanism cannot fully take effect, the benchmark interest rate formation mechanism is not sound.[21, p.30] 3. With bank's risk increasing, risk control ability is insufficient to match the needs of enterprises. In the process of interest rate liberalization, banks are faced with rising credit risk, market risk and operational risk. In addition, China's commercial Banks are lack of liberalization, sensitivity to interest rates and risk awareness, and poor risk control

16 ability. After the liberalization of the loan interest rate, banks have to increase the financing cost and risk of enterprises in order to pursue higher profit returns. [21, p.30] 4. Imperfection of the financial market development and unsound financial supervision mechanism exist. For the financial market, it is still heavily segmented and unbalanced with lack of financial products. Banks still occupy the dominant position, and the interest rate market space for non-bank is small. Besides, the number of institutional investors is insufficient, which hinders the formation of a complete market interest rate system. [21, p.30]

The definition of interest rates and their types can be categorized according to 8 methods, including the form of estimating the time value of money, the financing cycle, and the formation conditions. Based on the analysis and summary of the international experience of interest rate liberalization, it can be concluded that the relaxation of interest rate restrictions is conducive to the more efficient allocation of financial resources, which also proves the importance of China's interest rate liberalization. Finally, the combing and analysis of China's interest rate liberalization process from 1996 to 2013 revealed four issues that hindered China's interest rate liberalization, including the irregular formation of benchmark interest rates.

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CHAPTER 2 ANALYSIS OF CHINA’S BANKING SYSTEM

2.1 China’s banking system and the People’s Bank of China

The functions of the central bank are vested in the People's Bank of China. The People's Bank of China (PCB) was established on December 1, 1948, on the basis of the merger of the People's Bank of North China, the People's Bank Beihai and the Northwest Peasant Bank. Initially, the PCB was assigned the following functions: ⚫ execution of operations of the state treasury; ⚫ control over private loans; placement of public loans; ⚫ control over operations with foreign currency and precious metals. This system has undergone a number of changes over time. Most significantly, since September 1983, in accordance with the decision of the Central People's Government-the State Council of the People's Republic of China (the State Council) - the PCB has been acting as the central bank of the People's Republic of China and is not engaged in industrial and commercial loans and savings [18, p. 63]. The PCB manages the monetary policy of the state, applying the following regulations [18, p. 66]: ⚫ formation of the established proportions of requirements for contributions to the deposit reserve fund from credit and monetary organizations; ⚫ determination of the central bank's base interest rate; ⚫ re-accounting of promissory notes of credit and monetary organizations that have opened accounts with the PCB; ⚫ provision of loans to commercial banks; ⚫ buying and selling government bonds, other government bonds, and foreign currency on the open market. As already mentioned, the PCB manages the state treasury and can, on behalf of the financial departments of the State Council, start issuing and selling government loan bonds and other government bonds to credit and monetary organizations, and, if necessary, it can open accounts for credit and monetary organizations, but must not make an overdraft on their accounts. The PCB organizes a system of settlements between credit and monetary organizations and provides settlement services. At the same time, the specific calculation methods are determined by the PCB. In addition, in accordance with the needs of the implementation of monetary policy, the PCB can make decisions on the volume, terms, interest rates and forms of lending by commercial banks (the loan term should not exceed one year). 18

PCB regulates the activities of credit and monetary organizations and oversees their operations. It considers the creation, transformation, and termination of the activities of credit and monetary organizations and approves the list of operations carried out by them, as well as provides guidance and control over the credit and monetary operations of state - owned banks. In exercising its control powers, the PCB has the right to [15, p. 33]: ⚫ Audit, audit and control credit and monetary organizations on the status of deposits, loans, settlements, bad debts; ⚫ Perform verification and control in the event that credit and monetary organizations raise or lower the interest rate on deposits or loans, violating the established standards; ⚫ Require credit and monetary organizations to provide, in accordance with the established procedure, data on assets and liabilities, income and losses, and other information and materials of a financial and accounting nature. Commercial banks (CB) of China can be divided into two large groups, CB located on the mainland of China and commercial banks located on the territory of . By the end of 2020, ICBC’s assets have reached RMB 30.11 trillion, while ICBC (Hong Kong) has assets of RMB 740.3 billion.(Sources from ICBC financial report) After the reunification of Hong Kong with China on July 1, 1997, with certain reservations, it can be said that the banking system of the People's Republic of China was replenished with banks located on the territory of Hong Kong. But it should be remembered that according to Article 5 of the Basic Law on the Hong Kong Special Administrative Region, adopted at the third session of the National People's Congress of the seventh convocation on April 4, 1990, the right of private property is preserved in Hong Kong.[32, p. 28] Moreover, for 50 years from the moment of the formation of this district, the socialist system will not be introduced on its territory. The banking administration in Hong Kong has certain autonomy: ⚫ There is no central bank in the Hong Kong Special Administrative Region. ⚫ There is also no currency control. ⚫ Capital moves are carried out without any restrictions. ⚫ Bank interest rates are set by the Hong Kong Banking Association, considering the views of the Hong Kong Government. ⚫ The right to issue money belongs to the Hong Kong Government, which appoints the banks authorized to issue the Hong Kong dollar. To obtain the right of issue, the bank must have a one-hundred-percent reserve fund in US dollars [15, p. 35]. In accordance with the legislation of the People's Republic of China, the establishment of a commercial bank is carried out after the consideration of this issue by the PCB and its approval of a specific decision. Without these procedures, no 19 organizations or individuals are allowed to engage in attracting public deposits and other operations that fall within the competence of the CB, and organizations do not have the right to use the word "bank" in their name.

Figure 2.1 Three level structure of the banking system in China Note- Source: author’s elaboration on the basis of [7]

On the first level is the People's (Central) Bank of China and the "Chinese Development Bank" (3 pieces). The Central Bank plays the role of the issuing / credit center of the state, its management is entrusted with the task of developing and implementing monetary and credit policy. Management and control is carried out by the All-China Banking Regulatory Commission [7, p. 520]. Development banks conduct activities aimed at supporting public administration, the agricultural sector and export-import operations. The Chinese banking system implements state programs in various areas with the help of financial structures directly managed by the authorities. The next stage is occupied by the banks of the "Big Four". The banking system of the People's Republic of China was built in the form of a pyramid with a single centralized state bank with an extensive network of branches, 20

capable of concentrating not only the issue of money, but also the bulk of all credit and settlement operations in the country.

2.2 Big Four Banks

To the second level of the banking system belong: the Bank of China, the Industrial and Commercial Bank, Construction Bank and Agricultural Banks of the People's Republic of China. They conduct more than 60% of all domestic and foreign monetary transactions in the Chinese market.[7, p.520] These organizations have huge capital and are constantly in the corresponding Forbes ratings. 1. Bank of China "Bank of China" was founded in 1912, and at the moment it is the largest financial institution in China. In 1994, it acquired state status. After the events of the Chinese Revolution, the specialization changed – the bank began to carry out foreign economic activities, to provide currency exchange. Bank of China is the only bank in China that has been operating continuously for more than a hundred years, and it is also China's most internationalized and diversified bank. As of the end of December 2019, the group's total assets, total liabilities, and shareholders' equity reached RMB 21.27 trillion, RMB 19.54 trillion, and RMB 1.73 trillion, respectively, representing an increase of 9.25%, 9.23%, and 9.43% over the end of the previous year. The profitability has steadily improved, and the group's operating income exceeded 500 billion yuan, reaching 503.806 billion yuan, a year-on-year increase of 4.14%. [17, p. 22]. 2. Construction Bank of China "" is a state-controlled financial structure. It was founded in 1954 and for a long time directed budget funds for the development of capital construction. In the 80s, the Chinese payment system was reformed, which allowed the organization to expand its capabilities and make it commercial. The advantage of China Construction Bank is to support the construction of national infrastructure, and it has a lot of room for development in the international market.At the end of 2019, the group's total assets were 25.44 trillion yuan, an increase of 9.53% over the previous year. The total debt is 23.20 trillion yuan, an increase of 9.28%, of which deposits are 18.37 trillion yuan, an increase of 7.35%. The profit growth trend is good, and the core indicators are balanced. Achieved a net profit of 269.222 billion yuan, an increase of 5.32% over the previous year and an increase of 0.39 percentage points year-on-year. The average return on assets was 1.11%, and the weighted average return on net assets was 13.18%, maintaining the industry's leading level. [17, p. 23]. 3. Industrial and Commercial Bank of China (ICBC) 21

ICBC is considered one of the youngest in its category, since it was created only in 1984. Its current authorized capital is about 334 billion yuan. Its key areas of activity [7, p. 530]: ⚫ deposits of money in local or foreign currency; ⚫ loans for various terms; ⚫ currency and exchange operations; ⚫ provision of services for foreigners in the territory of other countries; ⚫ settlement and cash services; ⚫ representation of the client's interests in performing transactions with securities; ⚫ providing guarantees on the rights of the state bank; ⚫ consulting for clients of various categories. ICBC has many branches and reasonable regional distribution. At the end of 2019, the total number of ICBC institutions was approximately 17,200, of which 16,700 were domestic institutions and 412 were overseas institutions. Compared with small and medium banks, ICBC has a wider distribution of outlets. Among them, the number of grassroots business outlets also remained at around 13,000, which is at the forefront of the industry. ICBC's demand deposit and time deposit cost ratios are at a relatively low level in the industry. At the end of 2019, ICBC’s corporate current deposit cost ratio was 0.66%, and personal current deposit cost ratio was 0.31%; corporate time deposit cost ratio was 2.48%, personal time deposit cost ratio was 2.69%. ICBC’s current deposit and time deposit cost ratios, which are the lowest level in the industry. [7, p. 530] 4. Agricultural Bank of China (ABC) ABC started working in 1979, at the moment its authorized capital has reached 36 billion yuan. The positive growth dynamics allowed it to significantly improve its financial performance and become one of the largest financial structures in the country. Its main specialization is agriculture and providing social support to the population working in the relevant field. The organization has opened many branches in Hong Kong, , Shanghai and other cities of various sizes in China. Within the framework of the Chinese payment system, it performs various financial operations, including making deposits, issuing loans, and providing settlements for Chinese citizens and non-residents. ABC has a leading position in urban areas and will further strengthen this position with its extensive sales network and customer base. As of December 31, 2020, the total loans and deposits of rural residents in urban areas were 9,865.137 billion yuan and 11,618,417 million yuan, respectively. In China's rapidly developing vast county areas, the Agricultural Bank of China is the most important financial service provider and leader. As of December 31, 2020,

22 the Bank's total loans and total deposits in county areas were RMB5,305.305 billion and RMB8,754,484 million, respectively.[18, p. 70]

2.3 State-owned, joint-stock, and city commercial banks

This level mainly includes three types of state-owned commercial banks, national joint-stock commercial banks, and city commercial banks. Joint-stock commercial banks are a type of commercial banks. There are 12 national joint-stock commercial banks in my country: , Shanghai Pudong Development Bank, China CITIC Bank, , , , , , , Hengfeng Bank, Zheshang Bank, Bohai bank. City commercial banks are an important component and special group of China's banking industry. Its predecessor was the City Credit Cooperative established in the 1980s. At that time, its business positioning was to provide financial support for small and medium-sized enterprises and pave the way for the local economy. The Chinese government always retains control over its financial structures, holding a controlling stake. This form of organization allows to prohibit unwanted actions, and the banks themselves can continue to carry out monetary activities.[17, p.23] To do this, at the time, the legislation was reformed, making significant changes to the payment systems of China. The new laws allow citizens of different countries to take out consumer loans, mortgages, make payments for services and deposits, make paperwork, etc. Currently, the minimum amount of authorized capital required for the establishment of a commercial bank is 1 billion yuan, for a city cooperative bank-100 million yuan, for a rural cooperative bank-50 million yuan. The authorized capital must be the actual contributed capital. The People's Bank of China can regulate the minimum amount of authorized capital, but only in the direction of increasing the above amounts. At the same time, an important role was assigned to the development of the Chinese banking system, which had to solve three key tasks in the banking sector [12, p. 5]: - avoid the risk of a threat to the system-wide nature of the banking system associated with the presence of " bad debts” on the balance sheets of Chinese banks, - to relax excessive regulation of the industry and remove restrictions on banking activities, in terms of regulating bank rates, cross-border capital movement and currency exchange operations, quotas for lending volumes, operations on capital markets involving the placement of shares and other banking instruments,

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- strengthen competition in the banking market, increase the level of management and assessment of credit risk, create mechanisms for judicial and legal protection of the interests of credit institutions in terms of repayment of credit funds. Intensive reform of the banking sector, taking into account market instruments and Chinese specifics, determined the synchronicity and effectiveness of the chosen model of management of reforms in the banking sector, the main directions of which were [12, p. 10]: - determining the main parameters of the functioning of banking institutions with the simultaneous liberalization of the financial and banking system of the People's Republic of China, - the creation of a global financial system with the world financial center in Shanghai in order to influence the growth of the country's economy.

2.4 The role of Chinese commercial banks in the banking sector

China's banking sector is in the process of continuous development. Despite the fact that the structure of the Chinese banking sector and its management system correspond to the characteristics of the transition period from Chinese socialism to the new economic structure of the country, the Chinese banking sector has shown its dominant role in the performance of the global banking system. By the end of 2017,China's banking system has surpassed the Eurozone to become the world's largest banking system by assets. The total assets of the Chinese banking industry reached US$33 trillion at the end of 2016, compared to US$31 trillion in the Eurozone, US$16 trillion in the United States, and US$7 trillion in Japan. The value of China's banking system is 3.1 times the size of the country's annual economic output, while the value of Eurozone banks is 2.8 times its annual economic output.[15, p.34] The goal of the development of the Chinese banking system continues to be to: - to ensure the stability of the development of the banking sector and, as a result, to increase the efficiency of each individual bank; - distribute monetary resources among all parts of the Chinese economy through the established three-tier banking system; - promote the development of small and medium-sized businesses in order to form a financially secure middle class; - strengthen the monetary turnover and stability of the Chinese yuan in order to further promote it to the world capital markets.[7, p.520] The implementation of banking reforms in China is aimed at increasing the capitalization of the banking system and timely support of economic sectors in various periods, including crisis periods. 24

The rapid growth of the banking sector is accompanied simultaneously by the reorganization and restructuring of banks, the improvement of banking supervision with the application of international standards, the development and amendment of banking legislation. In Table 2.1, the compound annual growth rates of total RMB loans and deposits in China's banking industry from 2015 to 2019 were 13.69% and 11.97%, respectively, which reflects China's huge financing needs and China's banking sector strength.

Table 2.1 - Data on loans and deposits in RMB and foreign currencies of the Chinese banking industry Year Total RMB Total RMB Total foreign Total foreign loans (100 deposits (100 currency currency million yuan) million yuan) loans(100 million deposits(100 million dollars) dollars) 2015 718961 1043867 7769 4386 2016 816770 1138645 8351 5735 2017 939540 1357022 8303 6272 2018 1066040 1505864 7858 7119 2019 1201321 1641044 8379 7910 Annual 13.69% 11.97% 1.91% 15.88% growth rate Note- Source: author’s elaboration on the basis of public information

The dominance of the Chinese economy in global production could not but affect the position of Chinese banks in the formation of the pool of the TOP 10 largest world banks. (see Appendix Table 1) The third level of commercial banks are urban and rural commercial banks. Urban and rural credit cooperatives were created in order to reduce shadow banking at the level of small businesses and micro-loans. Their functioning contributes to the coverage of small and poorly secured economic entities within the framework of the state program for expanding lending to small and medium-sized enterprises.

Within the territory of the People's Republic of China, commercial banks are prohibited TO : ⚫ Engage in secured investments and stock transactions; ⚫ Make investments in real estate that is not intended for your own needs; ⚫ Invest in non-bank credit and monetary organizations and enterprises. The latter measure is intended to facilitate the focus of CB's efforts on improving the quality of their traditional operations.

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According to the legislation of the People's Republic of China, cooperative banks(CB in short) loans must comply with the established proportions between assets and liabilities; by the capital adequacy ratio (not less than 8%); by the ratio between loan balances and deposit balances (not more than 75%); by the ratio between the balance of liquid assets and liquid liabilities (not less than 25%); in addition, the balance of loans to the same borrower must not exceed 10% of the CB's equity [28, p. 12]. China's banking system also includes credit cooperatives (CC) and urban cooperative banks. Credit cooperatives - these are financial organizations whose main tasks are to accept deposits and provide loans to small companies located in cities and rural areas, conduct settlements between them, as well as accept deposits from the population. By the beginning of 1995, the number of CC in China was about 5,000 units. They had 156.2 billion yuan raised in savings, and their loan funds were 95.7 billion yuan, making them an important element of the Chinese banking system. However, the limited financial capacity of some CCs did not allow them to meet the needs of the growing urban economy, and most CCs were merged into urban cooperative banks. Urban cooperative banks play a leading role in the creation of local financial structures and help to increase the level of support for the development of the regional economy. If state-owned and commercial banks work with large and medium- sized enterprises, then urban cooperative banks should serve mainly medium-sized and small enterprises, commercial firms and industrial enterprises of local significance. The scope of their operations is limited to a specific city. City cooperative banks are established on a shared-equity basis. The holders of their capital are the population, enterprises with a capital of less than 1 million yuan, as well as the state represented by local authorities. At the same time, the total number of participants in a bank cooperative should be at least 20, and the total amount of capital-at least 50 million yuan [26, p. 17]. The banking system of the People's Republic of China is one of the most dynamic elements of the economy of this state. Among the recent changes in the banking system of the People's Republic of China, first of all, the transformation of state-owned banks into commercial banks in order to increase competition, as well as the increase in the number of urban cooperative banks.

2.5 Foreign banks

Foreign banks have become an important part of the country's banking sector. Foreign banks in China are those banks that are partially or completely owned by foreign capital. 26

In China, banks with foreign capital are divided into three groups: controlled banks created by foreign investors, whose main offices are located in the territory of the People's Republic of China; branches of foreign banks; banks whose shares are jointly owned by foreign and Chinese joint stock companies (joint banks). Since 2004, the number of foreign banks operating in China has increased by 10% annually. As of the end of 2020, foreign banks have established 41 foreign corporate banks, 116 foreign bank branches and 144 representative offices in China, with a total of 946 business institutions and foreign banks’ total assets of 3.78 trillion yuan. Overseas insurance institutions have set up 66 foreign insurance institutions, 117 representative offices and 17 professional insurance intermediaries in China. The total assets of foreign insurance companies are 1.71 trillion yuan. [ Foreign banks and their branches are also active in China. Traditionally, they have played a prominent role in China's banking system. In the early years of the People's Republic of China, only four branches of foreign banks located in Shanghai were granted legal status, which allowed them to maintain their presence in the country, however, almost symbolic. Since 1979, foreign banks have been allowed to establish representative offices in special economic zones: in Beijing and a number of other cities. However, the bank offices could only engage in market research, consulting, economic analysis, assistance in establishing contacts with the Chinese authorities, manufacturers and consumers, but not in banking activities. As the presence of foreign banks expanded, it became necessary to develop an appropriate regulatory framework. On January 7, 1994, the State Council of the People's Republic of China adopted the Regulation of the People's Republic of China "On the Management of Financial and Credit Institutions with Foreign Capital". In particular, the minimum amount of assets of a foreign bank for opening a branch in China was established, and the scope and range of banking operations allowed by it were determined [12, p. 18]. The largest number of foreign banks is established in areas where enterprises with foreign investments are concentrated. Thus, the share of foreign banks operating in the Shanghai area is 43% of the total assets of foreign banks in China, 45% of loans and 40% of deposits in foreign currency. At the same time, Japanese banks are leading among them [12, p. 21].

Taking into account the leading position of the Chinese economy, it is obvious that Chinese banks will follow the economic interests of their country and conduct a progressive expansion of the banking business in various countries, serving the trading operations of their clients by expanding the use of the yuan in world markets and providing them with a full-fledged banking service. 27

Taking into account the development trends in the global banking system, it is obvious that the competition of the Chinese banking system will increase due to the liberalization and removal of restrictions on certain types of operations, with the simultaneous unification and merger of banking regulators and their functions, with the eventual creation of a single mega-regulator of the industry. Taking into account that more than 99% of Chinese companies are small and medium-sized businesses, their contribution to China's GDP exceeds 60%, and tax revenues amount to about 50%, the policy of the state and banks will be aimed, among other things, at increasing lending to micro, small and medium-sized businesses in order to create a sustainable middle class in the country [25, p. 12].

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CHAPTER 3 ANALYSIS OF IMPACT OF INTEREST RATE LIBERALIZATION ON CHINA’S COMMERCIAL BANK

3.1 The influence mechanism of the liberalization of interest rate on commercial banks

The interest rate liberalization innovation leads to the significant change of the interest rate level in banks, having impact on the interest spreads and interest margin, which is the main profit source for banks. 1. The interest rate liberalization will lead to the higher interest rate and various interest spread performance. For most countries, the nominal and actual interest rate for saving has increased from negative or low rate to positive and high rate, which also prompting the increase of loan interest rate. According to Sache's research (1996), among the countries with complete nominal interest rate characteristics, 15 countries have experienced interest rate growth, of which 5 countries have experienced interest rate declines. And among the 18 countries with complete real interest rate conditions, there are 17 countries have experienced varying degrees of real interest rate growth [11, p. 59]. For developed countries, the average interest spreads had decreased after the interest rate liberalization, while this tendency is reverse in developing countries. The research shows that the average interest spreads in developed countries has reduced, such as, 54 basis points in America, 82 basis points in Japan and 21 basis points in China Taiwan (Province). Overall, the reduction is about 0.5％~1% [25, p.12]. Meanwhile, the interest spreads(lending rate minus deposit rate) in developing countries kept increasing at the rate higher than the average level in developed countries. According to the World Bank financial statistics in 2020, developed country Japan’s interest spread is 0.7%, ’s is 2.6% and the world average value is 5.6%. In general, if the countries have stable macro economy, advanced financial market and regulation and take step-by-step procedures, the interest spreads will narrow after interest rate liberalization. For those countries with unstable macro-economy and radical measures, the interest rate liberalization led to the interest spread widening. The current interest spreads in Chinese commercial banks are on the highest level in recent 20 years, entering into the top global list with 2.9% in 2020. Neither the business transformation nor the risk control can benefit from such conditions.[28, p. 11] In the context of greater credit funds gap between demand and supply in future, banks still play leading role for pricing. Extending the downward float interval, or even removal the lower limit for loan, will not have much impact on nominal interest rate.

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Some traditional banks with public business, especially the large state-owned banks, will experience the actual impact on interest rate level. According to the prediction from Research Center of McKinsey Financial Institute in 2020, the average interest spreads in banks in China will reduce by 11%-27% in coming 3-5 years [30, p. 52]. 2. The interest rate liberalization will cause decrease to both net interest spreads and net interest margin. The net interest spread represents the ratio of net interest yield (interest yield minus interest cost) to total assets of bank. It’s an important indicator for commercial bank’s efficiency, reflecting the transaction cost in resource configuration for financial institutes. For banks, this indicator is not the bigger the better, because for downstream customers, the higher the loan interest, the greater the risk of bad debts; for upstream depositors, if the deposit interest is lower, the depositors are more likely to lose. Therefore, the higher net interest margin is not better, but a balance between the net interest margin and the bad debt rate. The net interest margin represents the return rate of net interest yield, i.e. the ratio of net interest yield to average interest earning asset. It mainly depends on the net interest spread and will be affected by the size of interest earning asset and borrowed funds. To respond to the interest rate risks from liberalization, banks need to adjust the business structure to reduce the net interest spread. Angbazo(1998) uses dealer model frame to analyze the impact on net interest spread from interest rate liberalization and credit risks. The results show that banks tend to pursue more net interest spread to compensate the risks from high breach rate and interest rate fluctuation.[39, p. 1260] Drakos applied Generalized Least Squares (GLS in short) method to evaluate the efficiency of 83 banks in transformation in middle eastern Europe and the former USSR. The findings indicate that interest rate liberalization lead to lower net interest spread and higher efficiency [8]. Schwaiger & Liebeg considered the lower operation fee, higher efficiency and development of non-traditional business as the main factors to the net interest spread reduction. Because there is a negative correlation between spreads and industry risks, interest spreads are indeed affected by industry risks. Non-traditional industries have relatively low operating risks due to low operating costs and high growth potential. [4, p.24]. Through research on interest rate liberalization in The Republic of Tunisia, Bennaceur & Goaied had found its dual effect: partial liberalization will reduce the interest spread while complete liberalization can increase the profit rate for banks. Overall, the net interest spread will be downward along with the financial and economic development. The local banks estimate that interest rate liberalization will cause the net interest spread to reduce. In the context of interest spread protection, The cross-cycle net interest margin in China Bank industry is around 2.6%. If the interest regulation is losing, the effect is about 20 basic points [19, p. 12]. 30

A complete interest rate liberalization can result in effect of 15 basic points. Supposing the banks maintain the current customer size, there will be the need to narrow the long-term interest spread by 80 basic points. The net profit rate in China Commercial Banks will reduce by 35% with assumption of net interest margin reduction by 1.2%; if net interest margin reduction by 0.7%, the net profit will be reduced by 50% [1, p. 37]. It seems to be inevitable for net interest margin to reduce after liberalization. The decline in net interest margin after liberalization seems inevitable. Therefore, the development of intermediary business helps to improve the profitability of commercial banks, improve the service functions of commercial banks, and provide risk management tools. 3. The interest rate liberalization brings more complex risks to commercial banks. The innovation of interest rate liberalization created high risks and more complex period structure. The interest risk control became a tough task. Banks need to find high compensation to interest risk due to saving interest rate growth. The credit risks increase sharply as a result of higher reverse option and moral risks and unqualified or lack of credit system. Through research on interest rate liberalization in South Korea, Raj Aggarwal found the ROE has positive correlation with unexpected change to short-term interest rate and has nothing with long-term and expected short- term interest rate. The interest rate liberalization brings more competition on funding and financial resource distribution among the banks and between banks and other financial institutes. Banks are facing high operating risks.[17, p.63] By analyzing the data for 76 banks in China during 1997-2006, Xiaoqing Fu found that the progress of interest rate liberalization in China drives not only the competition on core business in banks, but also competition between banks and other financial institutes [27, p. 69]. In particular, banks will compete with other financial institutes on funding capacity and compete with currency market on fund collection and professional resource. Due to the common weakness in small and middle size commercial banks, such as lack of capital, single business pattern, low risk management level and high percentage of non-performing loan, the negative impact is obvious. Due to the impact of interest rate liberalization on bank loan interest rates, the high interest spread can not last long and small/middle-size banks are facing dual burdens from debt and asset. The saving interest rate is increasing sharply while the loan interest rate only haSe limited growth. The interest margin is narrowing. The term structure of liabilities and assets did not match to each other. There are much more risks for losses and closures. Many small saving institutes had been closed in America and Japan at the primary stage of liberalization. For example, in each year during 1987-1991, about 200 banks in America were closed. The peak figure reached 250 banks a year, nearly one closure per day. While in late 1980, total 985 banks were failed from 1985 to 1990 in Japan [9, p. 59]. 31

4. The interest rate liberalization increases the cost of commercial banks and makes it more difficult to match liability to asset. At the primary stage, liberalization can help to increase interest rate of saving so as to stabilize deposit and drive loan business. However, it also pushes the portfolio to higher cost and significantly change liability structure and term structure of saving. As a result, banks would like to seek loan projects with higher interest rate to get more profit and prevent risks. Through research on interest rate liberalization of commercial banks in Thailand from 1992 to 1996, Olaf Hübler found that banks prefer to have more risky assets and reduce mortgage lending to balance the breach losses[18]. According to DuTing’s opinion, there will be impact of 5-6 basis points on overall saving cost if long-term interest rate is liberalized. In this case, the liability structure in banks has to face high possibility of uncertainty.[5, p.26] By creating mathematical model for lending, Porter found that both capital cost and saving return will increase due to interest rate liberalization. Small banks can get additional savings and extend the business by opening the competition channels. Large banks will cut down the saving size to control funding cost [6, p. 25]. All those will lead to changes to structure of liability and assets and make it more challenge to manage risky assets.

3.2 Specific impacts on banks of different sizes

The impact of interest rate liberalization will vary for Chinese banks based on their asset size, income sources, management strength, and business strategies. In particular, large commercial banks, mid-sized joint-stock commercial banks, and small city and rural commercial banks face different challenges. As of end-2013, the five largest Chinese banks account for more than 40 percent of banking industry assets. While interest rate liberalization will weigh on profitability, large banks likely will face limited negative impacts in a more competitive banking environment.[7, p.928] They typically have stable customer relationships with large state-owned or state-controlled enterprises and benefit from economies of scale. Even in a fully liberalized interest environment, large banks may still find it more cost effective to focus on this market segment. In addition, large banks benefit from established stable deposit bases built on solid reputations, which gives them a competitive edge on household deposits. As net providers of liquidity on the interbank market, large banks are also better positioned to deal with tightened liquidity conditions that might be triggered by further liberalization of interest rates. Small city and rural commercial banks face greater challenges than their larger counterparts from interest rate liberalization. Unlike large banks, city and rural commercial banks are sensitive to funding and liquidity risks, and thus more 32 susceptible to market volatilities. Their limited branch network places them at a disadvantage when competing with large banks for retail deposits. Furthermore, small banks often cater to SME lending. Consequently, their loan portfolios usually carry higher credit risks and are more vulnerable to the business cycle. Due to their close ties with local governments, city commercial banks typically have large exposure to risky local government financing vehicles. These small banks also are generally less sophisticated in their ability to properly price risky loans in a liberalized interest rate environment. The impact of deregulating interest rates on mid-sized jointstock banks is somewhat uncertain. Already accustomed to intense competition for deposits, these banks have been proactive in adopting new business models in response to regulatory changes. After the PBOC raised the deposit ceiling in 2012, joint-stock commercial banks reacted swiftly by adjusting short-term deposit rates to match the new ceiling. These banks have the potential to gain larger market share in a competitive banking environment due to their more flexible management styles and modern business models. However, some mid-sized banks have become increasingly reliant on wholesale funding, which can carry greater liquidity risk if the interbank market faces heightened volatility [25, p. 12]. Chinese banks are actively addressing the challenges posed by the liberalization of interest rates. In their 2012 and 2013 annual reports, publicly listed Chinese banks reported that they are exploring multiple new business lines, such as SME lending, private banking, wealth management, cash management, and e-banking. Many banks indicated that strengthening the ability to price risky loans and wealth management products is a key focus of their strategy in upcoming years. To survive and succeed in a market-based interest rate environment, Chinese banks will need to pass the “market test” of their ability to properly price counterparty risks and manage balance sheets as they embrace new business opportunities and innovative products.

3.3 The impact of interest rate liberalization on new products, new business and margin structure in commercial banks

There are four main factors for financial innovations, which are to pursue high profit, vibration in financial market, to avoid financial governance, wide application of information technology and global communication network. All of these four factors are included in our reform of interest rate liberalization to drive the financial innovation in commercial banks. Followed by the risks faced by commercial banks, the first is liquidity risk, namely, brought by the supply of liquidity risk in commercial bank in the liberalization 33 of interest rate bank loan difference enable banks to reduce the income is reduced, equivalent to reduce the bank's money to flow leads to the shortage of liquidity, which may lead to liquidity risk Next is the pricing risk. The pricing mechanism of China's commercial banks is not mature, in the process of interest rate liberalization, interest rate restrictions will increase the challenge to pricing power Last is the risk of diversification. After interest rate liberalization, commercial banks will have to find other profit points due to the decline of deposit and loan spreads and the decrease of income. Commercial banks that leave the "comfort zone" and carry out diversified operations may encounter new risks in a relatively unfamiliar field. In the process of liberalization of interest rate, financial institutions have a more competitive, between investors in the competition of financial institutions, with an option for financial products, obtain the investors tend to be less risky, lower prices and higher yield of financial products, and different financial institutions to the risk assessment of different customer groups are not the same,The need to provide different products and services and product pricing makes financial institutions need to provide more diversified financial products and services.In addition, financial institutions themselves also need to carry out financial innovation to reduce their own costs. That is to say, in order to gain more consumers' favor or reduce their own costs, enterprises need to carry out more financial innovation to win the competition in interest rate liberalization.

3.4 Analysis of impact of interest rate liberalization on China’s commercial banks

1. The situation of the traditional business of commercial banks In China, interest income accounts for more than 80% of bank operating income, which is much different from the ratio of non-interest income to interest income in developed countries. The interest income of banks can be roughly divided into four categories. The first category is the remuneration for lending funds to individuals or companies and temporarily advancing money for customers. The second category is the income from investing funds in securities, The third category is part of the funds are deposited in the income of the monetary authority. The fourth category is the remuneration obtained by lending funds to other banks to help them get out of trouble. As shown in Table 3.2, the following six representative banks are selected as examples. It can be seen that the income from lending funds to individuals or companies or making temporary advances for them is the most important component of all interest-related income. In part, the reform of interest rates will compress the difference between deposit interest rates and 34 loan interest rates, and banks will not be able to continue to make profits through this approach. In addition, the income from investing in securities also occupies a very important position in the interest income. The prices of stocks, bonds, futures, etc. will fluctuate up and down, making it more difficult for banks to invest. The income of depositing funds in the monetary authority and the remuneration of lending funds to other banks are relatively small.

Table 3.2 – 2019 Composition of interest income of commercial banks (unit: 1 million RMB) Name Loan interest Investment Interest income Interest income income interest income from deposits in from deposit and Central Bank lending interbank ICBC 5382.19 1772.98 446.78 312.85 ABC 4107.90 1700.96 392.64 370.4 Bank of China 3919.56 1143.99 298.31 299.53 Construction 4772.04 1562.04 395.12 196.15 Bank Merchants Bank 1512.36 457.21 81.7 103.54 Bank of 1899.73 711.44 137.01 150.26 Communications Note- Source: author’s elaboration on the basis of commercial banks' annual financial report The most important part of the income structure of all banks in our country is the remuneration obtained by absorbing and lending deposits, while the income obtained through other services accounts for a relatively low proportion. As you can see in the Table 3.1, all of these commercial banks have above 60% income from interests in 2019. After the interest rate reform was carried out, it did not help the banks to seek profit in a short period of time. But in the long run, interest rate liberalization has intensified competition among banks, and customers have more channels for obtaining funds.

Table 3.1 – 2019 China’s main commercial banks’ income index (unit: 1 million RMB) Name Revenue Net interest Net non – Net interest income interest income income/Revenue ICBC 675891 471846 204045 70% ABC 506016 398104 107912 79% Bank of China 483630 306048 177582 63% 35

Construction Bank 605090 417799 187291 69% Merchants Bank 209025 134595 74430 64% Bank of 193129 134871 58258 70% Communications Shanghai Pudong 160792 108120 52672 67% Development Bank Note- Source: author’s elaboration on the basis of commercial banks' annual financial report

2. The impact of liberalization of interest rates on commercial banks Firstly, liberalization of interest rates helps banks optimize customer structure and reduce potential risks. As mentioned earlier, the liberalization of interest rates will make commercial banks take risks in pursuit of short-term profits and lend funds to companies with poor reputation and high risk but high interest rates. However, in the long run, in order to avoid risks and reduce non-performing loans, banks will inevitably strengthen the supervision of borrowers by establishing long-term customer contacts, loan commitments, and credit rationing. In addition, they will also trade with those who do not bring too much risk to themselves and have high reputation and will not ask them for too high interest rates, in the hope of long-term cooperation with them, and deal with those with low reputation and high risk. High-interest customers provide loans with high interest rates to compensate for the risks they take or provide part of the customer’s loan demand to reduce their possible losses in the future. Secondly, interest rate liberalization is conducive to commercial banks setting more reasonable prices for financial products. Before the reform of interest rate liberalization, bank loans to customers must be carried out under the provisions of the monetary authority, regardless of the quality of customers paying the same cost. Under this circumstance, the objects they most hope to cooperate with are those high- reputation customers who have given up bank loans because of unfair treatment. On the contrary, those bad customers have enjoyed low-cost treatment, but the bank cannot afford to pay high prices. Interest rates require such customers to compensate for the risks they take. If reforms are carried out, they can set more reasonable prices for financial products more freely and according to their actual conditions. If customers have the possibility of threatening their own interests in the future, banks can make their financing costs higher. If they are people who keep promises and have good development prospects, their costs can be reduced, and this kind of customers will also be willing to carry out economic transactions with banks. Thirdly, interest rate liberalization influences the traditional business structure of commercial banks. Income unrelated to interest is not the most important component of total income, but its development is of great significance to banks. After the reform, 36 this part of the income will become an important support for the bank. At present, the non-interest income of China's commercial banks can be divided into two categories. The first category is the fees and commissions obtained by helping customers to handle the business. The second category is other incomes that are not related to interest. The fees and commissions obtained from helping customers handle business occupy the most important position, so this part of the income is mainly discussed here. In the fee and commission business income structure, the income from bank card-related services, the fees charged by the client and the agency are the most important components of non-interest income, which helps listed companies issue or sell securities, Advising customers on financial matters, providing guarantees to customers or promising to provide funds to customers, and promoting wealth management products to customers do not occupy a very important position, and relatively few of these businesses have high technical content. Therefore, under the reform of interest rate liberalization, there is still a lot of room for the development of this part of my country's commercial banks. If commercial banks want to deal with fierce competition, they should not stick to the traditional deposit and loan business but need to find another way to promote the optimization and upgrading of business structure. In order to explore a long-term development path. Fourthly, interest rate liberalization influences the traditional business model of the financial industry. For a long time, China’s financial industry has been using separate operations form. This business model itself will bring different consequences. On the one hand, it is of great help to the reasonable division of tools within the industry. Various financial institutions can better improve their professional level and avoid conflicts in the three major areas of banking, securities, and insurance. And they can effectively maintain the internal stability of the industry. On the other hand, financial institutions in industries that adopt this model in international competition do not have an advantage. This is because the existence of this model makes the types of businesses of banks smaller than those of large and complete foreign banks. Overall strength has a disadvantage. In addition, separate operations are not conducive to communication and collaboration between financial institutions, and it is difficult to complement each other's advantages. Fifthly, interest rate liberalization increases risks faced by commercial banks. (1) Interest rate risk of commercial banks Before the reform, all banks received deposits and issued loans at a predetermined level and paid interest. Interest rates were controlled. Therefore, the income of banks was very stable and guaranteed before liberalization, and the overall interest rate level also tended to be stable. Therefore, interest rate risk could not be the main problem faced by commercial banks at that time. However, after liberalization, the overall interest rate level changes in accordance with the development of the market, but the development and changes of the market are often uncertain, making the changes in the interest rate level more difficult to predict. In addition, the main income means of banks are still in line with the interest rate level. The level of interest rate is linked to the level of interest rate uncertainty, which affects the income of banks and increases the level of interest rate risk.

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(2) Credit risk of commercial banks The suppressed interest rate level tends to show an upward trend after a sudden liberalization, and the rise in the interest rate level will increase the credit risk of commercial banks. Among the market-oriented interest rates, commercial banks, as for-profit financial institutions, will choose higher-yield projects in order to increase the income of their loan business due to the overall rise in interest rates. However, as opposed to high-yield, it is high-risk and willing to accept more .orrowers with high loan interest rates tend to have a higher risk, and therefore have a higher possibility of default. Banks cannot accurately know the true character of the borrower due to the information asymmetry in the financial market, which increases the business. The possibility of banks being exposed to adverse selection risks. In addition, borrowers who have accepted higher loan interest rates are often more willing to use loans to invest in projects with higher risks and higher returns because they have to pay more interest. Therefore, the problem of adverse selection is transformed into moral hazard. The lack of rigorous internal risk control makes moral hazard proliferate, and the bad assets of commercial banks will be difficult to control, which will deepen business difficulties. The non-performing loan ratio reflects the proportion of non-performing loans of commercial banks in the total loan balance. The higher the non-performing loan rate, the greater the risk of commercial banks, and the higher the requirements for commercial banks' credit risk management and control capabilities. This section counts the changes in the non-performed loan(NPL in short) ratio of 6 listed commercial banks from 2011 to 2020.

Table 3.3 - 2011-2020 non-performing loan ratio of 6 listed commercial banks (unit:%) Year ICBC Construction Bank of Pudong Merchants Bank China Communications Development Bank Bank 2011 2.74 2.6 3.12 2.06 1.46 1.54 2012 2.29 2.21 2.65 1.92 1.21 1.11 2013 1.54 1.50 1.52 1.36 0.80 0.82 2014 1.08 1.14 1.10 1.12 0.51 0.68 2015 0.94 1.09 1.00 0.86 0.44 0.56 2016 0.85 0.99 0.95 0.92 0.58 0.61 2017 0.94 0.99 0.96 1.05 0.74 0.83 2018 1.13 1.19 1.18 1.25 1.06 1.69 2019 1.50 1.58 1.43 1.51 1.56 1.87 2020 1.62 1.52 1.46 1.52 1.68 1.68 Note- Source: author’s elaboration on the basis of commercial banks' annual financial report

From Table 3.3, we can see that the changes in the non-performing loan ratios of the six commercial banks tend to be consistent. China has accelerated the process of interest rate liberalization after 2012, and the non-performing loan rate continued to rise from 2017 to 2020, which shows that the implementation of interest rate

38 liberalization has played a certain role in promoting the increase in the rate of non- performing loans. Under the background of interest rate liberalization, the narrowing of interest rate margins has brought tremendous pressure to commercial banks, and the growth of traditional businesses is weak; the risk control awareness and risk control capabilities of commercial banks are not enough, and commercial banks cannot accurately judge the risks of business, resulting in credit risk. On the other hand, under the macroeconomic background of the new economic normal, the profitability of some industries has declined, and the solvency of debt has declined, resulting in the continuous expansion of the scale of non-performing assets. (3) Liquidity risk of commercial banks Market-oriented reforms have affected the level of bank interest rates by market supply and demand. Fund demanders will seek lower borrowing rates to raise funds. The reduction in bank deposit-loan gaps directly affects banks’ operating income and increases the banks’ inability to replenish funds in time The possibility can be said to be that the cost of obtaining funds for banks has risen, resulting in a shortage of liquidity funds for banks, and there may be failure to obtain funds in time to repay debts, resulting in liquidity risks. 3. Innovations that commercial banks need to make In general, the commercial banks will play its role as accounting and agent centers on higher level. Their product innovation, which transfer from capital-intensive to knowledge-intensive representing with derivatives (Liyuji, zhaoyang,2005), will maintain the stable and healthy development of bank and resist the tough competition and interest risks. As estimated by Bank for International Settlements, value of interest exchange and other derivatives reached $600 trillion, increasing by 7 times than 10 years ago, nearly 11 times of annual global GDP. As of the first half of 2019, the nominal open positions of global over-the-counter and on-exchange interest rate options were US$45.30 trillion and US$80.75 trillion, respectively, accounting for 87.8% of global option derivatives [22, p. 25]. At present, the interest rate liberalization provides good chance to banks in China to create new products and services. Now, about 80% of profit in commercial banks in China comes from traditional saving and lending business [8, p.59]. They lack capability to get profit and need to change operation concept in the context of interest rate liberalization. The business innovation should focus on developing intermediary business and compensate the decrease of interest spread with non-interest spread income. The global cases show that wealth management is a main margin source for modern commercial banks, such as, the profit from wealth management accounting for 50％ in total margin in , the net profit from personal banking business maintaining 35％ in recent 10 years in United Bank of [12, p .44]. Xiao xinrong and Wu yonggang investigated the interest rate liberalization innovation in United States in 1980s. They found that interest rate liberalization played positive role to push the banks to turn to intermediary business. After liberalization, the non-interest income in American bank industry increased from 20% to 43% [24, p. 39

18]. In recent years, banks in China kept publishing new intermediary products, such as bank cards and Personal Wealth Management Service etc. These new made more and more contribution to bank’s income. In the first half year of 2009, the transaction fee and net commission in BOC, ICBC, CCB and accounted for 21.28%、18.70%、17.90% and 14.88% in their respective total business income. For other banks, the percentage is around 6%-11%, higher than that in 2009. (Puya, 2010) [5, p. 105]. Additionally, there are a large number of small and middle size businesses with funding issue in China. They have urgent demand on financial services and provide great profit potential to commercial banks if they can leverage the liberalization to set pricing be themselves. The commercial banks need to study the funding demand from small and middle size businesses and provide new products and service to them. With interest rate liberalization and globalization for RMB, more and more Chinese enterprises will extent their business oversea. It is a requirement and trend for commercial bank to develop Cross-border financial services. In addition, new IT and mobile communication technology make online banking and mobile banking the main profit source for band industry, creating more space for business innovation.

3.5 Countermeasures in the context of interest rate liberalization

1. Increase non-interest income sources Interest margins oriented by deposits-loans surplus are main profits for commercial banks. Threatened by the reform, it directly affects the profitability of the banks. In the competitive market, especially after the liberalization, financial system is gradually improved. Banks should find new profit growth points for survival, instead of relying on the interest only. Commercial Banks need to strengthen the relevant financial innovation whether on financial tools or products or services on the basis of the traditional business model. It is also wise to develop intermediary business system and high value-added investment, otherwise, the situations may be more difficult than before. Therefore, China's commercial banks, under the fierce competition plus that new financial products such as monetary market funds can threaten the interest need to expand new sources of income such as intermediary business. 2. Strengthen pricing ability Commercial banks, based on the general policy environment related to interest rate liberalization, proceed from their own perspective, choose a pricing method that truly suits them, and improve their pricing capabilities both internally and externally. Internally, commercial banks should base themselves on their status quo, fully consider the business characteristics of the businesses they operate, formulate corresponding pricing standards for different business categories, and deal with banking businesses with different characteristics in detail. At the same time, from the 40 perspective of management, it is necessary to standardize operating procedures, standardize management procedures, further improve the pricing management organization and improve the quality of related talents, and form its own set of management pricing system. Externally, it is necessary to strengthen the construction of the pricing mechanism of commercial banks, and to provide more complete and relevant technical support to further improve its own loan pricing model. 3. Improve core competitiveness and achieve precise positioning At present, there is a problem of homogeneity in the business development of commercial banks in China, because traditional businesses still occupy a dominant position, and the transformation of commercial banking business has not yet been realized.[40, p.31] It is the core competitiveness that different customers provide distinctive services. Although small and medium-sized banks have the disadvantages of small assets and narrow profit channels, small and medium-sized banks are simple and more flexible, which have regional advantages and understand the characteristics of the region. Therefore, on the basis of consolidating traditional business, small and medium-sized banks should actively cooperate with small and micro enterprises and emerging high-tech enterprises to provide help for their growth and establish long-term cooperative relationships. Personalized services should be paid more attention to. In the current situation where the Internet and mobile phones are very convenient, banks should strengthen the construction of commercial banks' online banking, so that customers can enjoy the most convenient and efficient services and improve customer experience. At the same time, commercial banks should actively cooperate with the local government and contributes to the development of the region. Large commercial banks should change their original low-efficiency business models, comprehensively coordinate the business relationships of various lines, reduce unnecessary processes and procedures when providing services to customers, and improve their own service quality and service efficiency. In terms of business structure, it is necessary to gradually shift to high value-added manufacturing, service and high- tech industries, and at the same time, the development of retail business must not be ignored. Each bank should use its own capital scale and talent advantages to actively develop high-tech products and businesses, increase cooperation with peers, and better play its role as a stabilizer of the financial market. 4. Improve risk management and control capabilities As long as the commercial banks ensure that they can always meet the supply of liquidity, it has sufficient solvency, it is best to manage liquidity risk. From the perspective of asset business, the liquidity of commercial banks should be supplemented by the reserve system. Then, attention should be paid to adjusting the asset structure of commercial banks, allocating assets with different maturities, establishing an internal asset automatic repayment mechanism and integrating asset securitization, etc. In addition to the asset and liability level, the liquidity of commercial banks can also be supplemented by increasing active liabilities, such as inter-bank lending.

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Finally, the bank’s internal liquidity risk reporting mechanism also needs to be established to ensure that the bank’s senior management can keep abreast of the liquidity status of commercial banks. On the macro level, commercial bank runs can also cause liquidity risks. Therefore, the establishment of a deposit insurance system is very necessary. Learning from American experience, the establishment of the Federal Deposit Insurance Corporation in the United States has effectively stabilized the financial market, which means that when financial institutions such as banks go bankrupt due to a business crisis, it can prevent bank runs and protect deposits’ interests. In this way, when the reform is underway, the establishment of a deposit insurance system by the country can greatly reduce the negative impact of interest rate liberalization, prevent liquidity risks caused by runs, and play a protective role. At this time, the deposit insurance system plays a role to maintain the financial market in financial liberalization and interest rates. The stability of the process of liberalization.[26, p.71] Since the early days of the founding of the People’s Republic of China, the state’s capital is relatively weak, and funds are needed for heavy industry and the construction of the main body of the country.[25, p.33] Therefore, commercial banks are required to lend to state-owned enterprises at a very low interest rate. Over the long term, commercial banks have accumulated a large amount of non-performing loans. After the beginning of interest rate liberalization, non-performing loans gradually affected the stability of the financial system. Asset management companies help commercial banks to remove non-performing loans, but at the same time they also have requirements for their own operating conditions. If commercial banks want to improve their own profit levels, their most important interest business must be guaranteed. The government’s help has reduced the non-performing loan rate of commercial banks. They only rely on the commercial banks themselves, and they do not have mature risk control capabilities. This may be fatal in the process of shrinking credit spreads brought about by interest rate liberalization. To reduce the impact of interest rate changes on the operation and management of commercial banks, it is necessary to effectively strengthen the risk control capabilities, innovation capabilities, and operating capabilities of commercial banks.[28, p.169] In order to attract customers, commercial banks will inevitably develop new businesses and improve service levels in addition to traditional lending businesses to attract customers, so as to increase new profit growth points and enhance their own competitiveness. They can make profits through a variety of businesses, such as helping listed companies to issue or sell securities, consulting customers on financial matters, providing services related to bank cards, providing customers with guarantees or promising to provide funds to customers, and selling wealth management products to customers And so on, but judging from the current status of banks, this type of service needs further development. In the future, the contribution rate of intermediary business to commercial banks will continue to rise.

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First of all, interest rate liberalization will lead to an increase in bank interest rates, thus affecting interest rate spreads and marginal interest rates. Finally, we know that the influence of interest rate liberalization on commercial banks is multifaceted, unbalanced and dual. Commercial banks face the challenge that their non-interest income needs to increase and mature international banks may take advantage of them due to their separate business model. They also need to pay attention to the interest risk, credit risk and liquidity risk that interest rate liberalization bring about.

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CONCLUSIONS

The work came to the following conclusions. The interest rate is one of the most important elements of commercial, credit or investment contracts. The interest rate refers to the relative amount of income for a fixed period of time. The size of the interest rate depends on a number of both objective and subjective factors, namely: the general state of the economy, including the monetary market; short-term and long-term expectations of its dynamics. In financial analysis, the interest rate is used not only as a tool for increasing the amount of debt, but also in a broader sense - as a measure of the profitability of any financial, credit. Investment or commercial activity. Interest rate liberalization is regarded as a dimension of financial liberalization in developed countries. In contrast, the discussion of the interest rate liberalization in China is more abundant and comprehensive. Internationally, interest rate liberalization is a gradual process. The process of interest rate liberalization in the United States began in 1970 and ended in 1986, which lasted 16 years. The whole process follows the characteristics of large amount first and then small amount, long-term first and short-term first. The liberalization of interest rates in Japan began in 1975, and it took 19 years before it was completed. Japan's interest rate liberalization reform began with the liberalization of government bond interest rates. Deposit interest rates were first liberalized, then loan interest rates were liberalized, long-term interest rates followed by short-term interest rates, large transactions first, then small transactions. China learns from the experience of developed countries and implements a market-based interest rate reform program that "first intersectors, then enterprises and individuals, and long-term and short-term". The impact of interest rate liberalization on banks has been mainly studied in two aspects. One is to study the impact of interest rate liberalization on bank loan pricing and spreads. The other is to study the impact of interest rate liberalization on bank risk. The analysis shows that the impacts of interest rate liberalization on commercial banks are: interest rate liberalization will generally lead to the rise of interest rates level of commercial banks, interest margin will be narrow, net interest margin and net interest spreads will decrease; commercial banks will face more complicated risks, rising costs, that increase the difficulty of the assets and liabilities matching; intensified competition of the commercial bank in the field of product and business innovations, speeding up the adjusting of income structure. Therefore, in the process of interest rate liberalization, there are some things for China's commercial banks to do: 44

⚫ Banks have to find new profit growth point and increase the proportion of interest margins. ⚫ They also have to strengthen the financial innovation, expand business range and increase competitiveness to make up for loss brought by traditional business. ⚫ As for risks of interest rates, credit and liquidity, measures should be taken to reduce loss and risks. It is also necessary to transform traditional business models into diversified and unique ones. In order to reduce risks, it is suggested to optimize costumer’s selction and recognize information well. ⚫ By the resources of financial industry, it has, to formulate policies and standardized operation process and improve operation efficiency and enhance competitiveness; also, to improve pricing ability and make use of resource allocation by policies. In conclusion I want to note, that China can learn the good experience from reform of interest rate liberalization in other countries in the world to better understand its impact on banks in China. China is transitioning to the final stage of interest rate liberalization, where deposit interest rates are fully liberalized. However, the supporting systems and conditions for realizing interest rate liberalization at this stage are not yet mature enough. There are still many problems in China’s commercial banking system, such as insufficient financial innovation, a low proportion of intermediary business income, weak supervision, imperfect pricing system, and low capital efficiency. From the experience of various countries, China’s commercial banks still need to make further progress. Deepen the reform of the financial system and institutions, continuously develop the scale of the financial market, innovate financial products, improve the interest rate transmission mechanism, and improve and improve the regulatory system.

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APPENDIX

Table 1 – List of largest banks Rank Bank name Total assets(2020)(US$ Billion) 1 Industrial and Commercial Bank of China(China) 4324.27 2 China Construction Bank(China) 3653.11 3 Agricultural Bank of China(China) 33572.98 4 JPMorgan Chase(USA) 3386.07 5 Bank of China(China) 3270.15 6 HSBC(UK) 2984.16 7 Mitsubishi UFJ Financial Group(Japan) 2892.97 8 (USA) 2819.15 9 BNP Paribas() 2398.01 10 Crédit Agricole(France) 2278.79

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