Controlling Problematic

Related Party Transactions

of Banks in Asia
Joseph P.H. Fan
Center for Institutions and Governance
Chinese University of Hong Kong
OECD & BIS Seminar on Corporate Governance for Banks in Asia
Hong Kong, June 19-20, 2006

The copyright of this document belongs to the author. Any use of the document, in part or in whole, should
be subject to the authors permission.

Outline
n
n
n
n
n

What are related party transactions?

Disclosure of related party transactions
Related party transactions in family
controlled banks
Related party transactions in state owned
banks
Controlling problematic related party
transaction, what work?
RPT

Joseph Fan

What are related party

transactions?
Business dealings between a party
and an entity that is
controlled/influenced by the party
n How prevalent?
n

Almost all firms engage in RPT

n Internal transactions are sometimes
necessary for bypassing markets where
business dealings are costly
n

RPT

Joseph Fan

Definition of Related Party

(IAS 24)
n

A party is related to an entity if it

n Directly or indirectly controls, is controlled by, or is under
common control with the entity
n Has significant influence over the entity
n Has joint control over the entity
n Is a close member of the family of any individual who controls,
or has significant influence or joint control over, the entity
n Is an associate of the entity
n Is a joint venture in which the entity is a venturer
n Is a member of the key management personnel of the entity
or its parent
n Is a close member of the family of any of the aforementioned
key management personnel
n Is an entity that is controlled, jointly controlled or
significantly influenced by, or for which significant voting
power in such entity resides with, any of the key
management personnel or their close family members
n Is a post-employment benefit plan for the benefit of
or of Fan
any of its related parties
RPT employees of the entity,Joseph
4

Disclosure requirements of
RPT (IAS 24)
n
n
n
n

Nature of relationships between parents and

subsidiaries, even if there were no transactions
Name of the entitys parent and, if different, the
ultimate controlling party
Compensation of key management personnel
For transactions between related parties
n
n

RPT

The nature of the relationship and info. About the

transactions and outstanding balances
Separate reporting categories: the parent, entities with
joint control or significant influences over the entity,
subsidiaries, associates, joint ventures in which the
entity is a venturer, key management personnel, and
other related parties

Joseph Fan

Disclosure requirements of
RPT
n

Typically disclose material RPT in

footnotes of corporate reports
n
n
n

n
n

Types and elements

Volume, amount
Pricing policy

Transactions eliminated on consolidation

are often exempted
Although various Asian economies require
detailed disclosure, in practice such
disclosure is limited
RPT

Joseph Fan

Types of Related Party

Transactions
Loans/borrowings/guarantees
n Investment, M&As
n Purchases/sales
n Consulting
n Intercorporate dividends
n Executive/director compensation
n

RPT

Joseph Fan

Types of Reported Related

Party Transactions in U.S.
(S&P1500 firms, 2001, Kohlbeck and Mayhew, 2004)

8
Consulting

Guarantees

Borrowings

Loans

RPT

Legal & Investment

Services

Leases

Related Business
Activities

Joseph Fan

Unrelated Business
Activities

Overhead
Reimbursement

Stock Transactions

45
40
35
30
25
20
15
10
5
0

(1200 listed firms in China 1998-2002, Jian and Wong, 2006)

Types of Reported Related Party

Transactions in China
60

50

40

30

20

10

9
Joint Investments
Rent Expenses
Rent Revenues
Stock Sales
Stock Purchases
Asset Sales
Asset Purchases
Interest Expenses
Interest Incomes
Services Expenses
Services Revenues

Purchases
Sales

RPT

Loans and Borrowings

Joseph Fan

Loan Guarantees for RP

Loan Guarantees from RP

Extents of Reported Related Party

Transactions by Industry
(S&P1500 firms, 2001, Kohlbeck and Mayhew, 2004)
90
80
70
60
50
40
30
20

Total

Other Services

Business Services

Joseph Fan

Financial

Retail

Wholesale

Utilities

Transportation

Technology

Equipment

Manufacturing

Natural Resources

RPT

10
0

10

Which RPT are problematic?

Transactions that transfer out cash or assets
from an entity without immediate or future
reciprocal compensation of cash or assets at fair
prices
n It is often difficult to determine whether an RPT
is problematic or not
n Difficulty of establishing a fair price
due to lack of a liquid market, or
during a period of high uncertainty
n Relationship based transactions
n Discrepancy in the time and/or form of
payment
n Accounting disclosure has limitation in dealing
with RPT
RPT
Joseph Fan
11
n

Factors conducive to
problematic RPT
n

Separation of ownership and control in complex

organizations
n Intra-group dealings, insider dealings
Powerful/entrenched stakeholders
n Unionized labor
n State and political influence

Transaction made under the influence of a

politician/bureaucrat or his allies (supporters, family
members, colleagues, friends, bribers)
More common among state owned
enterprises/banks

n
n

More fundamentally weak institutions

In the following, we separately examine RPT
issues of family and state banks
RPT

Joseph Fan

12

Separation of Ownership and

Control of Bank in Family Group
LCH Group and Liu Chong Hing Bank (HK)
Lius Holdings Ltd.

Lius Family

Other Investors

45.33%

16.53%

38.14%

Liu Chong Hing Investment Limited?

100%
LCH
Insurance

100%

100%

LCH Property
Management and
Agency

LCH Estate
Company

Bank of Tokyo-Mitsubishi

9.66%

RPT

60%

100%

Guangzhou
Chong Hing
Property Dev.
COSCO
Pacific

45.11%
Liu Chong Hing Bank
Ltd.?

20%

December Joseph
2003 Fan

Lius
Family

1.68%

Other
subsidiaries

Other
Investors

23.55%

13

Separation of Ownership and

Control of Bank in Family Group
LCH Group and Liu Chong Hing Bank (HK)
n
n

Liu family is the largest shareholder of LCH Bank

The family has at least 45% of voting rights of
the Bank, while its ownership of the Bank is only
28% ((45.33%+16.53%)*100%*45.11%)
Potential conflict of interest
n
n

A decision maker benefits from a transaction but does

not bear the full cost of his/her decision
For every dollar taken away from the Bank, the family
lost only 28 cent

Significant RPT between the Bank and its

affiliates during and shortly after the Asian
Financial Crisis, but RPT declined substantially
more recently
RPT

Joseph Fan

14

The Group borrows less

from the Bank
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
1998

1999

2000

2001

2002

2003

2004

2005

Interest expenses paid to associates/total interest expenses to bank loans

(LCHI)
Data resource: annual reports of Liu Chong Hing Investment Ltd. (194)
RPT
Joseph Fan

15

A decreasing trend in LCH Banks

profit from RPT
Profit from related party transactions/Operating profit
16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
1998

1999

2000

2001

2002

2003

2004

2005

Data resources: annual reports of Liu Chong Hing Bank (1111)

RPT

Joseph Fan

16

Why fewer RPT?

n
n

New laws or stronger enforcement?

Unlikely
Most likely due to the Banks strategy
change
n Expanding into arms length businesses
rather than depending on the family
group
n More professional, less family-influence
Chong Hing Bank--Erasing the family
surname from the name of the Bank
in the new headquarters building
RPT

Joseph Fan

17

Controlling Problematic RPT

in Family Controlled Banks
n
n

Family may have conflicts of interest with

minority shareholders and/or depositors
Reputation concern is typically sufficient
to mitigate these conflicts during normal
time
But during turbulent time, such as a
deregulating market or a large negative
profit shock, reputation and selfgovernance alone might not be sufficient
to contain conflicts of interest of
desperate controlling owners
RPT

Joseph Fan

18

Controlling Problematic RPT

in Family Controlled Banks
n

Mechanisms that separate the banking and nonbanking businesses (such as real estate
investment)
n
n
n
n

Simplifying and disclosing

organizational/ownership structure
Independent board committee that monitor
material RPT
Board (independent of owners, managers, and
bureaucrats) that monitor material RPT
Material RPT subject to regulatory approval during
turbulent times

Liberalizing the banking market to allow

competition
n
RPT

Let the market monitor the banks and the

regulator monitor the market
Joseph Fan

19

RPT in state owned banks

are more serious problems
n

n
n
n

Practically, state banks and SOEs are related

parties, transactions between them are therefore
always RPT
Politicians and their allies have incentives to
intervene state banks lending decisions
n Social welfare, votes, corruption
Internal monitoring is typically weak other
peoples money
Regulators often fail to monitor problematic RPT
of SOB, because of obvious conflicts of interest
Need an enforcement system independent of
political influences, but this is hard to come by
RPT

Joseph Fan

20

A case in point China

Construction Bank
n
n
n
n

n
n

CCB is one of four wholly government controlled

specialized banks before 2004
Chinas third-largest lender, focusing on lending to
infrastructure investment projects
The Banker magazine ranked CCB the 35th largest
bank in the world based on total assets as of 2004
Since 2003, went through a series of
restructurings: recapitalization, disposal and
write-off non-performing loans, issuances of
subordinate bonds, etc.
2004.9, became joint-stock commercial bank
2005.10, listed in Hong Kong exchange, from a
wholly state to a state-controlled public bank
RPT

Joseph Fan

21

As December,2004
Branch Total Assets
(Billion RMB)

Deposit
(Billion RMB)

Loans
(Billion RMB)

Amount

% of
total

Amount

% of
total

Amount

% of
total

Industrial
and
Commercial
Bank of
China

21223

5589.9

32.9%

5000

34.2%

3635.2

35.5%

Agriculture
Bank of
China

31004

4013.8

23.6%

3491.5

23.9%

2590.1

25.3%

China
Constructi
on Bank

14458

3904.8

23%

3489.4

23.9%

2225.6

21.7%

Bank of
China

11307

3489.6

20.5%

2637.2

18%

1797.1

17.5%

Total

77992

16998.1

100%

14618.1

100%

10248.1

100%

RPT

Joseph Fan

22

Lending Bias toward Related

Parties
n
n
n

An important but ignored fact: state banks

and SOEs are related parties
CCBs has been offering most of its loans
to SOEs
By contrast, performance and growth of
SOEs have been lagging behind the
private sector
Most of its impaired loans resulted from
the banks local branches lending to local
government controlled entities
RPT

Joseph Fan

23

Most loans go to SOEs

1800000
Total

1500000
1200000
900000

SOE
Collectively
controlled

600000
300000
0
2002
RPT

2003

2004
Joseph Fan

2005
24

Output and investment growth of SOEs

have been lagging behind the private sector

Joseph Fan
From:RPT
Allen et al 2005 JFE

25

Most impaired loans resulted from lending

to local government controlled entities
45.00%

Collectively
controlled

40.00%
35.00%
30.00%

Joint Ventures

25.00%
20.00% SOE
15.00%

Total

10.00%
5.00%
0.00%
2002
RPT

2003

2004
Joseph Fan

2005
26

Two former chairmen and

CEOs were caught in
corruption scandals

Wang Xuebing

Zhang Enzhao

Can public listing mitigate

unsound related party lendings?
n
n

n
n

The challenges with CCB are

representative of Chinas bank sector
The government has been in process of
listing its state banks, hoping problems
will go away
Not clear how it will work, in particular on
lending bias toward related parties (SOEs)
But lets look at how management and
governance structures have changed
RPT

Joseph Fan

28

Ownership structure before IPO

(as of 2004.12)
HuiJin
100%
JianYin

85.228%

10.653%

Shanghai
Baosteel

State Grid

1.545%

1.545%

Yangtze
Power
1.03%

China Construction Bank (BBC)

100%
Jian Xin
Bank Limited
RPT

75.1%
Sino-German
Bausparkasse
Corporation
Limited
Joseph Fan

29

Ownership Structure on IPO

(as of 2005.12)
Temasek

HuiJin
100%
JianYin

100%
State
Grid

61.48% 9.21%

Shanghai
Baosteel

1.34%

Yangtze
Power

1.34%

Bank of
American

0.89% 8.52%

AFH

others

5.88% 11.34%

China Construction Bank (BBC)

100%

75.1%

Jian Xin
Bank Limited

Sino-German
Bausparkasse
Corporation
Limited

RPT

65%
CCB Principal
Asset Management
Joseph Fan

30

Governance Structure of China

Construction Bank before IPO
(2004)
China
China Construction
Construction Bank
Bank

Communist
Communist
Party
Party Committee
Committee
*11
*11 people,
people,
Zhang
was
the
Zhang was the party
party secretary
secretary

Board
Board of
of Directors
Directors
*Zhang
*Zhangwas
wasthe
thechairman,
chairman,
33out
of
13
directors
out of 13 directorsfrom
from
the
theParty
PartyCommittee
Committee

Supervisory
Supervisory Board
Board
*4
*4members,
members,
chairman
chairman from
from the
the
Party
Committee
Party Committee

Management
Management
*7
*7people
people
,, all
from
the
all from the Party
Party Committee
Committee

RPT

Joseph Fan

31

Governance Structure of China Construction Bank after

IPO (2006)

Shareholder
Shareholder
GeneralMeeting
Meeting
General

BoardOf
OfDirectors
Directors
Board
*15
members
*15 members
*Guoisisthe
thechairman
chairmanofofdirector
director
*Guo
Andalso
alsosecretary
secretaryofofparty
party
And
committee
committee
*4executive
executivedirectors,
directors,
*4
Andall
allofofthem
themsit
sitininthe
the
And
Party
Committee
Party Committee
*4are
areindependent
independentdirector
director
*4

StrategyDevelopment
Development
Strategy
Committee
Committee
*12members
members
*12
*Guo
is
chairman
*Guo is chairman

AuditCommittee
Committee
Audit
member
*7*7member
*chairmanisisone
one
*chairman
Independent
director
Independent director

Presidents
*7 top managements
*all are in the party
RPT
committee

RiskManagement
Management
Risk
Committee
Committee
member
77member
*chairmanisisone
one
*chairman
Non-executivedirector
director
Non-executive

Nominationand
and
Nomination
Compensation
Compensation
Committee
Committee
member
*7*7member
*chairman
one
*chairman isisone
Independentdirector
director
Independent

Joseph Fan

BoardofofSupervisors
Supervisors
Board
members
*7*7members
shareholderrepresentative
representative
*4*4shareholder
Supervisors
Supervisors
externalsupervisors
supervisors
*2*2external
*Xieisischairman,
chairman,also
alsofrom
fromthe
the
*Xie
Party
Committee
Party Committee

RelatedParty
Party
Related
Transaction
Committee
Transaction Committee
member
*3*3member
*chairmanisisindependent
independent
*chairman
director
director

Performanceand
andDue
Due
Performance
Diligence committee
committee
Diligence
member
*4*4member
*xie
is
chairman
*xie is chairman

Financialand
and
Financial
InternalControl
Control
Internal
Committee
Committee
member
*3*3member
*chairman
external
*chairman isisexternal
supervisor
supervisor

32

Rent Seeking and Corporate Finance:

Evidence from Corruption Cases
Joseph P.H. Fan*
Oliver M. Rui*
Mengxin Zhao**
*Chinese University of Hong Kong
**Bentley College

The Corruption List

Province

Name

Position

Event Day

Sentence Day

Sentence

Number
of firms
in the
province
27

The
Bribing
Firms

The
Connecte
d Firms

The
Nonevent
Firms
24

Anhui

Vice-Province Governor

20010407

20031229

Death penalty

Bank

Wang
Huizhong
Liu Jinbao

Vice-Chairman & CEO of Bank Of China (HK)

20030525

20050812

Suspended death penalty

Bank

Wang Xuebin

CEO of China Construction Bank

20020111

20031210

12 years of imprisonment

Beijing

Chen Xitong

CPC Secretary

19950426

19980731

16 years of imprisonment

11

Central

Li Daqiang

Central

Xu Penghang

Vice-Province Governor

20000925

20000925

Dismissal from the service and CPC

20001011

20001011

Dismissal from the service

Shi Zhaobin

Vice chairman of national defense technology

commission and national economics and trade
commission
Vice-CPC Secretary

Fujian
Guangxi

19990818

20010927

Dismissal from the service and CPC

34

26

Xu Binsong

Vice-Chairman of Municipality

19980523

19990827

Life imprisonment

Guangxi

Chen Kejie

Chairman of Municipality

20000111

20000731

Death penalty

10

Guangxi

Liu Zhibin

Vice-Chairman of Municipality

20000319

20020624

15 years of imprisonment

10

Guangxi

Wang Qinglu

Vice-Chairman of PPCC

20010222

20010222

Dismissal from the service and CPC

13

12

Guizhou

Liu Changgui

Vice-Province Governor

20030417

20040430

11 years of imprisonment

12

Guizhou

Liu Fangren

CPC Secretary & PC Chairman

20030422

20040629

Life imprisonment

12

10

Hainan

Xin Yejiang

Vice-PC Chairman

19961227

19980526

5 years of imprisonment

10

Hebei

Jiang Dianwu

Vice-PC Chairman

19971101

19981207

10 years of imprisonment

13

13

Hebei

Chen Weigao

CPC Secretary & PC Chairman

20000301

20030809

Dismissal from CPC

25

21

Hebei

Cong Fukui

Vice-Province Governor

20000627

20010518

Dismissal from the service and CPC

24

22

Hubei

Meng QingPing

Vice-Province Governor

19980410

19991201

10 years of imprisonment

33

28

Jiangxi

Hu Changqing

Vice-Province Governor

19990808

20000215

Death penalty

12

10

Liaoning

Mu TuoXing

Vice-Province Governor

20010321

20011113

Death penalty

51

40

Xingjiang

Aman.Haji

Vice-Province Governor

20031015

N/A

N/A (Still under investigation)

25

23

Yunnan

Li Jiating

Vice CPC Secretary & Province Governor

20010620

20030509

Death penalty

17

12

Zhejiang

Xu Yunhong

Vice-Province Governor

19990922

20001017

10 years of imprisonment

35

30

393

43

42

308

Total

RPT

Joseph Fan

34

Borrowing Pattern of Listed Companies

Connected with Corrupt Bureaucrats
/bank officers (Mean Total Debt/Assets)

RPT

Joseph Fan

35

Debt Maturity Pattern of Listed Companies

Connected with Corrupt Bureaucrats/Bank
Officers (Mean Long Term Debt/Total Debt)

RPT

Joseph Fan

36

Long-term Borrowing Pattern of Listed

Companies Connected with Corrupt
Bureaucrats /Bank Officers
(Mean Long Term Debt/Assets)

RPT

Joseph Fan

37

What do we find?
n

An unhealthy trend of corporate finance

n Increasing trend of corporate debt load, but
decreasing trend of debt maturity
Corrupt companies and/or companies connected
with corrupt bureaucrats gain access to bank
loans
Does corruption grease the wheel of commerce?
n NO. We find little evidence suggesting that
rent seeking facilitates capital allocation in
China
Is corruption and crony lending unique to China?
n On the contrary

RPT

Joseph Fan

38

Corruption in Asian Economies

(Source: Transparency International: mean
Corruption Perception Index 1992-2000)
9

China
Taiwan
Hong Kong
Indonesia
Japan
Korea (South)
Malaysia
Philippines
Singapore
Thailand
United State
United Kingdom

8
7
6
5
4
3
2
1
0

RPT

Economy

Joseph Fan

39

What do we push for?

n

Not just about catching scandals

n But, fundamental institutional
improvements, i.e., transparent, merit
based rather than connection based
capital allocations
Taiwan could become a role model if its
legal system and citizen properly deal
with the first familys corruption scandals
which involve government controlled
banks and financial institutions
RPT

Joseph Fan

40

Controlling problematic RPT in

State Owned Banks, what work?
n

n
n

Firewall between politicians/bureaucrats and banks

n Away from bank key personnel (top managers and
directors) decisions
n Improving transparency
Removing SOBs policy burdens
n There is little evidence that SOB promote
economic development, but abundant evidence
that SOB slows it down
Freeing up restrictions of bank executive
compensation
Privatization
n Ultimate solution. But be careful: several Asian
economies are privatizing their SOB, generating
immense incentive of self-dealings through RPT
RPT

Joseph Fan

41

Conclusions
n
n

n
n

RPT in Asia are prevalent

The good news is that problematic transactions
in private banks have largely been contained
during normal time.
During turbulent time, more intense monitoring
of RPT by regulators are needed
Problematic RPT can be further mitigated by
market liberalization and improving legal
institutions
State owned banks however post a challenge
n Laws and regulations are not effective,
because of conflicts of interest
n We need institutional reforms that improve
government quality and reduce corruption

RPT

Joseph Fan

42