PERFORMANCE OF CHINA-OWNED BANKS IN HONG KONG

This paper reports results on the performance of mainland China-owned banks operating in Hong Kong and compares them to Hong Kong (SAR) owned banks and Foreign owned banks. In general, the test model performs well under diagnostic tests on variables such as net interest margin, non-interest expense, impaired loans ratio, equity multiplier and ownership structures. Profitability, as measured by return on assets and return on equity for Chinese owned banks increased over the period 2004-2010. Chinese owned banks recorded increased performance in terms of net interest margin and equity multiplier but decreased with respect to non-interest expense and impaired loans ratio. Banks having a license also appears to be a major contributor to banks profitability across HKSAR. Compared to Hong Kong based foreign banks and local Hong Kong banks, we found that in general the mainland China banks tend to perform poorly across a number of key banking performance indicators.


Introduction
This paper constructs a model of the profitability of China owned banks operating in Hong Kong (HK). Compared to other industries, China's outward investment across the financial sector represents a relatively small proportion of its total dollar investment abroad. However outward financial investment has being increasing gradually especially since 2006. To give an idea of this growth, shown in a figure at later page of this paper, we examine China's total outward financial investment over [2006][2007][2008][2009]. From the figure, it is clear that the growth in outward financial investments is almost entirely explained by financial investment to HK.
Discovering the factors driving the outward investment in the area of finance should be as important as that of China's outward investment in manufacturing and resources sectors. The objective of this research is therefore to analyse the performance of China's banks with a particular focus on HK. By using firm level data across a range of performance indicators, this research enables researchers to discover the key determinants of China's outward investment in the banking sector.
Chinese owned banks comprise approximately twenty five percent of all foreign owned banking assets operating in Hong Kong. The presence of Chinese owned banks operating in HKSAR allows us to apply firm-specific data in particular parent-specific characteristics of Chinese banks performance in Hong Kong. In order to investigate this issue fully, we compared Chinese owned banks with two other groups' namely local owned banks i.e. HKSAR and owned foreign banks.
The rest of the paper is structured as follows: section one provides an overview of foreign banks (including China's owned banks) operating in HKSAR; section two reviews previous studies conducted into measuring banks performance in HK including hypotheses testing; section three provides a description of the data sources and methodology; section five discusses the empirical results; the final section offers some concluding comments and provides some suggestion for Chinese bank expansion overseas in the future.  Direct Investment, 2006, 2007, 2008, 2009

Foreign Banks in Hong Kong
Hong Kong is one of the world's largest offshore banking centers, with approximately sixty of world's largest banks operating within the SAR of Hong Kong: see Table 1.

Hypotheses and Tests
This research employs firm-level panel data to examine several performance specific hypotheses.
As acknowledge relatively few studies employ industry-level data to test other countries' financial institutions performance in a third country. The data considered in this study employs Chinese, Foreign and Hong Kong owned banks in Hong Kong from 2004 to 2010, separately.
This paper takes into account institutional features such as expenses management, capital liquidity and firm's ownership.

Profitability measures
The profitability of banks operating across borders can be measured by several variables.
This study will consider the following dimensions; Return on Assets (ROA) and Return on Equities (ROE): the ROA is used to measure earning ability which is net income after taxes for the year relative to total average assets. ROA is an internal performance measure of shareholder value, and it is by far the most popular measure of performance because: (1) it proposes a direct assessment of the financial return of a shareholder's investment; (2) it is easily available for analysts, only relying upon public information; and (3) it allows for comparison between different companies or different sectors of the economy. The Return on Equity (ROE) is used to measure bank's profitability which is net income after taxes divided by total equity. However, ROA is biased upwards for banks that earn significant profits from off-balance sheet operations 1 They can accept deposits of any size and maturity. They are also allowed to provide current and savings accounts to their clients. 2 They are allowed to accept deposits of HK$500,000 and above. 3 They are licensed to accept deposits of HK$100,000 and above with the minimum maturity of 3 months.
such as derivative activities, as these activities generate revenue and expenses but are not recorded as assets (Rhoades, 1998). Therefore, we employ ROE as an alternative measure of profitability.

Hypotheses
In the context, of factors within the control of management the immediate factors, which would have an impact on bank profitability, would be those factors, which affect a bank's net interest income (Guru, et al, 2000). To this extent, the net interest margin could be expected to have a positive influence on bank's profitability.

Hypothesis 1: net interest margin has a positive impact on profitability in Hong Kong
Generally, bank's efficiency regards cost control would be reflected in profit. A Federal Reserve Bank of New York study found that enhanced expenses such as salaries and wages, pensions, and other (non-interest) expenses resulted in relatively slower growth in profitability (Federal Reserve Bank of New York 1973, pp. 70-71).

Hypothesis 2: non-interest expense has a negative impact on profitability in Hong Kong
Licensed banks are expected to have some positive value; otherwise no institution would be willing to bear the regulatory costs associated with gaining a licence. Previous research has indicated that foreign banks expressed a strong preference for banking licence status upon entering into a foreign market, Davis & Lewis (1982). Thus a bank licence may be considered as a firm-specific advantage. In our model a bank licence is treated as an exogenous variable, as the Chinese banks applied for a bank licence, but the decision as to their success or failure was outside their control.

Hypothesis 3: The possession of a bank license has a positive impact on profitability in Hong
Kong.
The ratio of impaired loans to gross loans (NPL) is included to capture the effect of credit risk on bank profitability. Evidence suggests that impaired loans may increase after periods of increased lending often when senior bank managers under competitive pressure to satisfy shortterm profit targets imposed by owners employ less rigorous lending standards (Salas and Saurina, 2002;Berger and Udell, 2006;Ruckes, 2004). Petersen & Rajan (1994) posited that banks concerned for short-run reputation will ease credit standards to boost assets growth and profitability in order to maintain comparability with peer banks. Furthermore, disaster myopia may occur when banks find it difficult to acknowledge and assess the possibility of a major shock to their loan books (Guttentag and Herring, 1986;Herring, 1999). Consequently, decisions are based on recent information, which is assumed to continue into the future. This myopia may be accompanied by overconfidence (where bank managers believe in their investing skills), which lead them to undertake excessive lending and risk leading to increases in impaired loans in the longer term. Overall, we expect a negative relationship between NPL and profitability.
Hypothesis 4: impaired loans ratio has a negative impact on profitability in Hong Kong The equity multiplier (defined as assets divided by equity) is the reciprocal of the capital-toasset ratio. It provides a gauge of bank's leverage (debt-to-asset ratio), or the dollar amount of assets pyramided on the bank's base of equity capital. A higher EM indicates that the bank has borrowed more funds to convert into asset with the share capital. The higher value of EM indicates greater risk for a bank. Samad and Hassan (2000) found that the higher returns might have been due to higher risky investments by the bank. This is supported by the increased debt equity and equity multiplier ratio.
Hypothesis 5: equity multiplier has a positive impact on profitability in Hong Kong.

Data and Methodology
This research considers the period from 2004 to 2010, the data was provided by BankScope, the Hong Kong Monetary Authority and the Chinese Financial Yearbooks. We cannot obtain earlier data because most data in these databases started from 2004.
The general consensus from the literature regards modelling bank profitability favours a linear analysis approach. To this extent, Short (1979) and Bourke (1989) considered several functional forms and concluded that the linear model produced results as good as any other functional form. In support of this, Molyneux et al, (1994) and Guru, et al, (2000) had also considered a linear model in their studies on bank profitability. Thus, in this study as well we have considered a linear model to analyse pooled cross-section time series data.
Our modelling begins with running four regressions simultaneously, using return on assets (ROA) and return on equity (ROE) as dependent variables we itemised our independent variables as net interest margin (MARGIN), non-interest expense (NIE) and the ratio of impaired loans to gross loans (NPL). Net interest margin is a measure of the difference between the interest income generated by banks and the amount of interest paid out to their lenders (for example, deposits), relative to the amount of their (interest-earning) assets. Based on the definition, we expect there is a positive relationship between profitability and net interest margin if the ratio is bigger the ROA and ROE should be larger. Theoretically, higher non-interest expense (including employee salaries and benefits, equipment and property leases, taxes, loan loss provisions and professional service fees) will reduce bank profitability which is showed by ROA and ROE in our study. Impaired loans ration represents banks' loan quality, we expect it has a negative effect on ROA and ROE.
Our initial empirical model considered seven of China's largest owned banks operating in Hong Kong (Table 2). Since licensed banks in Hong Kong can accept deposits of any size and maturity we also separated our banks into licensed/non-licensed groups to find if having a license can be an advantage to bank performance. Next, we compared Chinese owned banks with two other groups namely: Hong Kong locally owned banks and foreign (other countries except China) owned banks. Finally we ran a regression employing our enlarged sample of banks which included the top 30 banks (nine Chinese owned banks, nine local owned banks and eleven foreign owned banks) in Hong Kong (Table 3). In this regression we added one more independent variable s called Equity Multiplier (EM) 4 to carry out regression.  The basic regression model takes the form with parameters (γ, α, βs) and error terms (µ, ε): The variables specified as following with time subscript not shown:

Dependent variables
ROA : profits after tax / total average assets, ROE : profits after tax / total average equity, Independent variables MARGIN : (interest income -interest payment) / interest-earning assets, NIE : non-interest expense/ total average assets, NPL : impaired loans (NPLs) / gross loans, and EM : total assets / total equity.
In this study, all regression equations were estimated using pooled time series crosssection (TSCS) data in order to use the information in the data set. Table 4  and Nanyang Commercial Bank (NY). Interestingly row seven (NIE) indicates the relationship between non-interest expense and ROA and ROE. The result here indicates that in almost one hundred percent of cases, WL's NIE reduces its return on assets while non interest expenses are also highly significant and negatively related to the Bank's return on equity. However, for other banks this effect is insignificant and positive (except Nanyang Commercial Bank which is showed a negative relation). The last seven rows indicate that negative and significant relationship appears for impaired loans and ROA in the case of WL, and negative and significant in the case of CITIC bank.

Empirical Results
When we examine the results from Table 5 we conclude the following: overall the results for MARGIN indicate that net interest margin has a significant and positive relationship with ROA and ROE for two banks. Our results suggest that licensed banks are more profitable than unlicensed banks. For example, when net interest margin increases by 1%, licensed banks can   Notes: *, ** and *** denote significance at 0.10, 0.05 and 0.01 levels, respectively.
The statistics in Table 6  Regards the results for NIE and ROE, we only found evidence for 5 significant results including 2 for Chinese owned banks (BOC and WLU), 2 for Hong Kong local banks (BOEA and WLA)   non-interest expense has a negative and significant relationship with ROE in local owned banks (-11.1892) and foreign owned banks (-3.3588) overall only one bank group here showed a significant result. Regards the results for bank equity multiplier and ROE we find a positive and significant relationship between EM and ROE in all cases for Chinese owned banks, and for Hong Kong owned banks and foreign owned banks.

Conclusions
In this study, we constructed a model of the profitability of Chinese owned banks in Hong Kong.
Generally, the model proposed performs well for net interest margin, non-interest expense, and impaired loans ratio and equity multiplier. The purpose of this study was to evaluate how banking profitability in Hong Kong has been affected by these measures. Based on four regressions with annual data for the period from 2003-2010 our empirical results provide some interesting outcomes. The results indicate that for the top seven Chinese owned banks, Wing Lung Bank has superior recorded profits in terms of returns on assets and return on equity compared to other Chinese owned banks.
It is interesting to note that licensed Chinese owned banks will make more profits than unlicensed Chinese owned banks where both have similar net interest margin, management efficiency (non-interest expense) and asset's risk (impaired loans ratio). Comparing the top fifteen banks across our groupings (Chinese,HKSAR and Foreign), we found that in general Chinese banks tend to perform poorly in terms of MARGIN while profitability is ranked average in terms of non-interest expense and impaired loans. When we applied the equity multiplier indicator, the results support claims that Chinese owned banks is the least profitable amongst foreign owned and local owned banks.
The choices for China's banks future are therefore to continue expansion via merger and acquisition with overseas banks in Hong Kong. This is happening to a degree with European banks at present. The apparent advantages in terms of transferring technical and managerial efficiency gains to China's banks involved in M&A with foreign banks appears to be the major advantage of such activities. In addition foreign banks operating in Hong Kong have added to their overall performance in their foreign operations in the fastest growing banking markets globally.