Summary:
Since the start of its economic reform and opening-up in 1978, China has witnessed rapid economic growth. However, this development has been unbalanced, and in the financial market, this imbalance is evidenced by inadequate and expensive financing for small and medium-sized firms, in contrast to the easily obtainable, low-cost funding available to large firms. The literature proposes that small banks can more effectively meet the financing needs of small and medium-sized firms than big banks. China's banking sector is dominated by four state-owned big banks, and entry into the industry is strictly regulated by the government. What drove the Chinese government to restrict the entry of new banks into the industry？ Considering China's rapid and sustained economic growth and the lack of a systemic financial crisis in the past four decades, is it economically rational for the government to restrict bank entry and allow the banking system to be monopolized by big banks in the early stage of China's economic reform？ This study argues that the deposits of big banks would be partially transferred to newly established small banks such that the total loanable funds available from big banks would sharply decline if the entry barriers to the banking sector were lowered, as capital and total fund supply were scarce in China in the early stages of reform and opening-up. Consequently, the financing costs of state-owned enterprises (SOEs) increase as credit availability decreases because SOEs have enormous capital needs, while newly established banks have a small asset scale and cannot provide large loans to diversify risks effectively. In this scenario, the government's intervention in the banking sector, or the entry barriers to new banks, becomes a sub-optimal arrangement. From a transaction cost perspective, this study discusses how the catch-up strategy determines the banking structure in a country using a static game that includes firms and banks of different sizes. The theoretical analysis in this study focuses on two types of transaction costs when banks lend to firms—contracting and information costs. Contracting costs refer to the real costs incurred when finalizing loan agreements. One key feature of contracting costs is that they nearly change with loan size and can be approximated as fixed costs. The larger the amount of a single loan, the greater the economies of scale, and the lower the contracting cost per unit of financing. Information costs refer to the costs resulting from information asymmetry, such as the labor costs of screening firms and banks' losses from loan defaults. This study shows that considering the contracting and information costs, big banks are in a better position to fund large firms because big banks have the economies of scale to lend to large firms with large capital demands, thereby lowering the transaction costs of financing. In contrast, if one or a few small banks provide large loans to a large firm, they take on a high risk of bankruptcy in the event of a loan default. If small banks are to diversify their investments or limit the sizes of single loans to reduce their risk of bankruptcy, large firms would have to borrow from multiple small banks simultaneously, which would sharply increase the transaction costs of financing. This study provides policy references for further reform and development of China's banking industry. China's industrial landscape is characterized by the presence of a large number of labor-intensive small firms. Hence, this study proposes that local small banks should be developed further and interest rates should be liberalized further to meet the financing needs of small firms.
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