As an essential part of rural finance, the rural credit system provides multifaceted support for the rural socioeconomic development. However, in recent years, impacted by both internal factors and external shocks, the profitability, capital adequacy, and asset quality of the rural credit system have all experienced significant declines; some institutions even have exhibited "mission drift."
I. Challenges faced by the rural credit system
1. Below-peers performance
In recent years, the operational performance of the rural credit system has declined in all respects compared to other institutions. First, both its return on assets (ROA) and net interest margin (NIM) have dropped dramatically. In terms of profitability, though the ROA and NIM of all types of banks have declined from 2014 to 2022. However, rural commercial banks have suffered the most in ROA. Second, its capital adequacy needs to be enhanced. Except for rural commercial banks, the capital adequacy ratio of other banks has increased. Third, there has been a severe decline in asset quality. Although the non-performing loan (NPL) ratio of all banks has increased, rural commercial banks have experienced the largest increase of 72.1%, rising from 1.87% in 2014 to 3.22% in 2022.
2. Mission drift in the context of market development
The founding mission of the rural credit system was to create a financial institution with a cooperative nature, primarily serving rural households and small and micro-enterprises (SMEs). However, the overall environment is increasingly market-oriented. Due to the weak quality[2] of agriculture, rural areas and residents, and SMEs, compared with non-agricultural businesses and large and medium-sized enterprises, face greater nature-related risks and market risks. Additionally, their operational and financial resilience is relatively low. Consequently, some financial institutions in the rural credit system, in pursuit of short-term returns, may experience "mission drift." It manifests in the following ways: First, the number of legal entities in the rural credit system has reduced dramatically. From 2010 to 2022, the number decreased from 2954 to 2177, representing a reduction of 777 entities and a decline of 26%. The primary reason is that rural credit cooperatives have undergone restructuring through mergers and reorganizations.
Second, the investment businesses were overdeveloped. Against the backdrop of interest rate liberalization and digital financial development, some rural commercial banks, due to their weak loan disbursement capacity and inadequate professional investment capabilities, experienced sluggish growth in their traditional bank loans. Consequently, from 2013 to 2018, more funds were allocated to interbank wealth management and outsourced investments, causing significant changes in asset structure. Interbank certificates of deposit and interbank wealth management of city commercial banks and rural financial institutions grew faster than those of major state-owned and joint-stock banks. During this period, although the asset size of the rural credit system expanded rapidly, resulting in increased income to some extent, the expansion of investment businesses undermined the importance of credit businesses directly supporting rural market entities. And this, to some extent, deviates from its mission of "serving rural households and small and micro-enterprises (SMEs).", leading to "mission drift". Additionally, due to the maturity mismatch, there is also a high liquidity risk.
II. External factors——a cutting-throat competitive market environment
1. Rapid development of large banks in counties
There is a growing trend among major banks to expand their services to counties. Furthermore, the expertise of large banks in serving rural SMEs is improving. Since 2016, large banks have successively established specialized service institutions such as Inclusive Finance Departments and Rural Finance Departments and introduced specialized financial technologies for SMEs different from those serving "large and medium-sized enterprises." Currently, as shown in the graph, the balance of agricultural loans of the five major banks (Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China, China Construction Bank, Postal Savings Bank of China) has increased from 10.2 trillion yuan in 2019 to 15.7 trillion yuan in 2022, with a growth rate of 53.9% and an average annual growth rate of 15.4%, exceeding the 11.8% growth rate of all institutions' agricultural loans during the same period. Furthermore, the share of the agricultural loans in the total outstanding loans has been steadily increasing since 2019, rising from 29.1% to 31.9% in 2022. This indicates that large commercial banks are strengthening their support for county-level economies, while also gaining a growing market share in rural financial services.
2. Challenges posed to the rural credit system by large banks
Large banks' expansion to counties led to rising competition in the rural finance market and disrupted the existing business layout of the rural credit system in rural areas. The rural credit system needs to take measures to address the challenges brought by intensified competition and reduce customer churn, especially the loss of high-quality customers. These challenges primarily manifest in the following aspects: First, large banks offer lower financing rates. Second, it is easier for large banks to get access to national pilot policies. Third, large banks can provide fintech-enabled higher-quality services.
III. Internal factors
1.Deficiencies in administrative system
Except for municipalities and some provinces and autonomous regions, the administrative system of most provincial rural credit systems is led by provincial governments, with specific responsibilities delegated to provincial rural credit cooperatives unions. This administrative system is a result of China's transition from a fiscal-led to a financial-led economic development model, in which the central and local governments coordinate the allocation of national financial resources.
On the one hand, provincial rural credit cooperatives unions have played a significant role in providing business guidance, corporate governance, risk prevention and management, information system development, fund allocation, and smoothing relationships with county and municipal governments for rural credit institutions. On the other hand, as the property rights reform and corporate governance standards of rural credit system institutions gradually improve, there is an increasingly urgent demand for independent business development at the county-level legal entities. In this context, the contradiction between the establishment of provincial rural credit cooperative unions through "bottom-up equity participation by county cooperative banks" and the "top-down management" approach has become prominent.
Currently, there is a growing call to clarify the management functions of provincial rural credit cooperatives unions and smooth the relationships between the two legal entities.
2. Serious deficiencies in corporate governance of some rural credit institutions
Following the reforms in 2003 and the clarification of property rights, there has been a significant improvement in the corporate governance of rural credit cooperatives. However, although the corporate governance organizational structure, mainly composed of “the general meeting of shareholders, the board of directors, the board of supervisors, and the management,” has been widely established, some rural credit institutions still exhibit serious deficiencies in their governance. This is mainly reflected in a few individuals holding control over key operational decisions and the absence of an effective system of checks and balances in the principal-agency mechanism.
3. Low risk control capability
Since 2018, the central bank has been conducting regular evaluations of financial institutions. The results show that the rural credit system hosts the highest number of high-risk institutions. As shown in the table, among the evaluations conducted by the central bank on 4023 large, medium, and small banks in 2020 and 4021 in 2021 respectively, the highest number of high-risk institutions remained concentrated in the rural credit system. In 2020 and 2021, the number of those institutions in the rural credit system was 285 and 186, accounting for 8% and 5% of the total assets of the entire rural credit system respectively.
4. Limited digital transformation capability
The digital transformation of financial services is of great importance for financial institutions to improve efficiency and risk management. However, fintech investment requires substantial capital. However, as independent legal entities at county level, rural credit institutions have limited resources of talent, capital, and technology required for digital transformation. This indirectly results in its weak digital capabilities, which also becomes its weak link in the competition in the context of digital transformation. Thus, enhancing digital capabilities now becomes one of the challenges faced by the rural credit system.
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