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Carrots or sticks: The Taiwanese government's contrasting policy approaches to banking sector liberalization

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Carrots or sticks: The Taiwanese government's contrasting policy approaches to banking sector liberalization

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Content CARROTS OR STICKS: THE TAIWANESE GOVERNMENT’S CONTRASTING
POLICY APPROACHES TO BANKING SECTOR LIBERALIZATION
by
Leemen Lee
A Dissertation Presented to the
FACULTY OF THE GRADUATE SCHOOL
UNIVERSITY OF SOUTHERN CALIFORNIA
In Partial Fulfillment of the
Requirements for the Degree
DOCTOR OF PHILOSOPHY
(POLITICAL ECONOMY AND PUBLIC POLICY)
May 2004
Copyright 2004 Leemen Lee
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1 1
DEDICATION
Dr. Harrison Cheng
Ignatius of Loyola
Thomas Kuo-le Lee
Jen Huang
Carey Peiying Chen
Helena Lee
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Ill
TABLE OF CONTENTS
DEDICATION................................................................................................................... ii
LIST OF TABLES....................................... v
LIST OF FIGURES..................................................................................................... vi
LIST OF ABBREVIATIONS ................................................................................... vii
ABSTRACT....................................................................................................................viii
CHAPTER ONE: INTRODUCTION...............................................................................1
1.1 The research puzzle........................................................................................2
1.2 Research questions.......................................................................................... 4
1.3 Importance of analyzing the Taiwanese case................................................5
1.4 Arguments........................................................................................................6
1.5 Chapter structures............................................................................................ 7
CHAPTER TWO: LITERATURE REVIEW AND A MODEL OF
REGULATORY CAPTURE IN BANKING REFORMS........................................... 10
2.1 Explaining the role of government in financial liberalization....................10
2.2 Financial sector rents.....................................................................................18
2.3 Theories of regulation ................................................................................. 29
2.4 A game theoretical model of financial liberalization................................. 33
2.5 Summary........................................................................................................46
CHAPTER THREE: FINANCIAL CONTROL UNDER THE
DEVELOPMENTAL PARTY-STATE.........................................................................48
3.1 Introduction................................................................................................... 48
3.2 The structural characteristics of the banking system................................. 49
3.3 Financial sector rents under financial restraint........................................... 57
3.4 The bank law revisions of 1984-1985......................................................... 63
3.5 Summary and conclusions............................................................................69
CHAPTER FOUR: SEEKING RENTS IN BANKING SECTOR
DEREGULATION........................................................................................................ 71
4.1 Introduction................................................................................................... 71
4.2 International and domestic pressures to deregulate the banking
sector............................................................................................................. 71
4.3 Political transition and democratic initiatives............................................. 73
4.4 Politics of deregulation.................................................................................76
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IV
4.5 The delay in reforming basic financial institutions....................................85
4.6 Summary and conclusions............................... 89
CHAPTER FIVE: CARROTS OR STICKS: THE NEW GOVERNMENT AND
ITS REGULATORY REFORMS OF THE BANKING SECTOR............................. 92
5.1 Introduction.................................................................................................... 92
5.2 Overview of the deregulated banking sector...............................................94
5.3 Supervisory loopholes and the non-performing loan problem ................ 98
5.4 Dealing with problematic financial institutions.........................................102
5.5 Dealing with the problem of fragmentation...............................................108
5.6 Asset management companies to resolve the NPL problem....................116
5.7 Reform drawbacks...................................................................................... 128
5.8 Summary and conclusions.......................................................................... 138
CHAPTER SIX. ANALYSIS OF TAIWAN’S PATH TOWARD BANKING
SECTOR LIBERALIZATION..................................................................................... 143
6.1 Summary of Chapters Three to Five..........................................................143
6.2 Connecting Empirical Findings with the Model....................................... 147
6.3 Conclusions and Discussions......................................................................156
CHAPTER SEVEN: CONCLUSION..........................................................................158
7.1 Lessons Learned.................................. 158
7.2 The Taiwanese Case in Comparative Perspective.................................... 161
7.3 Coping with the Dichotomizing Banking Sector .................................... 163
REFERENCES...............................................................................................................166
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V
LIST OF TABLES
Table 3.1; State ownership in the banking sector, 1987 ............................................... 51
Table 3.2: Loans and output by public and private enterprises, 1970-1982 ............... 55
Table 3.3; Interest rate spreads, 1970-1985 ...................................................................57
Table 3.4 ; Results of the bank law revisions of 1984-1985 .........................................69
Table 4.1; Assets and earnings of KMT-owned enterprises, 1992-1998................ 85
Table 5.1; Numbers of headquarters and branches of domestic banks, credit
cooperatives, credit departments of farmers’ and fishermen’s
associations................................................................................................... 94
Table 5.2; Performance of domestic banks, 1991-2001................................................ 95
Table 5.3; Non-performing loans; Domestic banks vs. Basic financial institutions,
2002 December ......................................................................................... 102
Table 5.4; Performance ofFHC vs. non-FHC banks, 2001 ........................................ I ll
Table 5.5; Removal of non-performing loans; FHC vs. non-FHC banks................... 120
Table 6.1; Taiwan’s path toward banking sector liberalization; Analytical
summary.................................................................... 147
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VI
LIST OF FIGURES
Figure 2.1: The set of collusion conditions (Pc <1)....................................................... 39
Figure 2.2: The set of collusion conditions (Pc >1)....................................................... 40
Figure 2.3: Nonexistence of the collusion set................................................................40
Figure 2.4: Joint efficiency {mf>E > picL)..................................................................... 44
Figure 2.5: Joint efficiency {m^E < picL) ........................................................ 44
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V ll
LIST OF ABBREVIATIONS
AMC Asset Management Company
CBC Central Bank of China
CBT Cooperative Bank of Taiwan
CC Credit Cooperative
CDF A Credit Department of Farmers’ (or Fishermen’s) Association
CDIC Central Deposit Insurance Corporation
CFCC Chang-hua Fourth Credit Cooperative
DPP Democratic Progress Party
FHC Financial Holding Company
FSR Financial Sector Rent
ICBC International Commercial Bank of China
ITC Investment and Trust Company
KMT Kuomintang (the Nationalist Party)
MBB Medium Business Bank
MOF Ministry of Finance
NPL Non-performing loan
PFP People First Party
RTC Resolution Trust Corporation
SOE State-owned enterprise
TSU Taiwan Solidarity Union
TTCC Taipei Tenth Credit Cooperative
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V lll
ABSTRACT
This study analyzes banking sector liberalization in Taiwan from the late
1980s to 2002, It demonstrates that liberalization creates opportunities for politically
powerful players to negotiate and seek financial sector rents. This study develops a
simple game theory model to capture the rent-seeking dynamics in banking sector
liberalization and to explain why liberalization is prone to debt accumulation and
systemic crisis.
The contrasting results between reform achievements and drawbacks
demonstrated the importance for the Taiwanese government of creating positive
incentives and adopting a “carrot-and-stick” strategy for reforms. One important
conclusion that emerged from this study is that the timing, sequencing, and measures
of the major regulatory reforms in the banking system were to some extent attributable
to major changes in the political system.
This study pointed out that the establishment of financial holding companies
and the decentralized asset management company mechanisms resulted in widened
gaps in profitability, capital adequacy, and asset quality between the group of banks
affiliated with financial holding companies and the group of basic financial
institutions and banks without such affiliations. The Taiwanese government needs to
effectively cope with the dichotomizing trend in the banking sector.
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CHAPTER ONE
INTRODUCTION
This study analyzes banking sector liberalization in Taiwan from the late
1980s to 2002. It demonstrates that despite the fact that a major goal of banking sector
liberalization is to introduce market forces to the banking system and to limit rent-
seeking activities, liberalization nevertheless creates opportunities for politically
powerful players to negotiate and seek financial sector rents. Banking sector
liberalization is not only a grandly transformative project, but also a continual
political negotiation process. The path and results of liberalization depend crucially on
whether the government is able to obtain autonomy in coordinating reform efforts.
Through an in-depth analysis of Taiwan’s road to banking sector liberalization,
this study aims to analyze the interplays between the State and the banking industry. It
also identifies that an important way for the government to obtain autonomy is
through its strategic deployment of rents directly to the banking industiy and
indirectly through the banking industry to other social groups. Also, fiindamental
changes in the domestic political scene (such as democratization, the removal of the
provincial level of government, and a shift in power from one political party to
another) inevitably affect the dynamics of the liberalization trend.
In the following, I highlight that the paths ofbanking sector liberalization in
Japan, South Korea, and Taiwan were similar in terms of their proneness to systemic
crisis as a result of rapid deregulation and delays in strengthening their supervisory
infrastructures.
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1.1 THE RESEARCH PUZZLE: IS BANKING SECTOR LIBERALIZATION
PRONE TO SYSTEMIC CRISIS?
The Asian financial crisis relentlessly demonstrated the extraordinary
importance of financial soundness in achieving sustained economic development.
Since the crisis, though, there have been massive restructuring efforts targeting the
banking sector throughout the East Asian region. The necessity for fundamental
structural reforms in banking was identified long before the crisis. In the case of Japan,
its Ministry of Finance sought to strengthen the regulatory infrastructure of bank
operations since the early 1980s (Rosenbluth, 1989), but, as pointed out by many
scholars, the reform process was slow and ineffective (Hoshi & Patrick, 2000; Ueda,
1999). A series of failures in financial, fiscal, and monetary policies delayed both
economic recovery and the resolution of the financial distress that had gradually built
to crisis propositions by the second half of the 1990s (Cargill, Hutchison, & Ito, 2000).
The troubled financial system, along with other domestic and international factors,
dragged the Japanese economy during the 1990s into deflation and high
unemployment. The 1990s was thus referred to as Japan’s “lost decade” in terms of
economic and financial advancement (Cargill et al, 2000).
South Korea, in its pursuit of economic liberalization, failed to reform its
chaebols prior to the crisis (Lee, 2000). Even worse, financial deregulation weakened
the government’s capabilities in coordinating investment projects of the chaebols and
in monitoring their imprudent borrowing practices in the international financial
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markets (Chang, 1998; Kim, 2000). The Korean currency collapsed at the end of 1997
as the economy could not meet the demand for foreign exchange that resulted from
the massive capital outflows. The Korean government could do nothing but accept the
IMF’s rescue package (Kim & Park, 2001). Korea’s post-crisis comprehensive
reforms were surprisingly effective and resulted in the solid recovery of the economy
and the financial system.
The case of Taiwan was likewise interesting. Although Taiwan had made
substantial progress in terms of liberalizing its interest rates and lifting the ban on new
banks in the early 1990s, the needed reforms in areas such as agricultural finance,
privatization of State-owned banks, and the regulatory infrastructure of government
interventions in distressed banks were seriously delayed. Taiwan did relatively well in
weathering the Asian financial crisis of 1997-98; however, the country showed signs
of deflation and possible systemic crisis since 1998 (Chu, 2002).
The experiences of these three different countries raise important questions for
scholars of financial reform. One is to explain why the liberalization processes were
similarly prone to systemic crisis in the banking sector? In addition, why did the three
States all proceed relatively rapidly in deregulating their banking sectors but slowly
and ineffectively in strengthening their levels of information transparency,
supervisory capabilities, and corporate governance (Weare & Smolensky, 1999;
International Monetary Fund, 1998)? Structural reforms were postponed until the
economies went into severe crises (South Korea and Japan) or near-crisis
circumstances (Taiwan). Given the fact that the three East Asian States have a strong
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record of successful governmental intervention in altering industrial structures for
continuous economic development, the slowness and ineffectiveness of bank reforms
are most puzzling.
1.2 RESEARCH QUESTIONS
This study is also a politico-economic analysis of the regulatory changes in the
banking industry in Taiwan. Here, two key research questions arise. First, why has
Taiwan’s banking sector liberalization since the late 1980s focused on deregulation
without simultaneously strengthening the supervisory and regulatory infrastructure?
This has led to a near-systemic crisis in the late 1990s and then forced a kind of
systemic overhaul phase since 2000. Like the first research question, the second
research question focuses on the role and capacity of government: How was the
Taiwanese government able to obtain the needed autonomy for pursuing regulatory
reforms and for preventing a systemic crisis from happening?
According to Peter Evans, the term “autonomy,” in the context of
developmental States, implies “a self-orienting organization that generates sufficient
incentives to induce its individual members to pursue collective goals and assimilate
enough information to allow it to choose goals worth pursuing” (Evans, 1992, p. 178).
The degree of State autonomy is assessed by the robustness of the internal coherence
of the State apparatus as well as the self-orientation of the State (Evans, 1995). The
concept of self-orientation in the context of developmentalist States often refers to the
insulation of those highly talented incumbent technocrats from political pressures in
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making industrial policy. However, insulation does not necessarily imply isolation. To
the contrary, developmentalist State apparatuses are “embedded in a concrete set of
social ties that binds the State to society and provides institutionalized channels for
the continual negotiation and renegotiation of goals and policies” (Evans, 1995, p. 12),
In short, the concept of State autonomy is associated with the internally coherent
structure, self-orientation, and insulation of the State.
1.3 IMPORTANCE OF ANALYZING TAIWAN’S PATH TOWARD
BANKING SECTOR LIBERALIZATION
This study uses Taiwan as a single case study for analysis. A case analysis of
Taiwan’s banking sector liberalization experiences in several aspects contributes to
both the theoretical and empirical knowledge bases of pohtical economy in terms of
financial liberalization. First, this study explores how Taiwan’s domestic political
economy enabled the country to undergo a gradual approach to financial liberalization
and to avoid the contagion effect of the Asian crisis.
Second, in contrast with a comparative study of a number of countries, a
single-country analysis allows the researcher to avoid the challenges of comparability
and to closely examine the issues, processes, and results from banking sector
liberalization in a country-specific context. This study is thus able to analyze in detail
a number of issues and measures related to recent developments in banking reforms in
Taiwan.
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Third, this study attempts to fill the gap that currently exists because Taiwan
was less reported and researched than IMF members such as Japan and Korea. Weiss
(1999) suggested that an analysis on Taiwan might offer one of the least studied yet
most informative cases of a process of market openness managed by the State. Fourth,
while this study utilizes a game theory model to capture the interactions between the
government and the regulated industry, the single-country analysis on Taiwan serves
as a preliminary testing of the model. Last but not least, an analysis of Taiwan
contributes to the theoretical debates about the role of government in the financial
system and the process of financial liberalization, as well as the fate of the model of
the developmental State.
1.4 ARGUMENTS
Seeking to explain how State autonomy was obtained in the process of
banking sector liberalization in Taiwan, I suggest three important arguments. First,
State capacity or autonomy, measured by the State’s capability to impose structural
changes on the whole or part of the economy, is embedded in the policy orientations,
institutional arrangements, and the existing rent (rent-seeking) structures of the State.
The process ofbanking sector liberalization demonstrates the characteristics of such
an embedded autonomy.
Second, banking sector liberalization turn out to be prone to systemic crisis
because the State colludes with the private sector in seeking rents in the process of
reforms. The initial phase of liberalization is a deregulation-based process.
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7
characterized by various attempts that political elites and economic elites collusively
pursue rents in the process of regulatory reforms. The second phase of liberalization is
a restructuring process in which major modifications in the political structure occur
causing the “changed State” to seek to alter the structural weaknesses in the banking
system. In other words, fundamental changes in the political structure will inevitably
alter the State’s capacity and result in major changes in the government’s behavior
and the path ofbanking sector liberalization.
Third, effective structural reforms of the banking sector require the State to be
flexible and autonomous; hence, it may be necessary for the government to create
temporary rents in exchange for political support for its reform policies. The “carrot-
and-stick” strategy turns out to be an effective way for the government to overcome
the constraints of individual rationality imposed by politically powerful groups.
1.5 CHAPTER STRUCTURES
The main purpose of this study is to analyze the Taiwan’s path toward banking
sector liberalization. This study includes seven chapters. The first chapter is an
introduction of this research and links it with the debates on the role of rents in
banking sector liberalization. The second chapter reviews literature on the role of
government in financial liberalization and formulates a game-theoretical model for the
analysis ofbanking sector liberalization as strategic interactions between the
incumbent and the regulated sector that seek rents in regulatory reforms. It is
illustrated that deregulation may lead to political collusion between the regulator and
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the regulated sector. This coiiusion may intensify rent-seeking activities if the
expected returns on investment are lower than the expected benefits from rent-seeking
and political engagements. Chapters Three to Five trace the major regulatory reforms
of the banking system in three distinct periods in the liberalization process in Taiwan.
These periods are divided by the presidential leadership; (1) Financial restraint under
Chiang Ching-kuo’s authoritarian leadership from the mid-1970s through 1987, (2)
initial liberalization under President Lee Teng-hui from 1988 to 2000, and (3)
systemic structural reforms under President Chen Shui-bian since the year 2000.
Chapter Three demonstrates how financial restraint was maintained in the
developmental party-State in Taiwan before the banking system was liberalized.
Chapter Four traces the initial stage ofbanking sector liberalization through early
1990s, highlighting how the incumbent Nationalist Party, the Kuomintang (KMT),
leveraged its strong influence in the regulatory reform process for political support
and expansion of its own business enterprises.
Chapter Five analyzes the restructuring efforts led by the new government
under the leadership of President Chen Shui-bian and the Democratic Political Party
(DPP) in the aftermath of the Asian financial crisis, focusing on its attempts to alter
the existing structure of the banking system. It argues that the KMT was the center of
a broad rent-seeking network connected with all segments in the banking sector so
that the Lee government delayed comprehensive financial reforms. The shift in power
from the old Lee/KMT government to the new Chen/DPP government explains the
accelerated financial reforms since the year 2000.
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In Chapter Six, based on the empirical findings in Chapters Three to Five, I
connect the findings with the model presented in Chapter Two. In Chapter Seven, I
discuss some lessons learned from the Taiwanese case and reflect on the role of
government in the future ofbanking sector liberalization in Taiwan.
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1 0
CHAPTER TWO
LITERATURE REVIEW AND A MODEL OF REGULATORY
CAPTURE IN BANKING REFORMS
The preceding chapter suggests that banking sector liberalization can and
should be understood as strategic interactions between the incumbent and the
regulated sector that seeks rents in regulatory reforms. This chapter discusses the
contrasting views on the role of government in financial liberalization. This chapter
also advances the theoretical understanding of the roles and types of financial sector
rents. In addition, this chapter integrates insights in the theories of regulation into a
game-theoretical model that captures the domestic politico-economic characteristics
ofbanking sector liberalization and generates three broad propositions.
2.1 EXPLAINING THE ROLE OF GOVERNMENT IN FINANCIAL
LIBERALIZATION
Regarding the issue of the government’s responsibility for the tendency to
systemic crisis in financial liberalization, the existing literature is generally divided
into two distinct and conflicting views. One places blame for the systemic crisis on
the structural rigidity and the corrupt, rent-seeking problem of the domestic political
economy. It envisions a global convergence toward an integration of global financial
markets, a separation between the State and the banking system, and the increased
regulatory role of the State. This view attributes the tendency of liberalization to cause
crises to the structural problems residing in the developmental States (Arayama &
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11
Mourdoukoutas, 2000; Claessens, 1999; Cumings, 1999; Haggard, 2000; Moon &
Rhyu, 2000; Robinson, Beeson, Jayasuriya, & Kim, 2000; Ueda, 1999).
The consensus regarding how to restore financial soundness is that the
developmental State needs to be transformed into the regulatory State. By contrast,
the alternative view highlights the importance of the developmental aspect of the
States, the need for the existence of a strong State to coordinate structural adjustments,
and the mistake of jumping to a quick conclusion of global convergence and the
superiority of the Anglo-American, regulatory State model (Chibber, 1999; Lee, 2000;
Tyson, 2000; Weiss, 1999a, 2000).
Structural Rigidity, Rent-seeking, and Crony Capitalism
Structural rigidity has been the most accepted explanation for the
ineffectiveness and slowness in strengthening financial supervision of the 1990s in the
East Asian developmental States. Moon and Rhjoi (2000) argued that the
developmental States have changed and are captured by vested interests of social
groups. The developmental States are no longer autonomous, flexible, and efficient.
Instead, they have become structurally rigid, inefficient, and incapable of coordinating
economic liberalization effectively. The structural rigidity argument held that rents
and rent-seeking activities should be eliminated because they distorted the working of
market forces. Scholars accused the East Asian developmental States of “crony
capitalism” (Moon & Rhyu, 2000). The similarity in their proneness to crisis is
explained by the similarly rigid structures inherited in the developmental States. This
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claim is problematic because, as Cumings (1999) put it, how can the “miracle”
economies of East Asia turn overnight into cesspools of “crony capitalism”?
The negative view of rents and rent-seeking activities is not without criticism
either. It is arguable that rents and rent seeking can be instrumental to economic
development (Khan, 2000). Hellmann, Murdock, and Stiglitz (1996) pointed out that
financial sector rents could serve as positive incentives for banks to behave like long
term agencies and to overcome the problem of information asymmetry. In addition,
contrary to the hope of reducing the presence of government interventions, market
openness may result in more government interventions if openness and competition
intensify the over-capacity problem without providing appropriate exit mechanisms.
Liberalization thus creates conflicting goals in the sense that it attempts to phase out
government intervention in the banking sector, but at the same time, it increases the
need for government assistance. The process of bank reform thus becomes a series of
strategic interactions between the government and the private sector in attempting to
mediate their conflicting interests.
State Capacity, Structural Adjustment, and Economic Development
Developmental State literature emphasizes the State’s capacity in coordinating
structural adjustments of the domestic economy so as to gain competitive advantages
in the international arena. State autonomy (or capacity), based on the developmental
State literature, depends largely on three broad sources; the bureaucratic
characteristics, the State’s relative supervisory and bargaining power over the private
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economic actors, and the public support for State authority (Johnson, 1982, 1995; Kim,
1997; Okimoto, 1989; Weiss, 1998; Weiss & Hobson, 1995; Woo-Cumings, 1999).
State capacity in the liberalization process refers to: (a) the political integrating
power to coordinate the internal disharmony between State components and conflicts
between social interests, (b) a capacity to create and enforce efficient regulations for
overseeing economic actors, (c) a capacity to alter the economic structure to adjust to
the changing economic environments (Lee, 2000), and (d) a capacity to take prompt
action and make large up-ffont investments by the government to minimize the
problems of moral hazards associated with the restructuring process (Claessens, 1999).
In general, this developmentalist view disagrees with the claim that the role of
government in the financial system should be minimized in line with the Anglo-
American capitalist model without taking into consideration the fact that State
capacity is embedded in history and the society (Weiss, 2000). This view holds that it
is not the developmental States per se that are prone to systemic financial crisis; rather,
it is the financial liberalization process that is prone to crisis. It focuses on the
relationship between the State autonomy and the financial liberalization process,
emphasizing that State autonomy is crucial in the liberalization process. Comparing
Taiwan with the crisis-hit South Korea, Weiss (1999b) suggested that South Korea
was driven into financial turmoil not because it deviated too much from the Anglo-
American capitalist model but because it had abandoned too much of its
developmental capacity. By contrast, Taiwan’s experiences demonstrated the
importance of managing financial liberalization without abandoning the
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14
developmental project of promoting industrial upgrading and productivity
enhancement (Weiss, 1999b).
The post-crisis reforms also reflected the Taiwanese government’s learning
capabilities in coordinating the grand transformation, but not necessarily into the
Anglo-American model. The second research question of this study echoes the
emphasis of State autonomy and asks: How is the needed autonomy obtained? If
financial control is an important element of State autonomy, how can autonomy be
maintained in the liberalizing process during which the State capacity is weakened?
What are the domestic factors that affect State autonomy? How can State capacity be
prevented from being eroded by rent-seeking activities?
The developmentalist view, by comparing Taiwan’s absence of strong private
financial power with the presence of big conglomerates in Japan and South Korea that
hindered effective government interventions, uses Taiwan’s relative success in
weathering the Asian crisis as evidence for supporting the positive role of government
intervention. However, this view does not pay enough attention to the types and
outcomes of rent-seeking activities and how they affect the process and results of
Taiwan’s economic liberalization.
In addition, the developmental State literature explains primarily the role of
the State in achieving the economic surplus and, with few exceptions\ overlooked the
government’s substantial burden in subsiding losers and absorbing the losses. The
government’s policies and actions in dealing with losses are crucial for the analysis of
' See the argument and illustration for the “distributive” aspect of Japan (Weiss, 1998). Richardson also
demonstrates Japanese government’s substantial “recession/depression policies” targeting the weak and
sick industries (Richardson, 1997, p.230).
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15
structural reforms in the banking sector simply because bank restructuring is basically
a process for resolving substantial financial losses. In a situation of systemic
restructuring, it not only includes the processes of recognizing financial losses,
restructuring financial claims, and managerial and operational restructuring of a
number of banks, but also involves major changes in the institutional framework for
the financial and corporate sector (Claessens, 1999).
In the restructuring process, the government is likely to be involved in
mediating conflicting responsibilities. It is the government’s responsibility to provide
healthy regulatory infrastructure to restore a sound and safe banking system. The
government may still be held responsible for the guarantee of deposits, bailing-out of
ailing financial institutions, the promise of job security, and a fair, proper, and
legitimate use of taxpayers’ money. Interest groups tend to “politicize” their claims
and to integrate those claims into the discourse of political accountability. Therefore,
the capacity needed in structural reforms and loss management might be very different
from the capacity to coordinate and facilitate investment and growth. Scholars have
identified this gap (Cumings, 1999; Moon & Rhyu, 2000); however, the literature has
not given enough attention to the changing role of government from the
“developmental” State to the “restructuring” State.
Moreover, the developmental State literature has focused on how the
government adopted tight control of the credit-based financial system so as to
facilitate economic development (Demetriades & Luintel, 2001; Hellmann, Murdock,
& Stiglitz, 1996; Khan & Jomo K.S., 2000; Zysman, 1983). The banking system was
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16
an explanatory variable for explaining the economic transformation and the high
speed growth rather than an independent variable that needs to be explained. It is still
not clear whether and how the developmental State model can be adjusted for banking
sector liberalization.
The Dual Functions of the Banking System and the Negotiated Nature of State
Autonomy
So far, the need for a deeper understanding of the relationship between the
banking system and State autonomy has been clearly articulated, as has the
interconnection between banking sector liberalization and State autonomy. None of
the views of structural rigidity and the developmental State are entirely adequate in
explaining the relationships among State autonomy, financial liberalization, and the
tendency toward systemic crisis. The structural rigidity view looks only at the
negative role of rents, while the developmentalist view emphasizes the positive aspect
of rents. At this point, I propose a re-examination of the role of rents in the process of
banking sector liberalization. In the following, the dual fiinctions of Taiwan’s banking
industry are highlighted, as are the negotiated nature of State autonomy. These two
characteristics are important for an analysis ofbanking sector liberalization.
An examination of the factual accounts of Taiwan’s banking sector
liberalization presented in Chapters Three to Five suggests that Taiwan’s banking
system has been carrying out dual functions; financial intermediation as well as rent
creation and distribution. Taiwan adopted the State-led, credit-based financial system
while achieving prolonged economic growth. The role of financial intermediation had
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required the banking system to be able to allocate credits efficiently. Meanwhile, the
banking system has served as an important channel for rent creation and distribution
to fulfill the developmental State’s political accountability and in exchange for
political support to the incumbent government. The efficiency ofbanks’ financial
intermediation, as well as the flexibility and autonomy of the creation and allocation
of rents, were carefully monitored and balanced by the government’s tight control
over and substantial ownership in the banking system before liberalization.
In essence, the goal of financial liberalization is to strengthen the function of
financial intermediation and to eliminate the role of the banks as rent seekers or
distributors. This requires the transformation of the State-led financial system into a
market-led system in which the State acts as a regulator (OECD, 1999). The primary
task is to remove entry barriers and governmental interventions in prices and loan
policies, as well as to establish a governance infrastructure that emphasizes market
transparency and the juridical limitations on the influence of rent-seeking activities or
discretionary political intervention in the functioning of the financial markets
(Jayasuriya, 2000). In short, banking sector liberalization separates the State from the
banking system, “depoliticizes” the banking system and monetary policies, and .
replaces political discretions with market principles.
Nevertheless, reforms also alter the existing patterns of rent creation and
distribution, causing various distributive and re-distributive impacts on different
groups within society. Financial liberalization is, thus, not only inevitably involved
with complex political negotiations and confi'ontations in determining the issue.
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sequence, timing, and measures of reforms, but also subject to the influence of
changes in the political system. Strong State capacity is required to respond timely,
innovatively, and effectively to the challenges of liberalization. Meanwhile, the
creation and deployment of rents in the banking sector may play a positive role in
creating the incentives for reforms and facilitating the mobilization of political
support for reforms. This reflects the negotiated nature of State autonomy and the
importance of rents in enabling the government to obtain autonomy and to introduce
market-conforming mechanisms.
This study proposes to view banking sector liberalization as a dynamic process
of strategic interactions between the incumbent and the regulated sector that seek rents
in regulatory reforms. In addition, since this study analyzes regulatory changes in the
banking system and the relationships between regulatory reforms and the creation and
distribution of rents, theories on rent-seeking and regulation (regulatory change) are
highly relevant to this study. These two relationships will be explored in the next two
sessions, and the insights gained will be utilized to formulate a game theory model for
explaining the dynamics of rent-seeking and regulatory reforms in the banking
industry.
2.2 FINANCIAL SECTOR RENTS
Rents are generally defined as incomes that are above normal, and the
“normal” return usually refers to the income a firm would have received in a
competitive market (Khan, 2000). Government intervention in a market may alter the
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prices and the level of “normal” incomes, resulting in the creation of rents. Financial
sector rents (FSRs) refer to rents created in the financial system by direct or indirect
government intervention in regulating interest rates, loan policies, entry restrictions,
limitations on competition, and exit mechanisms. Financial liberalization attempts to
replace government interventions by market mechanisms, limiting rents and rent-
seeking activities in the financial sector. Nevertheless, rents might play a positive role
in fostering financial intermediation and economic development. Hellmann, Murdock,
and Stiglitz (1996) analyzed how FSRs contributed to economic success in East Asian
developmental States. Fay and Jomo (2000) examined why Malaysia failed to make
FSRs productive. They concluded that it is crucial to distinguish what types of FSRs
are created, who captured them, and how.
To evaluate the role of FSRs, Hellmann et al. (1996) emphasized the
distinction between rent transfers and rent opportunities. Hellmann et al. (1996)
pointed out that direct rent transfers alter the distribution of income and wealth
without directly providing incentives for banks to improve efficiency. Rent transfers
might also attract bankers’ political engagements aiming at sustaining those transfers
or increasing their shares of the transfers. By contrast, rent opportunities are
contingent on the banks’ action. Hellmann, et al. (1996) argued that, if the rent
opportunities provide incentives to activities that are underprovided in a competitive
market, then those rent opportunities are value-enhancing. In short, the role of FSRs
will be positive if they created the “right incentives” that lead to desirable economic
results. Various types of government intervention create various types ofFSRs. In the
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following, I discuss several different types ofFSRs and how financial liberalization
would affect those rents.
Rents in the Form of Extra Interest Margins
The first type ofFSRs created in the banking sector is associated with
government control of the deposit rate or both the deposit and lending rates (Stiglitz &
Weiss, 1981; Hellmann et al, 1996; Fay & Jomo K.S., 2000; Khan, 2000a).
Government intervention in interest rates creates a wide interest rate margin that
would not exist in a free market. To sustain the interest-rate control, government also
needs to limit competition within the banking sector as well as from the capital market
and foreign competitors.
Hellmann et al. (1996) presented a simple demand-supply model to analyze
this type of rent. Suppose the interest rate under the “free market” equilibrium (i.e., in
the absence of government intervention) is ro, and the deposit rate and the lending rate
are rd and ri, respectively. The rents ( jl - r^) are thus created for the banks to capture.
In addition, if the lending rate (rd) is lower than the “free-market” equilibrium rate (ro),
the firms would capture rents (ro - ri). The rents (ro - ri) reduce the cost of loans and
thus stimulate investment and capital accumulation (Shea, 1994). The size of the
interest-margin-based rents can be estimated by the interest margins of commercial
banks in an interventionist economy. For example, Fay and Jomo reported that the
gaps between average lending and deposit rates in Malaysia fi'om mid 1980s to mid
1990s were around 4-5 per cent (Fay & Jomo K.S., 2000).
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Interest margins are rent opportunities rather than direct transfers. Banks
materialize those rent opportunities by collecting interest payments from the loans
they made. Hellmann et al. (1996) argued that the existence of interest-margin-based
FSRs in East Asian States might provide two positive effects on the development of
financial intermediation. First, the persistence of interest margins creates a “franchise
value” for banks to operate as long-run agents so that they will invest in information
capacities to effectively monitor their portfolio and risks of loans. Second, the interest
margins provide incentives for banks to expand their deposit bases, through their
investment efforts to open new branches in new areas or to cultivate new depositors.
Financial liberalization requires the government to abandon its control of the
interest rates as well as entry barriers. The market competition would eliminate the
interest-margin-based rents.
Rents in the Form of Preferential Credit-allocation
The second type ofFSRs is associated with government intervention in credit
allocation. The intervention is intended to allocate credit to targeted industries, firms,
or activities. The-credit-allocation-based FSRs have been commonly used by the East
Asian States to facilitate the implementation of industrial policy (Patrick, 1994). For
example, in Taiwan the government adopted preferential loan programs to promote
exports, machine-imports, medium and small businesses, and the establishment or
enhancement of strategic industries (Shea, 1994). The credit-allocation-based FSRs
may come directly from the government’s own funds, or indirectly from State-owned
banks and financial institutions that are under government influence (Patrick, 1994).
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The deployment ofFSRs through selective allocation of preferential loans varies
among countries and programs in terms of the degree of government involvement and
how specific or selective the loan programs are.
Financial liberalization would reduce governmental intervention in loan
policies and credit allocation. Privatization of State-owned banks is thus often
considered as an important way to increase the independence and efficiency of those
banks.
Rents through Relational finance
The third type ofFSRs is associated with “relational financing”. Relation-
based FSRs are defined as rents created in the banking sector as a result of the rent-
seekers’ privileged relation with the government. Before financial liberalization,
credit rationing was common in the East Asian developmental economies. Firms that
maintained good relations with ruling political parties gained preferential access to
credit. This preferential access to credit may not reduce the efficient allocation of
credit because efficiency depends more on how the credit is used rather than who gets
it. In Japan, South Korea, and Taiwan, relational financing has often been companied
with the governments’ implementation of industrial policy and credit-based
intervention.
Financial liberalization requires the elimination of relational financing and the
creation of an “arm’s length” financial system in which banks achieve a high degree
of operational independence and efficiency. However, this is very difficult to achieve
simply because, compared with other liberalization measures centering on the removal
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of restrictions, the creation of an arm’s length financial system requires fundamental
reforms at the organizational level and often are associated with reforms of the bank-
business relationships.
Rents in the Form of Government Compensation for Losses
While the three types ofFSRs listed above create extra profit opportunities for
rent-seekers to capture, it is arguable that government direct or indirect subsides,
which compensate losses accumulated in the financial sector, may also qualify as a
form of rent. In a competitive market, a firm unable to make profits would exit the
market, and the owner of the firm bears the losses. However, if the firm receives
government compensation for the losses, the firm can stay afloat. The firm would also
stay in business if the government guarantees its financial liabilities. If
regulatory/supervisory loopholes exist in the disclosure of losses, the firm may take
advantage of those loopholes and hide their losses off its balance sheet. In fact, the
government may intentionally adopt regulatory forbearance for the banking sector in
distress so that both the government and the distressed banks can avoid prompt
restructuring responsibilities and loss recognition. These practices delayed the
removal of inefficient banks from the system and result in the accumulation of
substantial financial losses, which, in most cases, would ultimately be absorbed by the
government in the phase of painful systemic restructuring of the banking sector.
I provide a number of reasons to justify my attention to rents in the form of
government compensation for financial losses. First, the East Asian developmental
States have created a bank-dominated financial system and used FSRs to facilitate the
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implementation of industrial policy. Contrasting to a stylized negative view of rents
and rent-seeking activities, the high-speed growth in those countries from the 1960s to
the early 1990s demonstrated the positive impact ofFSRs on economic development.
Nevertheless, the types ofFSRs created in this period of high-speed growth served
mainly as a positive incentive to promote industrial policy and coordinate economic
activities. The economy and the financial system did not experience significant losses
until late 1990s. In fact, credit-allocation intervention and relational-financing may
result in inefficiency in financial intermediation if the government’s monitoring and
supervisory capabilities were weakened by financial deregulation (Lee, 2000).
Relational financing may intensify the magnitude of a credit bubble as well as the
problem of the bust of the bubble. Relation-based loans are often a major source of
non-performing loans (NPLs) and financial crisis. In order to understand the
interconnections between financial liberalization and the changes in the incentive
structure in the banking sector, it is thus necessary to examine FSRs from both the
profit side and the loss side.
Second, a major distinction between the loss-side and profit-side FSRs is that
the loss-side FSRs call our attention to the “exit barriers” in the banking sector, while
the focus of the profit-side FSRs has been on entry barriers. One of the exit barriers is
the expected government intervention to save ailing banks. In Japan, for example, the
government would not allow banks to fail. Similarly, the Taiwanese government often
made arrangements to save ailing financial institutions so as to minimize the damage
to public confidence in the government and financial stability. The ailing financial
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institutions may be saved or merged with other banks, which would absorb all the
losses the ailing banks accumulated. Another barrier is the lack of a regulatory
framework to allow the government to take prompt action in dealing with the ailing
banks. The politics of blame avoidance delayed the needed prompt actions. As a result,
insolvent banks might stay in the market for a long time. The distressed or insolvent
banks have incentives to take advantage of the exit barriers, seek rents through
various legal or illegal ways, and hide their losses, in that a substantial part of the
losses would ultimately be paid by the government.
Third, studies have shown that the rent elimination process can induce rent-
seeking activities to a degree similar to that which the rent creation process does, for
the beneficiaries of existing rents have incentives to protect their gains and avoid
losses (McChesney, 1989). Formal modeling has also illustrated that a negative rent
will result in the same amount of rent seeking as an equal size of positive rent
(Appelbaum & Katz, 1987). Financial liberalization may reduce the profit-side FSRs
by the introduction of competition into the banking sector. However, the intensified
competition and reduction of profits may cause some financial institutions to be
unviable and accumulate loss-side FSRs if the exit mechanisms are not in place to
make weak banks get out of business.
Fourth, various theories of the developmental State such as the “governed
interdependence” (Weiss & Hobson, 1995), “governed market” (Wade, 1990), and
“embedded autonomy” (Evans, 1992) emphasize that distributive politics has been
pervasive in the East Asian developmental States. It is reported that the policy loans in
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the 1970s in Japan were mainly directed to the weak industries (Richardson, 1997).
The Taiwanese government also provided preferential loans for the purpose of
industrial “upgrading.” This loan policy also served a distributive goal. Although this
loan policy was to facilitate the upgrading of the declining sectors or firms, the
outcome of this policy depend on how well the sectors or firms adjusted themselves
effectively to the changing environment. Those loans carry substantial risks, and they
are likely to become losses if the investment projects do not succeed. Difficulties in
effectively monitoring the behavior and performance of the borrowers may also
increase the possibility of defaults. In addition, policymakers tend to underestimate
the losses and the seriousness of problems in the banking sector (Chu, 2002).
Fifth, the loss-side FSRs tend to be self-reinforcing. Studies on the Asian
financial crisis have shown that the regulatory and institutional weaknesses of the
domestic banking sector may be responsible for the crisis. Dekle and Kletzer (2001)
developed a model to illustrate the dynamic process of how the domestic banking
sector falls into a vicious circle of loan renegotiation, portfolio deterioration, foreign
debt accumulation, and eventually a systemic banking crisis. When the borrower of a
bank loan becomes insolvent, Dekle and Kletzer’s model suggests that the bank may
still have incentives and advantages to renegotiate the loan with the borrower.
In addition, banks compete intensively to get “good clients” (i.e., those who
are able to repay their debts; and, as a result, banks are unable to charge these good
clients any interest premium). Banks can only charge interest premium and receive
higher expected returns (if realized) from clients with loan renegotiations. Moreover,
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the existence of deposit insurance and the government’s implicit guarantee of deposits
delays the trigger of a bank run when a loan renegotiation occurs. The firms doing
loan renegotiation will choose riskier projects because their own stake is insignificant
and they need to pay higher interests for their renegotiated loans. They are betting for
resurrection. This debt-accumulating process, which gradually changes the banking
sector so it is less stable and relies more heavily on loan renegotiation, is temporarily
sustained by the inflow of foreign capital, and constrained ultimately by the
government’s capability (for example, central bank reserves) to fulfill its international
liabilities (Dekle & Kletzer, 2001). As the debt reaches the ultimate limit, a systemic
banking crisis occurs.
Dekle & Kletzer’s model is both informative and limited. The model
insightfiilly points out the importance of the institutional and regulatory
characteristics of the domestic banking system in East Asia, such as the partial
competition in the banking sector with information asymmetries, various government
guarantees or bailouts, supervisory forbearance, and the lack of effective prudential
regulations. These characteristics played a decisive role in causing the financial crisis.
Dekle and Kletzer’s model portrayed a paradoxical role of government but did
not explicitly address the connectivity of the conflicting roles of government as the
guardian of safety and the provider of prudential regulations. On the one hand, the
government is the guardian of safety. It provides guarantees for bank liabilities
because the banking sector is still in the process of liberalization. Those guarantees.
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which are important for economic transformation, enhance the goals of economic
stability and protection of small depositors.
On the other hand, the government is expected to provide prudential
regulations and enforcement for the partially liberalized banking sector. Experiences
in Japan, South Korea, and Taiwan demonstrated that the more dramatic the
regulatory reforms intend to be, the more relative the share of costs the government
needs to shoulder. This is because the governments in those countries tended to make
their interventions so that they were not only beneficial to the society as a whole but
also no harm came to any specific group of citizens. Dramatic regulatory changes
often faced strong rebuttals from those who might be negatively affected by reforms.
Rents are difficult to be dramatically removed because rent beneficiaries demand
compensation for their “losses”. As a result, the governments prefer a gradual
approach to reforms through which the incumbents negotiate with various players at
various stages so as to make sure that the political support for the reform policies are
sufficient and the relative political gain by the opposition parties or factions is
minimized. Therefore, the paradoxical portrait of government requires the analysis of
the banking reform to be able to examine the political calculation of the incumbent
elites.
The reasons discussed above justify a special attention to the loss-side rents in
the analysis of financial liberalization and State autonomy. In sum, this section
expands the scope and definition ofFSRs. It highlights that the introduction of market
openness and competition, despite its effect on reducing the interest-margin-based
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rents, may not necessarily reduce the size ofFSRs as a whole. The practices of credit-
based intervention and relational-financing may continue, and, more importantly, the
NPLs (a key indicator of the loss-side FSRs) may gradually and quietly rise as the
competition and the problem of exit barriers are intensified.
2.3 THEORIES OF REGULATION
In this section I review theories of regulation. Based on the theories of
regulation and their relevance to this study, I have created a simple game-theoretical
model to capture the relationship between the regulator and the regulated industry in
the process of deregulation.
Public Interest Theory of Regulation and Deregulation
Theories of regulation and deregulation can be divided into four groups; the
public interest theory, the capture theory, the economic theory, and the political
process theory (Keeler & Foreman, 1998). Each theory has its own unique
assumptions of demand-side and supply-side motivations for regulation or
deregulation. The public interest theory assumes that the regulator pursues the public
interest in terms of maximum economic efficiency. The regulator will intervene in an
industry only to correct an inefficient monopoly, non-sustainable market equilibrium,
or severe negative externalities caused by information asymmetry. In other words, the
public interest theory sees regulation as a supplement to the free market. It treats rents
as deadweight losses caused by inefficient monopoly or information asymmetry. The
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regulator is assumed to be benevolent with a public interest in mind and the goal of
economic efficiency.
Capture Theory of Regulation
The capture theory suggests that the regulator is “captured” by the regulated
industry. The regulated industry - the demand side of regulation - is a rent-seeker. The
regulator is the sole provider of regulation. Deregulation would occur only if the
regulated industry losses its political bargaining power or the “capture” becomes
economically unnecessary.
Nevertheless, capture theory implies that deregulation can also be captured by
politically powerful actors. While regulation was captured and the industry was
inefficient, deregulation might distort the regulated sector even further. Rosenbluth’s
analysis of Japanese financial liberalization suggests that economic actors can
influence the regulatory process and “take the carrot and avoid the stick” (Rosenbluth,
1989). Hence, I have developed a model of banking sector liberalization assuming
that the regulator can be captured in the deregulation process.
The Economic Theory of Regulation
The economic theory of regulation was first advanced by George J. Stigler as a
supply-and-demand explanation of why producers are politically more powerful than
consumers in influencing the regulatory process (Stigler, 1971). The economic theory
is an extended version of the capture theory. It is argued that in an electoral system,
groups with lobbying strength demand economic regulation. The government
responds to this demand by supplying regulations. Stigler proposed as a general rule
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that every industry with enough political power to influence the State will seek to
control entry to that industry. Stigler also emphasized that producers form coalitions
and lobby for favorable regulations. Posner (1971) pointed out that regulation not only
created rents to producers but also redistributed rents among consumers (Posner,
1971). Peltzman (1976) integrated the economic theory of regulation into a general
model. Peltzman argued that the regulator maximizes a political support function of
certain variables - such as the prices of products and the costs of factor inputs - over
which the regulator enjoys explicit or implicit control (Peltzman, 1976). Becker and
Keeler extended this model to incorporate the public interest theory (Becker, 1976,
1983; Keeler, 1984). One focus is the cross-subsidization from one group to another.
The economic theory suggests the use of formal modeling to capture the
incumbent’s political calculation and the causal dynamics among key actors. While
the economic theory focuses primarily on the changes in relative prices, it falls short
in addressing several issues, as criticized in the political process theory. One main
problem is the “regulatory innovation” that would give the regulator and the regulated
industry new regulatory options to simultaneously enhance their individual utilities. In
addition to regulatory innovation, other issues such as timing, sequence, and possible
re-regulation are not fully explored in the economic theory. Moreover, political parties
and politicians engaged in regulatory reforms may play a role more autonomous than
the passive role portrayed in many economic-theory-based models. The approach of
formal modeling, while using a few rationality-based assumptions to generate precise
predictions, is thus limited in addressing the complexity and scope of regulatory
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changes. Taking into consideration both the merits and weaknesses in the formal
modeling approach, I will try to create a game-theoretical model that is flexible
enough to accommodate the wide range of possible outcomes of banking sector
liberalization.
Political Process Theory of Regulation
The political process theory emphasizes the importance of the political system.
For democratic societies, a main concern is the individual voters’ lack of incentives
and capabilities to become informed regarding their voting decisions. In other words,
the individual voters’ perceptions and beliefs depend mainly on mass media and the
opinions of politicians or activists. It follows that a significant shock, such as a
financial crisis, could serve as a discursive opportunity for politicians or activists to
take advantage of the temporary peak attention by the public, incorporate those events
into their own discourse, and try to influence the voters’ opinion. Regulatory changes
thus depend on the interactions among the external shocks, political entrepreneurs,
and the interests of the newly-informed voters.
For non-democratic societies, the focus has been on the regulatory behavior of
the regime, in light of its developmental or predatory orientation. Various models
have been presented (Shleifer & Vishny, 1998). This is an area that calls for more
attention, particularly for the countries that undergo economic liberalization and
political democratization simultaneously.
The political process theory provides insights into the political system,
particularly the incentives and strategies of political actors. This makes the game-
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theoretical concepts particularly useful to generate parsimonious results from a wide
range of political activities (McChesney, 1998). In addition, the political process
theory points out the importance of external shocks in relation to regulatory changes. I
will incorporate this insight into the implications of my game-theoretical model.
2.4 A GAME-THEORETICAL MODEL OF FINANCIAL LIBERALIZATION
Auerback’s work on Mexico’s financial liberalization viewed banking reform
as a process of strategic interactions between two groups: the incumbent elites and the
bankers (Auerbach, 2001). In this section, I adopt the same view and develop a game-
theoretical model for the analysis of banking reform. I assume that the incumbent
attempts to liberalize the banking sector, but subject to political influence from the
bankers. The bankers’ goal is to maximize their income that consists of a “normal”
portion (profits that would be earned in the absence of rents) and an “extra” portion
(that is, the financial rents captured by the bankers).
The model accommodates and facilitates the analysis of the politico-economic
characteristics of banking reforms in three major ways. First, the incumbent’s utility
function captures the valuation of the political costs of financial rents, as well as the
sensitivity of the bankers’ rent-seeking activities. Second, the model assumes that the
bankers can increase their income by investing either in technological improvements
or political engagement and collusion. The model generates an equilibrium solution
with a fully liberalized banking system (i.e., a free and competitive market without
government intervention). The equilibrium serves as a “threat point” (i.e., non-
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collusion solution) that each group can make threats to the other group. The model
then generates the collusion conditions based on individual rationality in the sense
that the collusion between the two groups should make both of them no worse off than
the payoffs they can get from the non-collusive equilibrium. This is similar to a cost-
benefit analysis of the collusion conditions of incumbent-banker interactions.
Third, the model analyzes the political interdependence between two types of
overarching forces that shape the fundamental path of financial liberalization: the
rent-seeking forces from various groups of rent-seekers who want to take advantage
of the institutional and regulatory weaknesses in the liberalizing economies, and the
regulatory/supervisory forces fi'om various sites in the political economy (such as the
central bank, the legislative agency, and the markets) aiming to eliminate moral
hazards and rent-seeking activities. It is suggested that each of the two forces tend to
be self-reinforcing. Rent-seekers often enjoy increasing returns on their rent-seeking
activities (Shleifer & Vishny, 1998). This implies hazardous moral problems that
might gradually drive the whole economy into a vicious circle of rent-seeking
corruption and serious crises.
In the following I provide a simple model that enables me to analyze rent-
setting and rent-seeking behavior in transition from financial restraint to liberalization.
There are only two players in this model: the incumbent and the banker. The
incumbent sets up the rents, while the banker captures the rents. Note that the “one”
banker in the model represents the whole banking industry as an “average”, so it does
not mean that there is only one banker who enjoys a monopoly.
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Financial Restraint
Financial restraint is characterized by the extraction of rents from the
household sector (depositors) to the banking sector but not to the political system
(Hellmann et al., 1996). Under financial restraint, the incumbent sets up a rent margin
(denoted by ao) above the market-clearing profit rate (denoted by p) to motivate the
banker to perform. Denoted by L the size of total outstanding loans. I assume that the
size of total outstanding loans equals the size of total take-in deposits. The size of the
financial rents is OoZ, and the banker’ market-clearing profits are pZ. The banker thus
receives annual cash flow of (ooZ + pZ) in the system with financial restraint.
Following Hellmann et al. (1996), I assume that all financial rents are kept within the
financial sector and captured by the banker.
Banking Sector Liberalization
Now suppose that the incumbent intends to liberalize the banking system. I
assume that the incumbent possesses absolute power in setting up a new rent margin
(denoted by a), but the incumbent is now subject to political influence from the
banker. A fu lly liberalized banking sector implies the elimination of all financial rents
(a=0). The case of (0 < a < Oo) would imply an improved banking system, in the
sense that the size of financial rents was reduced. Similarly, the case of a > ao would
indicate a worsened banking system in the sense that the amount of financial rents in
the liberalization regime was larger than before.
The banker responds to liberalization by making “investments” to improve the
bank’s income. Suppose the budget assigned to investments is E. The banker can
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spend the investment budget on two types of profit-improving measures:
technological improvements and political engagements. Technological investments
include all efforts to enhance the bank’s information capacity and efficiency, such as
investments in information technology, job training for portfolio and risk management
skills, and marketing programs, etc. Political engagements, by contrast, refer to the
banker’s attempt to secure or increase the financial rents through political influence
and power. This includes efforts such as bribes, the provision of favorable loans to
politicians whose (ability) willingness for loan repayment might be in question, and
other subtle ways of obtaining political influence. Technological investment increases
the bank’s operational efficiency and profit margins, but expenditures of political
engagement may be potentially wasteful and result in “deadweight losses” for the
economy.
Suppose the banker allocates fi-action P of the total investment budget for
political engagement, and fraction (1-P) goes to technological improvement.
Technological investment will increase the profit rate, and for simplicity, I assume a
linear relationship between the increase in the market-clearing profit rate and the
portion of the total investment expenditures on technological improvement, that is, (1-
P). Suppose the percentage increase in market-clearing profit rate is (1-P)k, with a
maximum value denoted by k when P = 0 and a minimum value of 0 if p = 1. A
higher k implies that, for every dollar spent on technological improvement, the effect
on the increase of the profitability rate is higher. The new market-clearing profit rate
is equal to p[l + (1-P)k]. The banker also receives financial rents equal to the size of
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the total loans times the new rent margin (a). The banker’s total annual cash flow
(denoted by n) becomes the sum of the market-clearing profits and rents, minus the
investment expenditures:
(2.1) 7t(a,p) = p[l + (1-3)k]Z + o l L - E
The incumbent evaluates the existence of rents as a disutility, for it is assumed
that the incumbent intends to minimize the rents. Suppose that this disutility is given
by an average political cost function of the rent margin (denoted by C(a)), times the
size of the existing loans (L). I assume C’>0 and C” >0, which imply the increasing
marginal disutility of rents. This reflects the typical constraint in public reaction to
rent-setting policies that, the higher the existing rents, the more difficult for the
incumbent to justify another increase in rents. Meanwhile, the incumbent gains
benefits from the banker’s political investment (fiE). For simplicity, I assume that the
incumbent derives a constant marginal utility from the banker’s political investment,
and this utility is denoted by m^E (denote by m the marginal utility coefficient of the
banker’s political investment in the incumbent’s utility function). A higher m implies
that, for every dollar spent on political engagement, the effect on the increase of the
incumbent’s utility is higher. Suppose the incumbent’s utility function is the sum of
the rent-associated disutility and the rent-seeking-associated utility. Under these
assumptions, the incumbent’s utility function can be expressed as
(2.2) U(a,P) = -C(a)L + mf>E
I assume that all parameters in the equations (2.1) and (2.2) are common
knowledge to both players, who interact strategically and communicate extensively to
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try to maximize their utilities. In the following section, I identify the conditions for
the two players to collude.
Conditions for Collusion
Each player can threaten the other player. If the incumbent chooses a=0, it
will make the banker unable to use P to try to influence a. The banker will be forced
to choose P=0. Similarly, if the banker chooses P=0, it will force the incumbent to
choose a=0. Therefore, there is an obvious mutual threat point of (a,P) at (0,0), which
represents a fully liberalized, non-corruptive banking system.
Voluntary collusion can happen if there exist conditions so that both players
can receive higher or equal utilities than the utilities derived from (0,0). The
individual rationality condition for the incumbent to collude with the banker is given
by U(a,P) > U(0,0), which yields:
(2.3) m^E > C(a)L.
The inequality in equation (2.3) implies that the incumbent’s political benefits
must be greater than the opportunity cost of rents. Similarly, the banker requires 7t(a,P)
> 7t(0,0), which yields:
(2.4) . a > pxp.
The inequality in equation (2.4) means that the banker’s gains in rents must be
larger than the opportunity costs of political investment. Therefore, the collusion
conditions are given by combining the inequalities (2.3) and (2.4). Figure 2.1
illustrates in the a-p plane the set of collusion conditions (the shaded area). The
comer solution is denoted by (otc,Pc)- Note that by definition P ranges between 0 and 1,
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39
but it is possible to have P<>1. Figure 2.1 is in fact the case of Pc <1. In this situation,
the incumbent and the banker have incentives to collude, but the banker is unwilling
to spend the whole investment budget (£) on political engagements.
Figure 2.2 illustrates the case of Pc >1- In this situation, the banker is willing to
spend the whole investment budget on political engagements, that is, P=l. In fact, this
case can be understood as a situation whereby the collusion set is limited by the size
of the investment budget available to the banker. Since I could not obtain substantial
additional insights from the case of Pc > 1,1 hereafter assume Pc <1. Figure 2.3
illustrates the case of the non-existence of the collusion set. In this situation, the
collusion between the banker and the incumbent will not satisfy the constraints based
on individual rationality.
Fig 2.1 The Set of Collusion Conditions {fic< 1)
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Fig 2.2 The Set of Collusion Conditions {fic> 1)
Fig 2.3 Non-existence of the Collusion Set
The analysis of the collusion conditions can be summarized as the first result
of the model:
Proposition 2.1 (The collusion proposition) If the collusion conditions
based on individual rationality - that is, m^E > C(a)Z and a > pKjl - are met, the
financial rents and rent-seeking activities will be persistent in the country undergoing
banking sector liberalization. The uniqueness of this proposition is that it gives the
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41
conditions of how economic factors and political factors jointly determine the possible
outcomes of their interactions.
This proposition points out the critical role of government in banking sector
liberalization. The initial deregulation of the banking sector will often induce
collusion between politicians and bankers, as illustrated by the existence of the
collusion set. Within the wide ranges of (a,P) in the collusion set, the government and
the banker engage each other in the negotiations and confrontations for regulatory
reforms. Therefore, the success of liberalization depends critically on the State’s
transformative capacity in gradually altering the collusion set (i.e., those politico-
economic parameters of C(-), p, k , and m) so as to approach the elimination of
collusion conditions.
In order to contract the collusion set, the goal of government is obviously to
increase p, k, and C(-) and to reduce m. To increase p is to increase the average
profitability of the banking industry, and to increase k is to improve the profitability
outlook for technological investment by the banks. An up-shift of C(-) implies that the
incumbent perceives higher disutility in colluding with the banker. To reduce m is to
reduce the incumbent’s sensitivity to the banks’ political engagement. To achieve
these goals, the government may deal with the banker in a “constructive” way within
the collusion set, adopting the carrot-and-stick strategy to use rents as temporary
economic incentives (the carrot) in exchange for needed political consent and
compliance from the banker in regulatory reforms (the stick) aiming to alter the
domestic politico-economic parameters that underpin collusion.
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While the p , k , m, and C(-) parameters are more associated with the State (or
State autonomy) than the banker, the parameter ratio E/L is mainly in the banker’s
hand. From the inequality (2.3), it is obvious that a higher E/L would make the
collusion condition easier to be satisfied. In fact, it is important to note that the ^E/L
represents exactly the percentage of loans used for political engagement. The f> E ,
which represents the rent-seeking “expenditures” used for political engagement, often
appeared in the form of preferential loans to politicians and political elites. These
political loans, in a strict economic sense, are transfers of wealth but not real expenses
or losses. Those loans might be put into profitable projects and become value-
enhancing, or be spent on political campaigns as rent-seeking expenses and become
economically and socially wasteful.
Collusive Coalition, Joint Utility, and the Need for External Shocks
Given the fact that the incumbent and the bankers in many countries
communicate frequently and intensively to discuss issues and measures regarding
banking sector liberalization, it is more likely that they will collude (if the collusion
set exists) rather than accept the non-cooperative outcomes. So far I have not specified
how a and P should be related. Within the collusion set, there exist unlimited
combinations of (a, P) pairs. Among them, there is a specific pair of (a, P) of great
theoretical significance. Shleifer and Vishny (1998) pointed out that the incumbent
and the regulated players might collude and pursue their joint efficiency. From the
viewpoint of full transferability of utility between the regulator and the regulated
players, joint efficiency is given by maximizing the combined utility of the two
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43
groups. In this section, I analyze the conditions and outcomes that the incumbent and
the banker form in their coalition and maximize their combined utility;
(2.5) (U+7t) = {-C(a)Z + m^E) + {p[l + (1-P )k]Z + oL -E },
which can be rewritten as:
(2.6) (U+7t) = [a-C(a)]Z, + (mE - pkL)P + (l+K)pZ- - E.
The incumbent-banker coalition faces the constraints of the collusion set while
pursuing the joint utility. In other words, the maximization problem is to find within
the collusion set a (a,P) pair that maximizes the joint utility. For the two cases of
either {mE > pxL) or {mE < picL), Figures 2.4 and 2.5 illustrate respectively how the
constant-utility curves and the associated efficient points for the two cases in the a-P
domain may look. The efficient point in the case of {mE > pxL) is at the right-hand
side of the collusion set, determined by the equations (2.7) and (2.8):
(2.7) a* = {C j\m E !pidL\
(2.8) p* = {Cy\mE!L).
The efficient point in the case of {mE < pxL) is given by the equations (2.9)
and (2.10):
(2.9) a - {C)-\mElpKL\
(2.1) P* = C{a)L/mE.
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Fig 2.4 Joint Efficiency (mE> pkL)
( U +JT) increases
O C
P
0
Fig 2.5 Joint Efficiency (mE < pkL)
( U +« ) increases
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4 5
The comparison of the two cases confirms that the sign of (mE - picL) is
crucial in determining the jointly efficient outcomes in banking sector liberalization.
If political engagements are more rewarding for the banker than technological
improvements (that is, mE > pic£), joint efficiency is approached by an increase in the
banker’s political expenditures and the incumbent’s provision of rents to their
maximum levels within the collusion set. By contrast, if the banker’s technological
improvements are more rewarding than political engagements (that is, mE < p k Z ),
joint efficiency tends to limit the rents and rent-seeking activities to relatively low
levels.
Proposition 2.2 (The coalition proposition) If the condition (mE >
PkL ), or equivalently (£/L > pic/w ), is met, the scenario of incumbent-banker
coalition produces a solution determined implicitly by the equations (2.7) and (2.8).
This solution also implies that rent-seeking activities may be more intensive than the
situation under financial restraint. This implies that the incumbent-banker coalition
may lead other types of rents to rise even if liberalization eliminated the interest-
margin-based rents. The high levels of rents and rent-seeking costs also indicate the
loss of State autonomy in pursuing reforms toward a sound banking system.
Proposition 2.3 (The crisis proposition) This proposition states that the
corner solution produced by the incumbent-banker collusive coalition is unsustainable
and prone to crises. The solution equation (2.8) indicates that the a changes in the
opposite direction with the [C (-)pkZ ,/w £]. In other words, a higher [C (-)p k Z /w £ ]
would produce a lower a . Under the joint efficiency scenario, structural reforms
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toward a sound banking system would alter the domestic politico-economic
parameters toward higher levels of C(-), p, and k, and lower levels of m and E/L. This
finding is similar to the preceding discussions on the collusion proposition and its
implications. However, the coalition proposition implies that the politico-economic
structure is rigid and State autonomy is lost. Also, the banking system is trapped in a
vicious circle of debt-accumulation as Dekle and Kletzer (2001) described. The
collusive coalition thus produces unsustainably high levels of rents and rent-seeking
costs. The political economy becomes increasingly vulnerable to political or economic
crises. These crises, in turn, serve as “shocks” that lead to fundamental changes in the
political economy and subsequent reforms in the financial system.
2.5 SUMMARY
In this chapter, I discussed banking sector liberalization from the view of
strategic interactions between the State and the banking sector. I identified four
different forms of rents in the financial sector: interest margins, preferential credits,
relational financing, and compensation for losses. I also reviewed four different
theories of regulation: public interest theory, capture theory, the economic theory, and
the political process theory. I absorbed relevant insights of those theories and created
a game-theoretical model to capture the interactions between the developmentalist
government and the banking sector in the process of banking sector liberalization.
The model generated three broad propositions. The collusion proposition
specified the conditions for rational collusion and highlighted the negotiated nature of
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4 7
State autonomy in pursuing reforms. In the coalition proposition I pointed out the
situation in which State autonomy is lost. The incumbent government lacks the
incentives and capabilities to pursue reforms. Instead, the incumbent forms a coalition
with the banker to maximize their joint utility. Maximization of their joint utility
would result in debt accumulation to an unsustainable level and result in financial
crises. The crisis proposition thus suggests that a collusive coalition, if one exists,
serves as a cause for crises. My analysis of Taiwan’s path to banking sector
liberalization in the following chapters is supported by those propositions.
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48
CHAPTER THREE
FINANCIAL CONTROL UNDER THE DEVELOPMENTAL PARTY-
STATE
3.1 INTRODUCTION
Prior to financial liberalization in the late1980s, the Taiwanese government’s
financial policies were very restrictive within a financial system that was credit-based
and dominated by State-owned banks. From the 1950s to the mid-1980s, the
Taiwanese government exerted control over the allocation of credit to achieve
industrial policy and economic development. Financial sector rents were created and
distributed under the government’s developmental plan. Those rents were in general
value-enhancing rather than value-reducing. The government’s close monitoring and
supervision of the financial system kept rent-seeking waste low. In this chapter, I
illustrate the characteristics of financial control in Taiwan under President Chiang
Ching-kuo’s leadership from 1978 to 1987.1 explore the interaction between the
Taiwanese government and bankers in order to understand how the assertion of State
autonomy affected the process and outcome of the bank law revisions of 1984-85.
The rest of this chapter is divided into three sections and a conclusion. The
first section introduces the structure and key characteristics of Taiwan’s banking
system during the 1970s and early 1980s. The second section discusses the creation
and distribution of financial sector rents, as well as the scope of rent-seeking activities.
The third section provides an analysis of the process and outcomes of the bank law
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4 9
revisions of 1984-85. The chapter concludes by emphasizing the importance of State
autonomy and political calculation in the regulatory reform of the financial system.
3.2 THE STRUCTURAL CHARACTERISTICS OF THE BANKING SYSTEM
Taiwan’s contemporary domestic financial institutions originated from three
sources: Japanese colonization, mainland China, and post-colonial Taiwan (Lai, 1997).
First, the Taiwanese provincial government^ inherited seven banks, credit
cooperatives (CCs), and the credit departments of farmers’ and fishermen’s
associations (CDF As) from the period of Japanese colonization. Second, several
banks which had been established in mainland China restored their operations in
Taiwan. Those banks were owned either by the central government (The Central Bank
of China, Bank of Communications, The Farmers Bank of China, and Central Trust of
China) or by private bankers (International Commercial Bank of China and Shanghai
Commercial and Savings Bank). Third, a number of financial institutions were created
in the post-colonial period and prior to the banking sector liberalization of 1991,
including two overseas Chinese banks (Overseas Chinese Commercial Bank and
United World Chinese Commercial Bank), two municipal banks, the Export-Import
Bank of China, seven medium business banks (MBBs), eight ITCs, and some CCs and
CDF As.
Since the Nationalist takeover in 1949, the financial system in Taiwan has
included both a formal system and an informal system. The formal system includes all
^ The government of the Republic of China comprised three hierarchical levels: central, provincial, and
local. The provincial government (of Taiwan) governed the Taiwan Province. In 1997, the provincial
level of government was removed as a result of governmental reforms.
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50
financial institutions and markets established according to financial regulations and
subject to supervision by financial authorities. The informal system is composed of
organizations and markets not set up according to financial regulations. The banking
sector is part of the financial system. The Bank Law of 1975 categorized banks into
four functional types; commercial banks, savings banks, specialized banks, and ITCs.
Monetary institutions—that is, financial institutions which accept demand deposits in
order to generate deposit money—include banks (except ITCs) and basic financial
institutions (i.e., CCs and CDFAs).^ The banking sector, in this study, refers to the
monetary institutions within the financial system. In the following segment, I will
discuss several characteristics of Taiwan’s banking system under President Chiang
who was elected in 1978. State ownership of the banking sector, the autonomy of the
central bank, a conservative lending policy, and the existence of informal finance are
all crucial to the understanding of financial restraint in Taiwan.
State Ownership in the Banking Sector
As shown in Table 3.1, the central, provincial, and municipal governments
owned thirteen of the twenty-four domestic banks in Taiwan in 1987. There were
thirteen local branches of foreign banks, but they represented less than five percent of
the total domestic lending. State-owned banks and the postal savings system
represented 92 percent of all bank assets, 89 percent of all bank loans, and 92 percent
^ ITCs accept only trust fund but not demand deposits. Therefore, ITCs are not defined as monetary
institutions (Shu, Lian, Yang, Liu, & Chen, 1985). Some scholars include CCs, CDFAs, and MBBs in
their definition of basic (or grassroots) financial institutions. However, as Lai argued, MBBs are very
similar to commercial banks and rather unlike basic financial institutions (Lai, 1997). Accordingly, 1
exclude MBBs from my definition of basic financial institutions.
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51
of all bank deposits. Even excluding the postal savings system, State-owned banks
still accounted for 90 percent of total bank assets and deposits.
Table 3.1 State Ownership in the Banking Sector, 1987
Bank name Owner Branches Assets* Loans’ Deposits’
1. Bank of Taiwan P 63 614 225 466
2. First P 105 362 175 288
3. Hua-nan P 88 382 201 290
4. Chang-hua P 104 349 185 264
5. City Bank of Taipei M 26 183 95 145
6. City Bank of Kaohsiung M 3 22 9 16
7. Bank of Conununications C 11 232 103 39
8. The Farmers Bank of China c 27 142 91 71
9. Land Bank of Taiwan p 58 336 208 227
10. Cooperative Bank of Taiwan p 87 562 268 447
11. The Export-Import Bank of China c 1 12 9 -
12. Central Trust of China c 3 54 33 23
13. Taiwan MBB p 88 214 141 102
State-owned banks subtotal 664 3,464 1,743 2,378
14. ICBC . Private 23 115 41 54.
15. UWCCB Private 8 78 46 50
16. Overseas Chinese Commercial Private 8 36 24 26
17. Shanghai Commercial and Savings Private 4 25 16 12
Private banks subtotal 43 244 127 142
18. Taipei MBB Private 34 49 33 44
19. Hsinchu MBB Private 24 29 21 27
20. Taichung MBB Private 29 35 25 32
21. Tainan MBB Private 16 16 12 15
22. Kaohsiung MBB Private 16 14 11 13
23. Hualian MBB Private 4 3 2 2
24. Taitung MBB Private 4 2 1 2
Medium Business Bank subtotal 127 148 105 135
25. The Postal Savings System C 1,157 874 - 792
Total (excluding Postal Savings) 834 3,856 1,965 2,655
Total (including Postal Savings) 1,991 4,730 1,965 3,447
C, P, M = Central, Provincial, Municipal governments
*in billion NTD
Source: excerpted from (Lee, 1994)
The clearly limited participation of private companies in the banking system
can be attributed to “the fundamental political exigencies that the KMT regime faced
in postwar Taiwan, namely, an alien and minority mainlander-controlled regime
governing a capitalist economy that was primarily populated by the Taiwanese”
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(Cheng, 1993, p.77). State ownership in the banking sector not only prevented
Taiwanese industrial groups from gaining financial power but also allowed the KMT
regime to implement a conservative monetary policy and to prevent a reoccurrence of
mainland China’s disastrous hyperinflation and currency crisis. The currency crisis of
1947-48 had been a primary factor in the defeat of the KMT leadership by the
communist regime in 1949 (Cheng, 1993a).
Central Bank Autonomy
Taiwan’s central bank, the Central Bank of China (CBC), enjoyed a high
degree of power and autonomy because it was subordinated to the President rather
than the Prime Minister. The President also appointed the governor of the CBC
(Cheng, 1993a),^ an arrangement which isolated the CBC from bureaucratic politics
and other legislative influences. CBC’s governor served a renewable term of five
years, and usually stayed on for long periods of time. The CBC staff also included
many highly talented technocrats, who enjoyed a prestige unmatched by the other
economic ministries (Chu, 1999). In fact, many ministers of finance were former
deputy governors of the CBC. Moreover, the CBC governor had substantial influence
regarding the appointment of senior officials to the State-owned banks (Chen, 1998),
and the CBC itself usually dominated the Ministry of Finance’s (MOF) monetary
policies (Shea, 1994). The independence of the CBC and its power over other
ministries were considered a special institutional arrangement to protect fiscal and
^ Autonomy of the central bank refers to the internal coherence of its govemance structure, its self
orientation in determining monetary policies, and the insulation from external political pressures.
^ In 1979, the revision of the Central Bank Law put CBC under the jurisdiction of the Executive Yuan.
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53
financial stability, which was crucial for the security of Taiwan’s economy and the
KMT regime (Chu, 1999).
The CBC also played a check-and-balance role against the expansionist
tendencies of the planning technocrats at the Ministry of Economic Affairs, whose
goal was to promote industrial development. The CBC and the MOF customarily
insisted that policy loans be backed by government-financed specialized funds so that
the size of policy loans could be kept under control while emphasizing fiscal
discipline (Chu, 1999).
Conservative Lending Policy
The painful memories of hyperinflation between 1949-53 in Taiwan urged the
Taiwanese government to take a conservative attitude toward their monetary and
lending policies. In addition, not being a member of the International Monetary Fund
(IMF) or the World Bank, Taiwan has not been able to depend on assistance from
those international institutions in the case of a severe financial crisis. More
importantly, Taiwan has faced a persistent threat from mainland China. As a result,
the KMT regime considered financial stability to be so crucial for national security
that it not only adopted a conservative monetary policy but also institutionalized the
CBC as a supra-monetary authority to guard the financial system against inflation and
fluctuations. The CBC and MOF have also been able to rely on an array of State-
owned banks to enforce financial conservatism.
In such a conservative atmosphere, credits were rationed based on the degree
of presumed risk (Cheng, 1993a). State-owned banks were much more willing to lend
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to State-owned enterprises (SOEs) than to private companies because the former were
virtually default-proof and risk-free. In addition, the regulations and enforcement of
information disclosure were lax, making it difficult for banks to monitor their loans
effectively and efficiently (Cheng, 1993a). The lack of transparency increased
uncertainty and risk. Moreover, the loans made by State-owned banks were
considered government assets by auditing agencies; therefore, the auditors paid close
attention to defaulted loans, and the subsequent write offs had to adhere to very
stringent standards and procedures (Shea, 1994). Taiwan’s civil servant system also
enhanced conservatism in the banking sector. As public servants, employees at the
State-owned banks would be subject to criminal prosecution for corruption or
negligence if the loans they authorized turn bad. Banks were allowed to incur a one-
percent bad-debt ratio on secured loans and three percent on unsecured loans. Ratios
in excess of these limits could result in serious scrutiny by the monetary authorities
(Yang, 1994). Therefore, employees at State-owned banks became very risk-averse to
protect themselves from trouble. Collateral was reported as the most important factor
for the bankers in approving loans (Yang, 1994).
The law also imposed criminal penalties for persons who bounced more than
three checks.^ As shown in Table 3.2, the risk aversion in the banking sector was
reflected in the disproportionate lending bias in favor of SOEs. The public sector
absorbed an average of 29 percent of total loans and produced 18.3 percent of output,
while the private sector created 81.7 percent of output from 71 percent in loans. Put
® This provision in the criminal law was abolished in 1986.
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differently, the ratio of output per dollar loaned for the public and private sectors were,
respectively, 3.58 and 6.52. It is thus obvious that the private sector was much more
efficient in terms of making the loans productive. This evidence suggests that the
banks’ strong preference for allocating credits to SOEs led to a pattern of credit
allocation that resulted in inefficiency in financial intermediation.
Table 3.2 Loans and Output by Public and Private Enterprises, 1970-82
Loans Output
Public Private Public Private
Amount % Amount % Amount % Amount %
1970 12.2 25.1 36.6 74.9 69.0 18.1 311.6 81.9
1971 16.3 23.4 53.4 76.6 75.7 16.6 380.1 83.4
1972 18.4 19.3 76.8 80.7 85.5 14.9 487.7 85.1
1973 22.7 16.9 112.0 83.1 109.0 13.8 681.0 86.2
1974 40.3 23.0 135.0 77.0 177.8 16.6 891.5 83.4
1975 58.4 26.8 159.4 73.2 210.5 18.7 915.0 81.3
1976 68.1 27.0 184.1 73.0 249.8 17.8 1,147.3 82.2
1977 80.0 28.4 201.1 71.5 293.3 17.8 1,354.3 82.2
1978 89.9 26.6 247.7 73.4 336.7 16.6 1,689.0 83.4
1979 117.2 27.6 308.1 72.4 420.1 16.9 2,060.7 83.1
1980 173.7 30.8 390.3 69.2 619.5 19.5 2,551.6 80.5
1981 207.6 31.9 442.6 68.1 726.5 20.0 2,910.7 80.0
1982 247.2 34.3 474.1 65.7 746.7 19.2 3,025.9 80.8
Average 29.0 71.0 18.3 81.7
(* in billion NTD)
Source: excerpted from (Shu et al, 1985, Table 14)
Financial Dualism
“Financial dualism” refers to the dual existence of formal financial markets
and the informal curb market. In the case of Taiwan, transactions in the informal
credit market included rotating mutual credits, deposits with firms, loans against post
dated checks, and secured and unsecured borrowing and lending (Shea, 1994). The
informal market offered higher interest rates to attract deposits, and the lending rates
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in the informal system were much higher than those in the formal system^ State
ownership and conservative lending policies in the banking sector made it difficult for
the private sector to access credits from the formal banking system. This was
especially true for households and small to medium businesses and, as a result, the
private sector relied heavily on the informal system for credits.
According to the CBC’s estimates for the 1980s,^ the informal curb market
persistently represented about one-third of the total domestic borrowing by the private
sector in the 1980s. Also, it was estimated that one-half of household borrowing was
through the informal system (Shea, 1994; Wu, 1993). Despite the high default risks
associated with the informal system, it was believed that the informal system in
Taiwan substantially enhanced domestic savings and efficiency in credit allocation
(Shea, 1994; Shu et al., 1985).
Summary
Taiwan’s banking system during the period of financial restraint, that is, from
the 1950s to the mid 1980s, was characterized by its conservative monetary policies,
the strong autonomy of the central bank, the State ownership of the formal banking
sector, and an active informal curb market. These features reflect the fact that the
financial control in Taiwan was meant to secure stability rather than promote
efficiency. In the following sections, I will discuss how the Taiwanese government
used selective credit allocation to promote economic development and how rents were
created and distributed in the banking sector.
’ It was reported that, while the average lending rates in the formal banking system were around 10-17
percent in the early 1980s, the rates in the informal market were around 26-30 percent (Shu et al., 1985).
* Flow of Funds in Taiwan District, 1989, Central Bank of China, Taiwan ROC.
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3.3 FINANCIAL SECTOR RENTS UNDER FINANCIAL RESTRAINT
Interest Rate Spreads and Compensatory Deposits
The existence of interest rate spreads, which are calculated as the difference
between the lending and deposit rates, allow banks to earn interest revenues. Under
financial restraint, the government controls the interest rate spread as a range higher
than would pertain in a competitive market, such that banks earn a rent above the
normal profit margin. Table 3.3 illustrates the average interest rate spreads in the
banking industry in Taiwan from 1970 to 1985. It can be seen that the spreads had
been maintained at about 6 percent throughout the 1970s and early 1980s. It was not
until 1982 that the interest rate spreads, along with both the lending and deposit rates,
started to drop significantly.
Year
Average
Lending rate
(1)
Average
Deposit rate
(2)
Interest Rate
Spread
(3) = ( l) - ( 2 )
1970 14.81 8.67 6.14
1971 14.48 8.99 5.49
1972 13.96 8.62 5.34
1973 14.38 8.42 5.96
1974 19.59 13.45 6.14
1975 16.64 10.56 6.08
1976 12.98 7.50 5.48
1977 10.97 5.77 5.20
1978 11.55 5.39 6.16
1979 12.82 5.70 7.12
1980 14.28 8.10 6.18
1981 16.34 10.13 6.21
1982 14.93 10.38 4.55
1983 12.03 8.43 3.60
1984 10.92 8.16 2.76
1985 10.83 7.64 3.19
Source: Excerpted from (Yang, 1994), Table 7.2.
*: Annual Percentage Rate
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The interest rate control in Taiwan was gradually removed in the 1980s. A
formal money market was established in 1976, and its interest rates were used as an
indicator for the competitive interest rates in the banking sector (Shea, 1994). Since
1980, the CBC embarked on a series of steps to remove controls on interest rates. In
November 1980, the CBC announced the Essentials of Interest Rate Adjustment that
allowed banks to freely determine their interest rates on negotiable certificates of
deposit (CDs) and debentures, as well as the discount rates on short-term bills. The
CBC also expanded the spread between the regulated maximum and minimum
lending rates. After 1985, commercial banks were required to set a prime rate, and the
CBC also abolished the restriction that the maximum deposit rate could not exceed the
minimum lending rate (Chen, 2002). In 1989, the revised Bank Law removed all
controls on both the deposit and lending rates (Cheng, 1993a). In short, the interest
rate deregulation allowed banks to set up their own competitive deposit and lending
rates, and resulted in a significant reduction in interest rate spreads from 1982 on. The
interest rate spread dropped by about 300 basis points from 1980 to 1985.^ It was thus
suggested that, prior to interest rate deregulation in the banking system, the rents in
the form of controlled interest rate spreads had been three percent of the amount of
outstanding loans.
Yet due to the common practice of forced compensatory deposits, the actual
size of the interest rate-based rents must have been higher than the estimated three
percent of bank loans. The State-owned banks, with their monopoly of the banking
® One hundred basis points are equal to one percent.
In fact, the CBC could still easily control the interest rates through its strong influence over the State-
owned banks that dominated the banking system (Economic Daily News, 1989.7.12).
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59
sector, usually required private borrowers to deposit back into the banks a portion of
the credits they received. This compensatory deposit is entirely different from an
unused line of credit. Banks could not earn interest payments from unused credits,
whereas a compensatory deposit is a loan that the private borrower must deposit back.
In other words, without actually providing the loan, a bank could earn the interest
revenues equal to the interest rate spread times the size of the compensatory deposit.
Therefore, compensatory deposits increase the borrower’s cost of borrowing as well
as the rent a bank can collect. Private borrowers had accepted these requests for
compensatory deposits because they had had no better alternatives. Moreover, the cost
of borrowing in the informal curb market was much higher. It was reported that the
State-owned banks required private borrowers to make compensatory deposits equal
to one-fifth to one-fourth of the amount of the loans they received (Shea, 1994). This
was equivalent to an extra spread of 100 to 150 basis points. In sum, I estimated that
the size of the interest rate-based rents was at least 4.0 to 4.5 percent of the amount of
outstanding loans.
Policy Loans
The developmentalist State often intervened in the allocation of credit through
government-directed programs that provided lending to targeted sectors, activities,
groups of firms, or individual companies in quantities and interest rates that would not
be provided by existing financial institutions acting independently from government
guidance (Haggard & Lee, 1993). For example, the Taiwanese government adopted
policy loans to facilitate industrial development. In addition, from the 1960s to the
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6 0
early 1990s, the government provided preferential financing to exporters (Shea, 1994).
Exporters could apply for short-term loans based on letters of credit, documents
against acceptance or payment, and shipping documents (Yang, 1994). Banks were
required to charge borrowers of these types of loans low interest rates, and the CBC
provided a special low rediscount rate to designated banks for export-related loans
(Yang, 1994).
The Taiwanese government also provided special loans (and special CBC
rediscounts) to agriculture, machinery imports, and selected strategic industries such
as electronics and information technology. The strategic industry loans were extended
by the Chiao Tung Bank and the Taiwan MBB with funding from the Executive Yuan
Development Fund and the two banks’ own sources. The difference between the
lower strategic loan rate and the prime rate was between 175 to 275 basis points (Shea,
1994). In addition, in 1982 the government provided a NTS16 billion low-interest
development loan program to small and medium enterprises (Cheng, 1993a). The
government also required MBBs to extend at least 70 percent of their total loans to
small and medium enterprises (Yang, 1994). In sum, the government’s policy loans
covered a wide range of industries and enterprises.
Limited Rent-seeking Activities
The seven State-owned commercial banks owned by the provincial
government were under constant pressure to offer soft loans to individual members of
the Provincial Assembly. The CBC allowed the members to grab rents through soft
loans borrowed from the State-owned banks; nevertheless, the CBC controlled the
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61
scale of the rents by setting an implicit quota of soft loans to individual members of
the Provincial Assembly on an equal basis (Cbu, 1999). Rent-seeking activities by the
private sector were mainly limited to the local level. That basic-level banking was
subject to more relaxed inspection themes not only because of its limited banking
functions and small operations, but also because the basic-level financial institutions
bad long served as cash cows for the KMT-affiliated local factions (Cbu, 1999). Local
factions sought rents mainly through various types of privileged access to public
resources (Chu, 1994). For example, local factions usually controlled the local
oligopolies such as local transportation, construction, and basic-level finance (through
CCs and CDFAs). In addition, the factions could make huge profits from land
speculation using soft loans from State-owned banks and insider information or
political maneuvering to influence urban planning boards regarding zoning issues
(Chu, 1996).
The KMT regime under President Chiang Ching-kuo’s leadership from the
mid 1970s to 1987 adopted several measures to confine the rent-seeking activities of
corruption-prone local factions. First, in every region of the island, the KMT regime
intentionally nurtured two or more local factions that competed with each other for
local elections and business opportunities. The rival factions exhausted their power in
competing with each other so that they would not act collectively to bargain with the
KMT regime for more rents. Second, the CBC and the MOF imposed on local
financial institutions a strictly limited scope of deposit/loan operations and
geographical span, as well as a requirement to redeposit their surplus reserves in
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62
designated State-owned banks (Chu, 1999). Third, the authoritarian regime was
capable of exercising discipline on rent-seekers when needed. These controlling
measures have continued to keep the non-performing loan ratios at a very low level
(Yang, 1994).
S um m ary
In this section, I estimated that the size of interest rate-based rents was about 4
to 4.5 percent of the amount of outstanding loans under conditions of State-controlled
financial restraint. Interest rate deregulation caused a significant drop in interest rate
spreads. I also reviewed the preferential loan programs. A relatively wide range of
industries and enterprises benefited from governmental policy loans. The subsidies
were primarily designed to promote industrial upgrading and economic development.
I noted that the scale of policy loans was constrained by the government’s
conservative monetary policy in the 1970s and 1980s. I further suggested that rent-
seeking activities were limited under financial restraint, due to the strong autonomy of
the authoritarian, developmental State. In the following, I will discuss how the
authoritarian government responded to the economic and political pressures for
deregulating the restrictive banking system.
' The scandal of the Taipei Tenth Credit Cooperative provides the best example, as we will see in the
next section.
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3.4 THE BANK LAW REVISIONS OF 1984-85
Background
From the late 1970s to the mid 1980s, Taiwan’s banking system encountered
increasing difficulties in maintaining financial stability and efficiency. Serious issues
included the excess supply of liquidity that resulted from a steady rise in domestic
savings and a slowdown in domestic investment, a rampant underground finance
market, and out-of-control investment and trust companies (ITCs) (Wang, 1986).
The establishment of ITCs was supposed to facilitate the development of a
long-term credit market and the merging of merchant banking with investment
banking (Cheng, 1993a). However, ITCs began to deviate by taking demand deposits,
speculating on the real estate and stock markets, and accumulating shares to gain
control of manufacturing enterprises. While there were increasing concerns over the
scandals caused by the expansion of ITCs, ITCs aggressively sought political
protection. In the following, I will analyze the process and results of the bank law
revisions carried out in 1984-85.
The Cathay Group and the Political “Thirteen Brothers”
The Tsai family created the Cathay conglomerate, which covers insurance,
trust & investment, real estate, plastics and several other sectors. Armed with three
financial institutions - Taipei Tenth Credit Cooperatives (TTCC), Cathay Insurance,
and Cathay ITC - the Tsai family, from the late 1970s to the mid 1980s, aggressively
sought to leverage their financial power for political influence. Two family members
The three major crises involved the Asia ITC in 1982, and the Cathay ITC and the Oversea Chinese
ITC in 1985 (Wang, 1986).
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6 4
were installed in the Legislative Yuan under the KMT ticket. The family also
established close personal ties with high officials in the MOF, the KMT
administration, and the military. The Cathay Group’s accumulation of political capital
created expectations of instant and unconditional government relief in the case of
financial distress (Cheng, 1993a). In 1983, when Tsai Cheng-zou was elected as a
legislator, he and twelve other legislators formed a political group called the “Thirteen
Brothers.” Most of them had strong links to business, local political factions and
financial institutions, and continued to wield power in Taiwan (Wang, 1996).
The Tsai family, with the support of the “Thirteen Brothers” and their
extensive political ties, actively engaged in the process of bank law revision. In the
normal process for bank law revision, the MOF organizes a committee to draft a
proposal, which is then submitted to the Legislative Yuan for approval. In this case,
the MOF invited Tsai Cheng-zou, and his brother, Tsai Cheng-nan, to serve on the
proposal-drafting committee as representatives of the Legislative Yuan and the
financial services industry. It was obvious that the committee was subject to strong
influence from the Tsai family (Wang, 1996). Not surprisingly, the MOF’s 1984
proposal was, for the most part, biased toward the favorable treatment of ITCs. The
three major revisions proposed were; (1) to allow ITCs to request MOF’s permission
and make direct investment in the manufacturing and real estate industries, (2) to
allow ITCs to provide short-term financing (i.e., accepting demand deposits and
making short-term loans), and (3) to impose tightened regulation of banks’ (including
ITCs) lending practices concerning related persons (Lee, 1994).
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65
This proposal provoked serious debate and confrontation in the Legislative
Yuan. The pro-ITC “Thirteen Brothers” argued that the provisions in the proposal
were consistent with the market-oriented principle. However, many other legislators
worried that the deregulation of ITCs would be a serious threat to the economic order
and break the line of specialization between banks and ITCs. It was suspected that the
proposal was the result of the MOF’s negotiation with and concession to the Tsai
family; the MOF used the revision of short-term financing in exchange for the
prohibition of direct investment in the manufacturing and real estate industries (Lee,
1994). This revision stated that direct investment in those industries basically would
be prohibited unless approved by the MOF. It did not, in other words, preclude the
MOF from using its discretionary authority to grant ITCs permission to engage in
direct investment in manufacturing and real estate. In fact, in May 1983, the MOF
announced new guidelines, “Administrative Rules for Trust Business,” which allowed
ITCs to provide short-term financing and to make direct investment in the
manufacturing and real estate industries (Wang, 1996). The issues of ITCs’ short-term
financing and direct investment were so controversial that they could not be resolved
through the negotiating mechanisms in the Legislative Yuan or the KMT’s central
policy committee.
The issue of banks’ lending to related persons was also full of controversy.
The MOF intended to tighten the regulation covering bank lending practices to
insiders and related persons. The original regulation only prohibited banks from
making no-collateral-backed loans or endorsement to major stockholders and
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66
employees of the banks. In response to the 1982 Asia ITC crisis and the rise in ITC
owners’ use of the names of their employees and relatives to get loans for speculative
purposes, the revision was intended to expand the restrictions to include not only
major stockholders and employees but also the close blood-based and marriage-based
relatives of major stockholders and loan-service-related employees (Lee, 1994). The
revision would impose criminal penalties on violators of the restrictions on related-
person lending.
Although the MOF initially did not make a concession to ITCs on this issue, at
the Legislative Yuan this revision faced strong opposition from the “Thirteen
Brothers” and other pro-ITC legislators. Legislator Lee Tsun-jen, for example, argued
that such a provision would substantially hinder the operations of banks; Legislator
Tsai Theng-zou also criticized the KMT’s conservative policy and tight control (Lee,
1994).
Legislator Hong Yu-Ching, one of the Thirteen Brothers, proposed a new
version that would include only the blood-based relatives of bank owners and
employees in the definition of related persons. In other words, the marriage-based
relatives (i.e., in-laws) of bank owners and employees would be allowed to get bank
loans or endorsement without adequate collaterals (Lee, 1994). The Legislative Yuan
passed Legislator Hong’s version, but it also raised serious allegations in the mass
media and among the public that the MOF was losing its autonomy to the emerging
local faction-based political power (Wang, 1996).
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Suppressing the Emerging Political Network
President Chiang Ching-kuo became ill from 1983. The issue of who would be
Chiang’s successor arose. Chiang Yen-she was the KMT’s Secretary General, and
Wang Sen was the head of the Department of Political Warfare. Both men held the
ambition of being successors to Chiang, and, toward this end, networked with the Tsai
family and the Thirteen Brothers. Minister of Finance, Shu Li-de, was also close to
this political network (Lee, 1994).
In late 1984, Chiang’s health improved and he reasserted his authority. He was
very concerned about the close connections between government and capitalists and
local factions. Several moves were taken. First, the KMT’s Central Committee
meeting in November 1984 made a final decision that ITCs could not provide short
term financing services (Lee, 1994). Second, the MOF withdrew the Administrative
Rules for Trust Business. Third, a new series of legislative negotiations were initiated,
but none of the Thirteen Brothers was on the new committee. Fourth, during the
central committee meeting in January 1985, Chiang Ching-kuo expressed his worries
concerning the close relations between bureaucrats and faction leaders (Wang, 1996).
All of these moves indicated that Chiang was about to suppress the Tsai-based
political alliance.
Meanwhile, the Cathay group was in financial distress. The Cathay ITC and
the TTCC extended numerous loans directly or indirectly to Cathay-affiliated
businesses. Cathay group’s distressed business operations and financial status led
depositors to lose faith in both the group and the TTCC, and a bank run ensued. The
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government immediately asked the Cooperative Bank of Taiwan (CBT) to provide
liquidity and assistance. The CBT took over TTCC and all of TTCC’s managers were
replaced by staff members from CBT. Cathay ITC guaranteed a substantial amount of
commercial papers and bankers’ acceptances for Cathay-affiliated companies. The
government handled the Cathay ITC crisis by immediately organizing three other
banks to manage Cathay Investment (Cheng, 1993 a).
In addition to the prompt response to the financial aspects of the two Cathay-
related crises. President Chiang Ching-kuo also made several political moves to
suppress the emerging politico-economic network. Tsai Cheng-zou soon faced an
Investigation Bureau investigation on accusations of fraud. Wang Shen was demoted
to the position of ambassador to Paraguay, away from the power center (Cheng &
Haggard, 1992). The demotion of Wang Shen was suspected to be associated with his
ambition to succeed Chiang Ching-kuo and the raised specter of military intervention
(Lee, 1994). Several top government officials such as Chiang Yen-she and Shu Li-de
were moved to other positions, and the “Thirteen Brothers” group broke apart (Wang,
1996). After Chiang’s clampdown on the emerging Cathay-based political network in
early 1985, the KMT’s Central Committee decided to impose tight restrictions on
ITCs, prohibiting ITCs from involvement in short-term financing and securities
trading, as well as direct investment in the real estate and manufacturing industries.
Sumimairy
Table 3.4 summarizes the results of the bank law revisions of 1984-85. The
MOF’s 1984 proposal aimed to deregulate the ITCs. The legislative results in 1984
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reflected the ongoing, unresolved debates between liberalism and conservatism. The
revisions of 1985 were in fact tighter than the original regulations. This demonstrated
the priority of conservatism over liberalism under Chiang’s leadership.
Table 3.4 Results of the Bank Law Revisions of 1984-85
Issue
Original
regulations
MOF’s proposal
of 1984
Results in 1984
Results in
1985
Direct investment in
manufacturing or real
estate industries
Allowed
MOF’s approval
required
Undecided Prohibited
Short-term financing Prohibited Allowed Undecided Prohibited
Related-person lending Loose Tight Hong’s version Tight
Securities trading Allowed - - Prohibited
3.5 SUMMARY AND CONCLUSIONS
In this chapter, I first discussed the structural characteristics of the banking
system in Taiwan under Chiang’s leadership. State ownership in the banking sector
enabled the government to implement its policies with a great amount of autonomy. In
addition. State autonomy was further enhanced by the conservative orientation toward
monetary polices and the institutionalization of CBC autonomy. Moreover, the
existence of an active informal financial market improved the efficiency of financial
intermediation and reduced the private sector’s reliance on the State-led, formal
banking system for financial services.
Second, I analyzed the creation and distribution of rents in the banking system.
I estimated the size of the interest rate-based rents. I also reviewed policy loan
programs and suggested that those programs targeted a wide range of sectors and
enterprises. In addition, I pointed out that rent-seeking activities were mainly confined
to the local level.
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Third, I reviewed the legislative process and results of the bank law revisions
of 1984-85.1 compared the original regulations, the MOF’s proposal, the 1984 results,
and the 1985 results. While the controlled banking system was showing increasing
inefficiency, the Chiang government adopted a gradual approach of liberalization
starting with an interest rate decontrol. The government, however, refused to
deregulate the ITC sector, imposed tighter control on ITCs, and pressed down the
political network led by Wang Sun and the Tsai family. This demonstrated the
absolute autonomy of the developmental party-State under Chiang’s leadership, which
was capable of acting decisively on both the economic and the political systems. In
the next chapter, I will analyze the banking system liberalization that took place under
Lee Teng-hui’s leadership.
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CHAPTER FOUR
SEEKING RENTS IN BANKING SECTOR DEREGULATION
4.1 INTRODUCTION
In the preceding chapter, I pointed out that during the period of financial
restraint from the 1975 to the mid-1980s, rent-seeking activities were mainly limited
to the local level. As this chapter will illustrate, the rent-seeking forces gradually
penetrated to the national level as national elections paved the way for political
democratization. Money politics and rent-seeking activities also drove the banking
system into serious structural problems. This chapter will demonstrate that banking
sector deregulation in the 1990s was not without its problems but ended up providing
the KMT with rent-seeking opportunities and other substantial benefits.
This chapter begins with an overview of the international and domestic
contexts of Taiwan’s banking sector deregulation. The remainder of the chapter will
focus on two themes that emerge from the politics behind the deregulation: the lifting
of the ban on new private commercial banks and the delay in reforming basic financial
institutions.
4.2 INTERNATIONAL AND DOMESTIC ECONOMIC PRESSURES TO
DERGULATE THE BANKING SECTOR
Why did the government, after four decades of resistance, finally decide to lift
the ban on private banks in 1989? Scholars have pointed out that the Taiwanese
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government’s commitment to opening up the banking sector was a response to the
increasing international pressure and the inefficiency of the domestic banking sector
(Chu, 1994; Shea, 1994; Liu, 1992). In the 1980s, Taiwan faced a number of
international and domestic challenges that placed substantial pressure on the repressed
banking system. In the international arena, the United States began urging the
Taiwanese government to lower trade barriers, open up its domestic market, and
appreciate the currency. In the domestic economy, the source of pressure mainly came
from the increasing inefficiency of financial intermediation and the problem of
“underground finance” activities.
In the 1980s Taiwan faced an investment decline in the domestic economy.
Gross investment, which had been maintained at the level of about 30 percent of GDP
throughout the 1970s, dropped sharply to 25 percent of GDP in 1982 and to 16.3
percent of GDP in 1986 (Liu, 1992). By contrast, the level of gross savings grew
steadily from the averaged 30 percent of GNP in the late 1970s to 37.5 percent in
1986 (Liu, 1992). As a result, there was a huge excess of savings over investment.
The banking sector became crippled by the increasing mismatch between
investment and savings. In 1986, the total deposits in the banking sector were NT$3.3
trillion, but the total outstanding loans were merely NT$2.1 trillion. In other words,
banks lent out only 63 cents for every dollar they took in. To protect their profits,
banks - which were predominately State-owned - lowered interest rates and
discouraged deposits. The excess liquidity thus flooded into underground financial
Annual report. Central Bank of China, 1986.
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channels. The inefFiciency of financial intermediation and the excess liquidity became
urgent problems in need of solutions. The Economic Reform Commission of 1985
strongly recommended liberalization of the banking system in order to ease the
aforementioned international and domestic pressures and to enhance the efficiency of
the banking system (Wang, 1986).
A battle was fought over how the banking sector should be liberalized. The
main issues to be dealt with concerned the governance and operation of the State-
owned banks, and the removal of entry barriers. In the following, I will discuss the
political transition that took place in Taiwan beginning in the mid-1980s, which
played a crucial role in shaping the government’s specific arrangements and
sequencing of banking sector liberalization.
4.3 POLITICAL TRANSITION AND DEMOCRATIC INITIATIVES
In the early 1980s, the authoritarian KMT regime in Taiwan faced increasing
challenges from grassroots social movements as well as opposition political parties,
which eventually made a democratic transition possible (Cheng, 1993b). In September
1986, the opposition challenged the KMT’s authority by establishing the Democratic
Progress Party (DPP), the first new political party in postwar Taiwan. Instead of
cracking down the new political party, President Chiang Ching-kuo responded with
the intent to lift martial law, which restricted the civil right to form political parties
and civic associations (Cheng, 1993b). In 1987, the martial law was lifted. In January
1988, Chiang Ching-kuo suddenly passed away and the Vice President, Lee Teng-hui,
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7 4
assumed the presidency. President Lee continued on the path of democratization;
meanwhile, he accelerated the pace of economic liberalization and banking sector
deregulation.
Political liberalization^'^ challenged the KMT’s long-standing domination in
Taiwan. The KMT found itself gradually losing its support to the opposition. This
trend was particularly acute after 1987 as the opposition established the DPP. The
KMT’s share of total popular votes dropped steadily from 73.6 percent in 1980 to
60.6 percent in 1989, while the share of the opposition/DPP increased from a mere 8.3
percent in 1980 to 28.2 percent in 1989 (Hu & Chu, 1992).^^ The KMT was still the
majority party, but its political power was weakening. The KMT-dominated party-
State was in transition to a political system with inter-party competition. Prior to the
late 1970s, the KMT had kept Taiwanese elites and Taiwanese capital out of its
decision-making core and limited their influence to the local level. Yet, the
opposition/DPP steadily grew to become a serious threat to the KMT regime
beginning in the 1980s. The KMT sought to expand its support base by adopting the
strategy of inclusiveness and allowing more Taiwanese elites to take key positions in
the KMT and the government.
Meanwhile, the KMT faced serious conflicts within its own party. When Lee
Teng-hui became the President in early 1988, his power base within the KMT was not
as strong as that of the conservative old-timers such as Yu kuo-hua (Prime Minister at
the time) had been (Wang, 1996). Since Lee presented himself as a native Taiwanese
Cheng (1993b) provided an insightful analysis of the democratic changes that took root in Taiwan at
this time.
The election in 1989 was for legislators, provincial councilors, county magistrates and city mayors.
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75
and liberal reformer, the conservatives within the KMT feared that they would
become marginalized. As the power struggle over political succession between the
conservatives and President Lee intensified, the KMT leaders were inclined to seek
support from Taiwanese and business elites. Hence, the intra-party politics, together
with the intensified inter-party competition, required Lee Teng-hui to pursue a
strategy of inclusiveness and to indigenize the KMT.
The KMT authoritarian regime had maintained tight control on the banking
system, as discussed in Chapter Three. I argue that the dismantling of its political
control translated into difficulties in resisting the economic and political pressures for
banking sector deregulation. First, the inefficiency of financial intermediation
resulting from the government’s exclusive ownership in the banking sector was a
serious concern. The weakening of the authoritarian regime made it difficult to
maintain the inefficient status quo. Second, the KMT’s strategy of inclusiveness
implied that the KMT would be subject to the influence of and penetration by the
Taiwanese political and business elites. The Cathay scandal illustrated the fact that the
Taiwanese business elites were seeking to gain deeper access to the political system
and the banking industry. As the KMT pursued inclusiveness and “Taiwanization,”
the political pressure for opening up the banking system increased. As a result,
banking sector liberalization became not only economically desirable but also
politically inevitable.
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4.4 POLITICS OF DEREGULATION
In 1989, the government decided to lift the ban on the establishment of new
commercial banks. This was a dramatic regulatory change because the ban had been
imposed on Taiwan’s banking system for four decades. In the following, I will discuss
the banking sector deregulation and the KMT’s involvement in it.
Retreat of the Conservative Old-timers
The CBC and the MOF had been occupied by conservative mainlanders. The
Prime Minister from 1984 To 1989, Yu Kuo-hua, was the leader in the conservative
camp. He was also one of the few powerful figures in the KMT. Yu Kuo-hua served
as Minister of Finance from 1967-69 and Governor of the CBC from 1969 to 1984.
He had nurtured and promoted a number of people who now occupied key positions
in the government and in the KMT. Yu Kuo-hua believed strongly in fiscal and
monetary conservatism^^ and openly opposed Lee Teng-hui’s ambition of
deregulating the banking sector (Lee, 1994). Banking sector liberalization thus
became a testing ground for Lee Teng-hui’s liberal commitment and political skills
(Wang, 1996). Lee Teng-hui allied with Lee Huan, Secretary General of the KMT at
the time. During the KMT’s thirteenth Party Congress held in July 1988, Lee Teng-
hui and Lee Huan successfully pushed Yu Kuo-hua out of the KMT’s power core in
the open competition for membership in the Central Committee (Wang, 1996).
According to the Three Principles of the People, the philosophy and guideline enunciated by Dr. Sun
Yat-sen in the 1920s, the government shall develop public capital and restraint private capital so as to
prevent the concentration of private economic power and to foster economic equity (Shea, 1994).
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77
Yu Kuo-hua resigned in May 1989, and his cronies stepped down from their
positions before and after Yu’s resignation (Wang, 1989)/’ Lee Huan replaced Yu
Kuo-hua as the Prime Minister. Lee Teng-hui also quickly took advantage of the
retreat of the conservative group and filled many key finance-related positions with
his own people: Kuo Wan-jong (Minister of Finance), Shea Shen-chung (Governor of
the CBC), Shu Yuan-dong (President of the Bankers Association of the Republic of
China), Lian Kuo-shu (President of the Chiao Tung Bank), and Lo Ge-shuan
(President of the Chang Hua Bank). Most of them were Taiwanese and either
graduated from or held teaching positions (as did Lee Teng-hui) at the National
Taiwan University (NTU); therefore, they were called “the NTU group” (Wang,
1996). These circumstances overturned the main political resistance to banking sector
liberalization. It is noted that although President Lee Teng-hui used his appointment
power and promoted the NTU group to many governing positions in the CBC, MOF,
and major State-owned banks, the institutional arrangements of the central bank and
the supervisory roles of the monetary authorities were basically intact. The CBC still
possessed independence and power over other ministries on monetary policies as
described in Chapter Three.
Lifting the Ban on the Establishment of New Banks
On July 11, 1989, just two months after Yu Kuo-hua’s resignation, the
Legislative Yuan passed a revised Bank Law. It was reported that the fast passage of
the revised Bank Law was due to Lee Teng-hui’s strong mobilization of the KMT
Among those who resigned were Chien Chun as Minister of Finance, Ho Shen-chung as senior
officer in the MOF, Sun Yi-shuan as chairman of the Bank of Taiwan, Wang Chan-ching as the
Secretary General of the Executive Yuan.
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78
legislators, as well as support from the DPP (Economic Daily News, 1989.7.12). The
revised Bank Law removed the ban on new banks. The MOF was granted the
discretionary power to approve applications for establishing new banks. The revised
Bank Law limited individual ownership stakes to five percent and related-parties’
holdings to fifteen percent of a new private commercial bank (Tang, 1999). The
revised Bank Law also granted the MOF the authority to determine the number of
bank branches in an area (Article 26).
In April 1990, the MOF announced the Guidelines for the Establishment of
Commercial Banks, which required new commercial banks to have minimum capital
ofNTSlO billion (approximately US$400 million). This minimum capital requirement
was considered extraordinarily high by international standards (Chu, 1994). The MOF
limited each new bank to open at most five branches at its initial establishment (Yang,
1994). There were nineteen applicants for new bank licenses. The MOF granted
fifteen licenses and turned down only four. By mid-1992, sixteen new commercial
banks had been formed. All of the sixteen banks had big business groups as major
shareholders, and those big business groups had been major beneficiaries of industrial
policy, having enjoyed monopolies or oligopolies in the domestic market (Lee, 1994).
Those big business groups also had maintained close business relationships with
State-own enterprises and KMT-owned enterprises (Wang, 1996).
In 1991, fifteen new banks were approved; Asia Pacific, Baodao, The Chinese Bank, Chung Shing,
Cosmos, Da An, E. Sun, Far East, Futon, Grand, Our, Sine Pac, Taishin, Pan Asia, and Union. The
MOF also approved the establishment of the En Tie Bank in June 1992. In addition, the China Trust
Company converted to a commercial bank in July 1992.
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79
The heavy participation of the big industrial capitalists in the establishment of
the new banks reflected the characteristics of embedded State autonomy. On the one
hand, the KMT regime had selectively nurtured a few capitalists in the process of
industrial upgrading. On the other hand, the KMT regime had relied on those business
elites’ investment and participation for further economic development. The
developmentalist regime’s autonomy was embedded in the changing State-business
relations. The establishment of new banks provided business elites opportunities to
simultaneously expand their influence in the economy as well as in the political
system. The business elites and the KMT shared the same interest in creating and
maintaining a profit-making, rent-exchanging network; hence, there was no need for
the business elites to undertake collective action against the KMT regime. Instead, the
business elites cultivated particularistic ties to obtain proprietary returns on their
political engagements (Chu, 1994). Business groups sponsored specific candidates for
the legislative elections of 1989. It was reported that, among the one hundred
legislators elected in 1989, thirty-eight had direct ties with business groups; and
thirty-one out of the thirty-eight business group-tied legislators belonged to the KMT
(Chang, 1992). It was reported that twenty-six legislators were initial investors in
eleven of the new banks (Tang, 1999).
The Ministry of Finance intended to privatize State-owned banks immediately
after the sixteen new banks were established in 1991 (Economic Daily News,
1999.1.17). However, it was not until 1998 that the banks owned by the provincial
government started to be privatized. Why? To what extent could the delay be
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8 0
explained by the KMT-centered rent-seeking alliance? The bank deregulation allowed
the KMT to extend its support base, while privatization would do the opposite. Since
the State-owned banks represented ninety percent of the deposits and loans in the
banking sector, the impact of the privatization of State-owned banks would be
considerably higher than the establishment of new banks. The sequence of
establishing new banks before privatizing State-owned banks could provide the
government with better control of the process of banking sector liberalization. In
addition, privatization of State-owned banks, which implies the transfer of the assets
and controlling power of banks from the provincial government to the private hands,
requires a shift of power from the provincial government to the central government.
Lee Teng-hui’s political power was still not strong within the KMT in early 1990s, so
it would have been politically unwise for him to insist on the completion of the
privatization idea, for State-owned banks were mostly owned by the provincial
government, which was strongly opposed to the privatization project. Consequently,
the Lee government decided to postpone the project of privatizing State-owned banks.
The constitutional and governmental reform of removing the provincial level of
government is a crucial factor that leads to the privatization of State owned banks.
The provincial government used to own seven major banks. Those banks were
subject to the supervision by the provincial council. Provincial councilors thus could
influence the banks’ decisions in loans and personnel and grab rents for themselves. It
was reported, for example, that some councilors asked State-owned banks to give
favors to certain companies (through making preferential loans or stock purchases)
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81
they personally invested or affiliated. Another common practice was to use “head
accounts” and got substantial amount of loans from State-owned banks. Those loans,
mostly without adequate collaterals, later became a major source of non-performing
loans or bad debts (Economic Daily News, 1999.1.17). Privatization of those State-
owned banks would close those rent-seeking channels and put those rent-seekers
“under the sun”. This was one of the main reasons that privatization had been banned
since 1989, despite all necessities and benefits from the economic aspect. The
removal of the provincial level of government, therefore, represented the removal of
the political obstacles for privatization.
The Ministry of Finance used to command State-owned banks to provide
assistance to basic financial institutions that were in distress, or to take over insolvent
ones. The two State-owned banks (the Cooperative Bank of Taiwan and The Land
Bank) incurred a substantial amount of losses taking over a number of insolvent CCs
and CDF As. This made weak State-owned banks even weaker in terms of profitability,
capital adequacy, and asset quality. This increased the difficulty for privatization
because the government wanted to sell the banks at a “good” price but the fair value
of those banks might not be as high as the government expected.
Privatization of State-owned banks started in 1998, accompanied by the
removal of the provincial level of government^^. Even when the government started to
privatize the State-owned banks, it still needed to face resistance from the employees
This reform was to reduce bureaucratic redundancy and to improve governmental effectiveness and
efficiency. This study does not intend to explain the political reform itself; rather, the political reform,
which represents or alters the shift of power in the political system, is the main factor that this study
uses to explain the timing of privatization o f State-owned banks.
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8 2
at those banks. As the Federation of Bank Employee Unions threatened to initiate a
large-scale demonstration prior to the “three-in-one” national election^*’, the Ministry
of Finance announced a very generous pension plan and guaranteed job security for
all employees affected by privatization (Economic Daily News, 1998.8.19).
It is noted that although the government has reduced its ownership in many State-
owned banks to less than fifty percent as the qualification for privatization, the
government is till the largest shareholders and continues to possess decisive influence
in those privatized banks. As a result, the relationships between the government and
those banks became ambiguous. When the Central Bill Finance Company encountered
crisis, the four newly privatized banks^\ despite their reluctance from profit
considerations, accepted the MOF’s “invitation” of taking over the Central Bill
Finance and incurred losses (Economic Daily News, 1999.1.17).
Summary
The revision of the Bank Law was a sophisticated political choice made by the
Lee government. President Lee Teng-hui opened up the banking system to private
participation in exchange for political support. The high minimum capital requirement
and the MOF’s discretionary power provided by the new Bank Law allowed the Lee
government to retain supervisory and bargaining power over the private sector and to
limit the number of entrants. Big business groups and some legislators were active
participants/investors in the establishment of new banks. They formed a broad-based
“ The “three-in-one” national election included the elections of legislators (the Fourth Legislative
Yuan) and the city mayors and councilors of Taipei and Kaohsiung.
Chang Hwa, Hwa Nan, First, and Taiwan Business Banks were privatized in early 1998.
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rent-seeking network with KMT-owned enterprises and State-owned enterprises. Lee
Teng-hui also delayed the privatization of State-owned banks.
The “KMT conglomerate”
I have discussed the ways in which the KMT, facing international and
domestic pressures to open up the financial system, strategically guided the process of
banking sector liberalization to secure political support from business groups. In fact,
the KMT itself was a major rent-seeker in the process of economic liberalization. The
KMT rapidly expanded its own business enterprises and grabbed the economic rents
made possible by the economic liberalization that removed restrictions on trade and
finance, privatized State-owned enterprises, and deregulated a number of industries
such as petrochemicals, telecommunication, and transportation. The profits earned by
KMT-owned enterprises were the most important funding source for the KMT.^^
Those profits allowed the KMT to be financially independent and to maintain a party
organization of more than four-thousand full-time, paid cadres (Chu, 1994). As the
political competition intensified, the KMT needed a larger budget for campaign
expenses. KMT-owned enterprises thus represented a reliable funding source for
campaigns.
KMT ownership of business enterprises began in the 1950s. The KMT-owned
enterprises were beneficiaries of government protection. The move toward political
liberalization and democratization implied that KMT-owned enterprises might lose
the privileges they used to enjoy under the KMT’s authoritarian regime. In fact, from
^ An enterprise can be defined as a KMT-owned enterprise if the KMT controlled more than half of the
shares of the enterprise.
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84
1988, the KMT took advantage of the economic liberalization to rapidly expand its
businesses and transform itself into a big conglomerate. The KMT, through seven
holding companies, participated in almost all government-sponsored high-tech
industries and promoted joint ventures among State-owned enterprises, the KMT, and
business groups (Chu, 1994). The KMT cooperated with business groups in several
ways, including the cross-holding of shares, joint ventures in new companies or
projects, ownership transfer from the KMT to business groups, and KMT’s
emergency financial support to distressed business groups (Chang, 1999). In 1993, the
KMT had committed to long-term investment in 121 companies; in 1998, the number
increased to 282 (Chiang, 2000). The KMT also recruited business elites into its core
investment decision body in order to enhance cooperation between the KMT and
business groups (Chang, 1999).
In 1998, the total assets of the KMT-owned enterprises amounted to NT$638
billion, which was the fifth highest among all business groups in Taiwan (Huang,
2001). The KMT owned seven financial institutions, including three securities
companies, one securities and finance company, and three banks. Moreover, the
KMT-owned China Development Corporation and Dai Hwa Securities Company were
underwriters or planners for many of the privatization projects of State-owned
enterprises (Chang, 1999). Furthermore, the KMT also owned thirteen construction-
related enterprises, eight media companies, and twenty enterprises in a wide range of
industries (Huang, 2001). Half of those KMT-owned companies were established in
the 1990s. The KMT-owned holding companies also speculated on the stock market
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85
for short-term gains, and probably with insider information^^ (Huang, 2001). As a
result, the assets and earnings of the KMT conglomerate increased rapidly in the
1990s. Table 4.1 shows that, from 1992 to 1997, the net assets of the KMT-owned
enterprises grew from NT$46 billion to NT$115 billion. In the same period, the
earnings increased by more than five fold, from NT$2.6 billion to NTS 16.6 billion;
the return on equity (ROE) also improved dramatically from 0.056 to 0.145. The
decline in earnings in 1998 was mainly due to the KMT’s rescue efforts for a number
of companies that encountered financial distress (Huang, 2001). But, in general, the
KMT clearly benefited to a substantial degree from its business expansion during the
period of economic liberalization.
Table 4.1 Assets and Earnings of KMT-owned Enterprises, 1992-98
1992 1993 1994 1995 1996 1997 1998
Equity
(1)
46.4 55.8 59.8 75.1 91.6 114.6 147.0
Earnings
(2)
2.6 5.3 7.9 7.4 8.8 16.6 12.1
ROE (3)
= (2)/(l)
.056 .095 .132 .098 .096 .145 .082
Source; excerpted from (Chang, 1999), Table 4.5. The average ROE was my calculation.
Unit: billion NT$
4.5 THE DELAY IN REFORMING BASIC FINANCIAL INSTITUTIONS
Governance crisis in the basic financial institutions
As of 1996, the total number of members in farmers’ associations was about
1.83 million, including 1.02 million (56%) farmer members and 0.81 million (44%)
^ Huang (2001) found out that the Central Investment (the KMT’s leading holding company) had often
been right about market fluctuations and sold its positions at relatively high levels. Huang also found
out that the Central Investment closed a lot of positions the day before President Lee Teng-hui made his
assertion of “equal sovereignty between the two sides of the strait,” which immediately sank the stock
market From these findings, Huang suspected that the KMT was using insider information for market
gains.
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8 6
non-farmer, sponsor members (Liu, 1998). From 1974, board directors were elected
by representatives of the members (Wu & Chao, 2000). While a farmer association
might have a membership of thousands of people, the number of representatives is
often fewer than one hundred. Hence, a small number of active representatives could
have great influence on the elections of board directors.
The rent-seeking problem had been confined to a basic, local level under
President Chiang Ching-kuo’s soft authoritarian leadership. However, with the
opening of elections at the parliamentary level, local factions integrated their
resources to compete for the newly released rent-seeking opportunities brought by the
national elections (Chen, 2002).^^ The existing corrupted network between factions
and the KMT politicians soon transmitted into national representative bodies, but the
KMT, due to its reliance on factions for political support, chose to tolerate the
corruptive practices used by a great majority of the KMT legislators (Chu, 1996).
Local factions sponsored specific candidates for legislative elections; and the KMT
increasingly relied on local factions to secure its majority seats in the Legislative
Yuan. In 1980, eighteen out of the fifty-seven KMT legislators were affiliated with
local factions. In 1989, local faction-affiliated KMT legislators increased to forty-two
out of seventy-two; in other words, sixty percent were tied to local factions.
Delay in Reforming CDFAs
The rent-seeking network among politicians, local factions, and the KMT
regime under Lee Teng-hui’s leadership resulted in a serious governance crisis of the
For example, in 1998, the eighteen farmers’ associations in the M ao Li County had 83,178 members
and 801 member representatives. The ratio of member-to-representative was about 104.
^ Bosco (1994) presents a detailed account of factions’ local politics in Taiwan (Bosco, 1994).
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basic financial institutions. From 1994 to 1996, there were a total of thirty-three runs
on Credit Departments of Farmers Associations (CDFAs) (Chang & Lai, 1999).
Depositors feared that the directors of the farmers’ associations or credit cooperatives
(CCs) were not being held accountable. Those CDFAs encountering runs had similar
rent-seeking problems: (1) a substantial amount of loans concentrated in the hands of
a few members, (2) abuse of authority by an executive director or board directors in
granting loans, and (3) underreporting the amount ofNPLs (Lee, 2001).
Immediately after the near systemic crisis that was triggered by the scandal of
the Chang-hwa Fourth Credit Cooperative (CFCC) in 1995,^® the MOF seriously
sought ways to resolve the problem with CDFAs. The MOF’s reform proposal was to
merge CDFAs into county-based financial institutions according to their locations.
They would have been independent from farmers’ associations, but the Ministry of
Internal Affairs as well as the Council of Agriculture opposed this proposal due to
resistance from the farmers’ associations (Economic Daily News, 1997.10.7). The
MOF believed that the problem with CDFAs could not be solved without major
reforms of this governance structure and the implementation of professionalism
(Annual report. Bureau of Monetary Affairs, MOF, 1998). However, the political ties
were not easy to be untied. As the presidential election was approaching, the reform
Many runs were a result of the contagion effect triggered by the CFCC crisis that occurred in August
1995. The authorities discovered that Ye Tsuan-shui, the chief executive officer of the CFCC, had been
making illegal loans and stealing money from the CFCC for six years. A run on the CFCC ensued right
after the mass media reported the scandal. The government authorities soon held a series of emergency'
meetings and announced that the CFCC would be barred from banking operations for three months
while an investigation was to be conducted. This announcement caused depositors to panic because the
authorities did not provide emergency liquidity to save the CFCC. A contagion effect spread to
depositors with other CCs and CDFAs that did not join the Central Deposit Insurance Corporation.
Within six months after the onset of the CFCC crisis, there were a total of sixteen runs on CDFAs (Lin,
1999).
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of CDFAs, which would have negatively affected the KMT’s ability of vote
mobilization through farmers’ associations, was thus postponed.
In fact, the MOF had drafted a total of five different frameworks regarding the
reform of the CDFAs’ governance structure (Liu, 1998). Those frameworks differed
along three lines. First was the issue of whether or not to establish new regional
and/or national agriculture-dedicated banks; second, the issue of whether to separate
CDFAs from farmers’ and fishermen’s associations; third, the issue of which
authority (the Ministry of Finance or the Council of Agriculture) should be in charge
of agricultural finance. President Lee Teng-hui himself preferred the proposal of
setting up a position of chief executive officer for every CDF A so as to introduce
professional management into the operations of CDFAs (Lin, 1999). This proposal
was strongly rejected by executive directors of farmers’ associations because it would
have reduced the executive directors’ controlling power over the credit departments
(China Times, 1999.4.20).
The Lee government hesitated to initiate major reforms because the reforms
might have hurt the KMT’s support base. To the contrary, the KMT was willing to
make concessions in order to maintain its collusive relationships with local factions
and to win major elections. The KMT-affiliated factions used to rely on vote-buying
practices for elections. In 1998, there were more than two-hundred farmers’ and
fishermen’s association staffs accused of being involved in vote-buying crimes. For
example, in the Miao Li County, either the chairmen or executive directors in one-
thirds of the eighteen farmers’ associations were accused of bribery in the election of
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89
board directors to fanners’ associations (Lin, 1999). In November 1999, the KMT
mobilized its votes in the Legislative Yuan and passed revisions to the Farmers’ (and
Fishermen’s) Association Law. The main revision was to allow the associations’
executive directors or chairmen to resume their positions, which had been suspended
due to accusations of bribery (Lin, 1999).^^ The underlying reason why the KMT
revised the law was widely believed to be to obtain the support of the local factions in
the upcoming presidential elections of 2000 (Lin, 1999).
Summairy
In summary, political democratization and economic liberalization from the
late 1980s to late 1990s gave local factions the opportunity to seek rents beyond the
localized scale and scope of their past practices. Lee Teng-hui relied heavily on local
factions’ support to his leadership. Local factions controlled farmers’ associations and
used CDFAs as their main rent-seeking channel. As a result, the Lee government was
reluctant to reform CDFAs, despite the fact that the CDFAs were the most seriously
troubled segment of the banking system.
4.6 SUMMARY AND CONCLUSIONS
In this chapter, I argued that, although the move toward banking sector
liberalization in Taiwan in the late 1980s can be attributed to international and
domestic economic factors, it was primarily domestic political factors that determined
the specific timing, sequence, and measures of the liberalization project. I pointed out
Prior to the law change, directors of farmers’ associations were suspended from their positions if
accused of a crime. The revision allowed a director accused of a crime to stay in office until convicted.
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9 0
that the KMT regime under President Lee Teng-hui’s leadership faced external
competition from the opposition/DPP as well as internal power conflicts between Lee
Teng-hui and conservative “mainlanders” (i.e., those people tied to the nationalist
exodus from China in 1949). I emphasized that the revolutionary regulatory reforms
in the banking sector (the 1989 Bank Law revisions) came after Lee Teng-hui had
won his power struggle with the conservative group. I also discussed how the Lee
government carefully maintained a gradual approach to banking sector deregulation.
The Lee government took several measures to retain control and bargaining power
over the liberalization process, including the choice of the timing of liberalization, the
high requirements for setting up a new bank, and the discretionary power granted to
the MOF.
The banking sector liberalization forwarded in President Lee Teng-hui’s era
centered on deregulation. The autonomy of the central back was basically intact. Big
business groups and KMT legislators were active participants and investors in the
establishment of new banks. The deregulation was also accompanied by delays in
privatizing the State-owned banks and in reforming basic financial institutions, and by
a rapid growth of the KMT into a big financial/industrial conglomerate. These
findings suggested that the Lee/KMT regime colluded with big business groups and
local factions in the process of banking sector deregulation. I argued that domestic
political factors contributed to the Lee/KMT regime’s willingness to form a broad-
based, rent-seeking network with political factions and business elites.
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91
In the next chapter, I will analyze how the Taiwanese government under Chen
Shui-bian’s leadership initiated structural reforms of the banking sector that can no
longer be delayed.
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CHAPTER FIVE
CARROTS OR STICKS: THE NEW GOVERNMENT AND ITS
REGULATORY REFORMS OF THE BANKING SECTOR
5.1 INTRODUCTION
The previous two chapters highlighted that the political factors were no less
important than the international or economic ones in the analysis of Taiwan’s banking
sector liberalization. The politics of banking sector liberalization in Taiwan was
portrayed as the emergence of a rent-seeking network involving multiple players such
as the KMT, local factions, and industrial groups. The political aspect explained better
than the economic aspect on several critical choices in the path of banking sector
liberalization.
First, regarding the issue of the sequence of liberalization, the government
liberalized the banking sector but postponed the privatization of State-owned banks
until 1998. This choice was heavily criticized as a policy mistake (China Times,
2001.6.29) and violated the standardized economic prescription that suggested the
privatization of State-owned banks be undertaken before the deregulation of the
banking sector (McKinnon, 1991). In fact, the privatization project was delayed until
the constitutional and governmental reform resulting in the removal of the provincial
level of government. Given the current lack of competitiveness of State-owned banks
and “State-influenced banks” (i.e., the banks that used to be State-owned and the
government is still the largest shareholder after privatization), this specific path could
hardly be explained by economic reasons. This study explained that this specific
choice reflected the rent-seeking politics played by Lee Teng-hui and the KMT to
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93
maintain their political power. Second, the reason that the Lee government adopted
the “no-stick” strategic orientation toward the worsening problem in basic financial
institutions, particularly the credit departments of the farmers’ and fishermen’s
associations (CDF As), was mainly due to the political logic and the interwoven
relationships between the KMT and local factions.
Third, as this chapter argues, the aggressive reform attempts under Chen’s
leadership targeting the basic financial institutions can be explained in part by the
changing political environment (i.e., the effect of shift in power), despite the
importance and urgency of the problem in this financial segment. Chen Shui-bian was
elected to president in early 2000, ending the half-century long of KMT’s control of
Taiwan presidency. The shift in power marked a turning point in the process of
financial reforms in Taiwan. While Lee Teng-hui was criticized for bringing the so-
called “money politics” into Taiwan, the new President Chen determined to break
down the KMT-centered rent-seeking network. Financial reforms illustrated perfectly
such an inter-party battle after the shift in power.
The goal of this chapter is to analyze the major reforms in the banking sector
under the leadership of the new government. The process and results of those reforms
illustrate the negotiated nature of State autonomy in the pursuit of structural reforms
of the banking sector. In the following, I first provide an overview of the performance
and the regulatory environment of the banking sector since the 1990s. Then I will
focus on the non-performing loan (NPL) problem and analyze the major regulatory
reforms resulting in the establishment of the Restructuring Trust Corporation,
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9 4
financial holding companies, and asset management companies. I will also discuss the
project of privatization of State-owned banks in relation to the removal of the
provincial level of government. Then I will analyze major reform drawbacks in
attempting to expand the RTC, establish the Financial Supervisory Council (FSC),
and reform the credit departments of the farmers’ and fishermen’s associations
(CDFAs). I will conclude this chapter by contrasting reform achievements with
drawbacks, showing that the reform results fit well into the main propositions
developed in Chapter Two.
5.2 OVERVIEW OF THE DEREGULATED BANKING SECTOR
Domestic banks competed severely and expanded aggressively since the early
1990s. Table 5.1 shows that the number of branches in domestic banks nearly tripled
in ten years since 1991.
Table 5.1 Numbers of headquarters and branches of domestic banks,
credit cooperatives, credit departments of farmers’ and Ashmen’s
associations
Year
Domestic Banks CCs C ]DFAs
HQs Branches HQs Branches HQs Branches
1991 25 1,046 74 425 311 785
1992 40 1,212 74 439 312 803
1993 41 1,382 74 482 312 822
1994 42 1,577 74 530 312 865
1995 42 1,807 73 556 312 930
1996 42 1,936 73 595 312 972
1997 47 2,176 64 505 314 991
1998 48 2,404 54 446 314 1,007
1999 52 2,576 50 416 314 1,020
2000 53 2,693 48 394 314 1,022
2001 53 2,992 39 373 285 931
2002 52 3,068 37 358 278 887
Source; Financial Statistics Monthly, Central Bank of China, Taiwan ROC
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9 5
It is noted that the number of credit cooperatives decreased due to the
government’s policy to encourage medium business banks and credit cooperatives to
merge with or convert into commercial banks. Financial liberalization also promoted
direct finance and reduced the corporate sector’s reliance of capital on financial
intermediation by the banks. While financial intermediation through banks
represented 89 percent of the capital flow in Taiwan in 1991, the ratio declined
gradually to 72 percent in 2002^®. This implies that banks faced not only competition
from other banks but also from the financial markets.
Table 5.2 Performance of domestic banks, 1991-2001
Year
Return on
Assets
Return on
Equity
NPL ratio*
1991 0.62 14.22 0.97
1992 0.55 8.69 0.81
1993 0.60 9.86 1.14
1994 0.65 10.52 1.82
1995 0.59 9.64 2.85
1996 0.66 10.30 3.68
1997 0.73 10.43 3.70
1998 0.59 7.61 4.36
1999 0.49 6.16 4.88
2000 0.39 4.90 5.34
2001 0.40 5.20 7.48
Source; Financial Institution Important Business Statistics, Central Bank of China
Unit: percentage
*: Excluding loans under surveillance (See Section 5.3 the NPL classification problem.)
Increased competition made it difficult for banks to maintain wide interest
spreads and margins simply because there were other banks ready to engage in a price
war. The ratios of non-performing loans to the total loans increased gradually from
28
Data on direct and indirect financing is available at www.cbc.gov.tw/economic/statistics/loan-s.xls.
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less than one percent in early 1990s to 4.36 percent in 1998 and 7.48 percent in 2001
Table 5.2 shows a gradual decline in bank profitability and an increase in NPLs in the
domestic banks from 1991 to 2001.
A Fragmented Financial Sector
The degree of concentration in Taiwan’s banking sector, measured by four-
firm concentration ratio and the Herfindahl index^^, was among the lowest level in
Asia (Caparusso, 2001). This indicated a highly fragmented banking system in
Taiwan. The unnecessary jfragmentation was due to the regulatory structure that
limited operations across different segments of financial services and made it very
difficult for an efficient allocation of capital (Lin, 2001b). This restriction limited the
space for information integration and profits.
In addition, the financial regulatory framework was very restrictive in the
sense that it used the so-called “positive listing” criteria in that banks could only sell
products that were explicitly described in the regulation (Cheng, Irvine, & Scarff,
2001). This is sharply different from the regulations in the United States where a
“negative listing” is in place and banks can sell any products as long as they are not
explicitly prohibited by the regulation. As a result, financial services in Taiwan
suffered fi-om the lack of innovation.
^ This ratio uses the old classification criteria that are considered as under-stated. Please refer to the
later discussion of the NPL classification problem.
The four-firm concentration ratio measures the market share of loans of the four largest banks in the
whole sector; and the Herfindahl index is the sum across all banks o f the square of each bank’s market
share of loans.
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M ajor Regulatory Changes in the Banking Sector
The regulatory structure changed dramatically since 2001. The Financial
Institution Financial Institution Merger Law was in effect since December 2000. In
June 2001, the Legislative Yuan passed six new major financial regulations; Financial
Holding Company (FHC) Act, Resolution Trust Corporation (RTC) establishment and
management regulations, Deposit Insurance Law Revision, Business Tax Regulation
Revision, Insurance Law Revision, and Bill Finance Management Regulation.
The Financial Institution Merger Law, the FHC Act, and RTC Act are
particularly important to the banking sector. The RTC regulation defines the
responsibilities of the government in dealing with “problematic” financial institutions
(see 5.4 for detailed analysis). The FHC Act provides a new regulatory foundation for
the integration and consolidation of the financial sector (see 5.5 for detailed analysis).
The Financial Institution Merger Law serves as a legal base to facilitate mergers and
acquisitions of domestic financial institutions by other domestic or foreign financial
institutions. Another major provision (Article 15) in the Financial Institution Merger
Law is the establishment of asset management companies (AMCs), which are
expected to major buyers of NPLs (see 5.6 for detailed analysis). These new
regulations are believed to provide a better regulatory environment.
The authorities’ attitude and the “positive listing” principle have changed as
well. In February 2002, the Ministry of Finance announced the new guiding principle:
Loose on products, tight on numbers! (Economic Daily News, 2002.5.4) This means
that the MOF is supportive of innovation and of the introduction of new financial
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products. Cheng Kuo-le, Director General of the Bureau of Monetary Affairs, MOF,
pointed out that the government was willing to approve all new financial products that
satisfied the criteria of adequate risk management and information transparency
(Economic Daily News, 2003.1.25).
5.3 SUPERVISORY LOOPHOLES AND THE NON-PERFORMING LOAN
PROBLEM
The accumulated write-offs of bad debts by domestic banks amounted to
NT$1 trillion from 1999 to 2002 (Economic Daily News, 2003.1.25). Nevertheless, it
was estimated that there were still NTS 1.7 trillion non-performing loans (NPLs)
remaining in the domestic banking sector (China Times, 2002.9.9; Chang, 2003a).
Most economists have attributed the NPL problem to the “economic” reasons, tracing
the origin of the problem of NPLs back to the early 1990s as the banking system
liberalization started. The sixteen new banks competed with old private banks. State-
owned banks, and basic financial institutions. The excessive competition for
customers among banks resulted in rapid credit expansion without adequate risk
assessment of borrowers. As the bubble economy later burst and the macroeconomic
conditions went south, many borrowers (corporations and individuals) found
themselves unable to service their loans; as a result, those loans became non
performing and the NPL problem worsened gradually along with the declining
economy and the rise of unemployment. In short, the NPL problem can be attributed
to excessive capacity and competition, inadequate credit expansion, and the declining
macro-economy.
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The NPL problem is an obvious consequence of economic failures. However,
as the previous chapter presented, the KMT, as a major rent-seeker and center of the
rent-seeking alliance in the process of banking sector liberalization, used financial
sector rents to maintain its power, even as the rents became increasingly “loss-
induced” in the sense that the financial losses incurred by the banking sector were
shouldered or compensated by the government. The question is why the old (Lee)
government failed to control the accumulation of the losses (bad debts and NPLs) in
the banking sector until the new (Chen Shui-bian) government came in? In the
following, I will start with the analysis of the regulatory/supervisory weaknesses in
guarding information transparency. It can be argued that the existing
supervisofy/regulatory loopholes, located exactly at the important rent-extracting and
transferring channels in the KMT-centered broad rent-seeking network, have
sustained the rent-seeking network by allowing it to accumulate loss-induced rents.
The NPL Classification and Information Transparency Problem
The Lee government made little progress in improving information
transparency as one of the critical measures to protect the depositors and ultimately
the government itself. The NPL ratios, an important indicator of the operational health
of the banking sector, have been the target of criticism. The NPL classification was
criticized as being improper and understated. A loan would be classified as non
performing if it was late by 90 days in principal repayment and 180 days in interest
payments. In comparison with most countries using 90 days as a cut-off for NPLs on
both interests and principal, this definition ofNPLs was somehow more lax. In
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addition, if a loan was classified by regulators as “Under Surveillance^*,” it then could
not be classified as an NPL. It was quite common that, as competition intensified,
banks tended to provide loans to riskier projects and be involved in loan
renegotiations and rolling-over (Dekle & Kletzer, 2001). To maintain the health and
transparency of the financial sector, the authorities are supposed to prevent the banks’
practices of understating their losses or size ofNPLs. The fact was that Taiwan’s
authorities promoted the classification of “Loans under Surveillance” for companies
that were truly in distress so as to avoid acknowledging the existence of a troubled
banking system (Tabbush, 2001). This can be best illustrated by the incident in which
four large companies (Kuofeng, Chinfon, Ever Fortune, and Hung Kuo) defaulted on
their loans in 2000, and the government allowed the creditor banks to restructure the
loans and classify them as performing (Caparusso & Chang, 2001).
Moreover, the definition ofNPLs applied in Taiwan left no room for
qualitative judgment on the default risks of loans. When a NPL was restructured, the
loan would be excluded from NPLs as long as the borrower was servicing the loan
with new terms (Lin, 2001a). All of these problems with NPL classification were
improved in 2001. The MOF required financial institutions to disclose figures of both
NPLs and “Loans under Surveillance” (Lin, 2001a).
In addition to the NPL classification problem, there were other concerns as
well. Financial institutions, if not publicly listed, were not required to disclosure the
size ofNPLs or financial statements other than the balance sheet. Also, their financial
“Loans under Surveillance” includes the 91-180 days interest-past-due loans and restructured loans.
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statements did not have to be certified by independent accountants. This
regulatory/supervisory weakness made it easy for the basic financial institutions to
hide their problems but difficult for the public or depositors to find out the true
operational results of financial institutions. There was also a lack of disclosure
requirements for related-party transactions and the risks of assets. Taiwan’s
regulations for financial institutions on public disclosure of business information were
thus considered obviously insufficient (Chen et al., 1999).
New Banks’ Practices of Related-party and Related-company Lending
In Chapter Four, I presented evidence to show that the KMT established a
broad rent-seeking network with local factions and industrial groups. The banking
sector served as a channel for rent extracting and rent transferring. The sixteen new
banks formed in 1991 were established by families/conglomerates. While these banks
had plenty of equity but no loans, they extended credit as fast as possible and lent
extensively to related parties (Tabbush, 2001).
In addition, the Bank Law’s restrictions on “related-party lending” were not
comprehensive. A major loophole was the lack of restrictions on lending to “related
companies” such as companies within the same business group or those whose shares
were substantially controlled by the same person or company (Economic Daily News,
2001.3.29). As a result, the practices of lending to related persons and companies
turned out to be a source ofNPLs (Wang, 1999). The failures of Chung Shing and Pan
Asia Banks also vividly showed how bankers and politicians could take advantage of
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the supervisory loophoie and grab (loss-induced) rents from banks (China Times,
2000.5.16 & 11.19).
5.4 DEALING WITH PROBLEMATIC FINANCIAL INSTITUTIONS
As defined by the RTC regulation, “problematic” financial institutions refer to
financial institutions that become (1) insolvent, (2) unable to pay off their debts, or (3)
financially deteriorating and are identified by the authority as unable to continue their
operations (Article 5). In the following, I focus on the problem with basic financial
institutions and the government’s RTC solution.
Problematic Basic Financial Institutions
Basic fmancial institutions include credit cooperatives (CCs) and the credit
departments of farmers’ and fishermen’s associations (CDFAs). Table 5.3 shows that
the segment of basic financial institutions is in serious trouble, in terms of its high
amount of accumulated NPLs.
Table 5.3 Non-performing loans, Domestic banks vs. Basic
financial institutions, 2002 December
Domestic banks
Basic fmancial institutions
CCs CDFAs
(1) Loans 12,346 360 491
(2) NPLs 864 154
(3) NPL ratios (%)
(3) = (2)/(I) *100
7.0 18.1
Unit; NTS billion
Data on loans is available at Ministry ofFinance’s website at http:/7210.69.13S/sta/'mdex-9202-32..xis;
data on NPLs is available at http://2I0.69.135/sta%dex-9202-ll.xis.
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To deal with the problem with CCs, the government’s strategy was to
encourage them to merge with or convert into commercial banks. As early as 1995,
the Ministry of Finance announced the standards and procedures for CCs to convert
into or merge with commercial banks. In addition, the regulations were revised in
2001, aiming to eliminate the local factions’ long-standing control of CCs (China
Times, 2001, 10.27). The revised regulations limited the terms of the board members
of CCs to four years, but the chair can only be re-elected once. Moreover, the
qualifications for board members were tightened. This strategy was quite successful
and the number of CCs reduced from 73 in 1996 to 37 in 2001.
The problem with the CDFAs is very hard to solve. The market share of the
CDFAs did not change much throughout the past two decades, but the profitability
fell and the NPLs rose sharply in recent years. Comparing with commercial banks, it
is obvious that CDFAs are less competitive. The problem with the CDFAs can be
assessed from the economic, regulatory-managerial, and political aspects.
From the economic standpoint, the decline of the agricultural economy implies
the loss of income for the farmers and the decline of values of farmland. CDFAs
provide banking services exclusively to farmers and fishermen and therefore face
substantial default risks. Even if CDFAs have attempted to cultivate new customers
beyond the agricultural sector, they are less competitive than commercial banks for
obvious reasons such as their lack of economies of scale and of superior technology.
From the regulatory/managerial aspect, CDFAs are defined as subsidiaries to
the farmers’ associations. This means that CDFAs cannot operate with the same
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degree of autonomy that commercial banks enjoy. For example, if a CDF A creates a
profit, it is required by law that only two-fifths of the profit can be used as retained
earnings and the other three-fifths must be transferred to the parent farmers’
association. This requirement reduces CDFAs’ abilities to increase capital bases and
absorb risks. Compared with commercial banks, CDFAs are like “branches without
headquarters” (Kuo, 2001). The size of individual CDFAs is no larger than that of
branches of a commercial bank, while CDFAs do not have the vertical or horizontal
relationships similar to those of bank branches belonging to the same bank. In
addition, there is a lacking of an ownership stake by association members so as to
provide incentives for them to monitor the CDFA’s performance. Moreover, multiple
governmental authorities (Ministry of Interior Affairs, Council of Agriculture,
Ministry of Finance, and the local government) that lack clear responsibilities (Huang,
1999) supervise the farmers’ associations. Bureaucratic politics are acute because
government agencies want to avoid blame. From the political aspect, the farmers’
associations have been criticized by the long-standing control of the governing board
by local factions, as discussed in Chapter Four.
The Resolution Trust Corporation (RTC) Solution
RTC is designed to be a temporary mechanism to facilitate the restructuring or
liquidating of poor-quality assets in the banking sector within the timeframe of four to
five years after its establishment. The Central Deposit Insurance Corporation (CDIC)
may require insolvent fmancial institutions to cease operations and/or to exit the
market through compulsory takeovers (annual report, Bureau of Monetary Affairs,
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MOF, 2001). The RTC would compensate for the financial losses of compulsory
takeovers. RTC’s primary target is, as explicitly stated in the regulation, insolvent
basic financial institutions. The Ministry of Finance imposes the principle of “prompt
corrective action” on financial institutions^^, and the RTC provides the government
with resources to enforce the principle.
Many countries adopted the RTC mechanism and it has proved to be an
effective way to handle systemic bank restructuring. Given the serious NPL and
insolvency problems in the banking sector, the establishment ofRTC became a
consensus among major political parties. A question regarding the establishment of
RTC is how and how much it should be funded. The Legislative Yuan has been very
reluctant to fund RTC through the government budget because of the budget deficit
constraints and the negative impression that the government bails out the rich with
public money. Meanwhile, Taiwanese banks have been required to pay a gross
business revenue tax, and this is a tax not imposed on banks in other countries (ING
Barings, July 2001). The tax rate was five percent before 1999. The Ministry of
Finance proposed to gradually waive this tax. The financial business tax was first
reduced to two percent in early 1999 and scheduled to be totally waived in 2001. This
tax revenue, which is about NT$30 billion per year, is a perfect source to fund RTC
because it makes the least changes in the existing tax structure and can be interpreted
as using banks’ money to save banks. The RTC is thus funded by the business tax
The “ prompt corrective action” theme requires financial institutions to take prompt corrective actions
to re-capitalize their asset base if their capital adequacy ratios are below the minimum requirement. The
government would be required to intervene or cease the operations of a fmancial institution if it failed
to correct the capital adequacy problem within a certain period o f time, or its net worth became
negative.
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revenue and premium income for deposit insurance for four years till 2005. The total
budget for RTC is around NTS 140 billion.
As reported by the Ministry of Finance, the sum ofNPLs in CCs and CDFAs
was NTS187 billion^'^ at the end of 2000. One could assume that seventy percent of
those NPLs will become bad debts, or roughly NTS131 billion. This implied that the
$140 billion RTC should be enough to cover the NTS131 billion losses and to solve
the NPL problem in the basic fmancial institutions if the reported NPL figures were
reliable and new NPLs did not rise sharply. It was thus believed that the NTS 140
billion should be enough to clean up the NPL problem in basic financial institutions.
This belief turns out to be too optimistic.
RTC-initiated Compulsory Takeovers of Insolvent Basic Financial Institutions
In August 2001, the government coordinated efforts by ten banks to take over
twenty-nine insolvent CDFAs and seven insolvent CCs (annual report. Bureau of
Monetary Affairs, MOF). In July 2002, another seven insolvent CDFAs and two CCs
were taken over by the Land Bank and Cooperative Bank of Taiwan (CBT) under the
RTC mechanism. In total, the two waves of compulsory takeovers included thirty-six
CDFAs and nine CCs.
The two waves of RTC-initiated restructuring showed the proactive role of and
the prompt action by the govemment^^. The RTC solution strengthened the
As of the end of 2000, the sizes ofNPLs in CCs and CDFAs were NT$62 (11.6 percent of loans) and
NT$135 bilhon (17.9 percent of loans), respectively.
Many politicians suspected that the underlying purpose o f the two-wave restructuring efforts
targeting CCs and CDFAs was to cut off the KMT local elites’ access to local financial resources
(China Times, 2002.9.23). This suspicion was not fidly justifiable because Lee Teng-hui, former
chairman of KMT, quitted KMT^ established the Taiwan Solidarity Union, and joined the “Pan Green
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government’s capability in coordinating various arms (MOF, CBC, CDIC, and the
receiving banks) to make a strike. Through these efforts, the government also
demonstrated a strong policy orientation to force all insolvent financial institutions to
exit the market. Yet, according to the Ministry of Finance, the cost of the first wave of
takeovers is about NT$80 billion, which is significantly higher than the initial
estimate ofNT$60 billion (Commercial Times, 2001.10.03). The ten receiving banks
found a substantial amount of financial losses hidden in the balance sheets of the
thirty-six insolvent basic financial institutions (United Daily News, 2001.8.13). The
RTC compensation for the second wave of takeovers was NT$14 billion (Economic
Daily News, 2002.7.13). After compensating for those takeovers, the available funds
for RTC were reduced to merely NT$40 billion (Economic Daily News, 2003.1.4),
while the accumulated NPLs in the segment of basic financial institutions alone
remained as high as NTS 154 billion at the end o f2002 (Economic Daily News,
2003.2.17).
The RTC solution provided the government with resources to compensate
various groups affected by the compulsory takeovers. The RTC money was used not
only to compensate the receiving banks and to provide a full guarantee of deposits,
but also to cover the financial losses for members of credit cooperatives who put
money into credit cooperatives as “share money”. The Ministry of Finance even asked
RTC to pay to establish pensions for the employees of the insolvent financial
institutions without sufficient reserves for pensions (Commercial Times, 2001.10.03).
Camp” with DPP. The targeting on CDFAs impacted negatively both on KMT and TSU. However, it
was no doubt that, comparing with KMT and the old government, DPP and the new govemment were
less connected with local factions and less dependent on the mobilization o f vote through local factions.
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All of these “generous” payments by RTC reduced resistance of the compulsory
takeovers but increased the government’s fmancial burden.
Although the RTC compensates receiving banks based on a fair evaluation of
losses, the actual losses tend to be higher than the compensation amount. In addition,
it would be difficult for receiving banks to absorb the personnel in CDFAs because of
their lack of skills in commercial banking business. The main benefit receiving banks
can get fi'om takeovers is to obtain more branches than allowed^^. The “true” private
banks are thus uninterested in participating in the government-initiated takeovers.
This may explain why nine of the ten receiving banks are State-owned or “State-
influenced” banks^^.
5 .5 DEALING WITH THE PROBLEM OF FRAGMENTATION
The Financial Holding Company (FHC) Act was passed in June 2001, with
KMT’s strong support (Central Daily News, 2001.6.29). Considering KMT’s deep
footing^^ in fmancial services and the benefits the FHC Act delivers, it is not
surprising that the KMT has been a major promoter of the FHC Act. The FHC Act
substantially reduced the restrictions that had resulted in a fragmented financial sector.
^ The limit set by the Ministry of Finance is that each bank can open up to six new branches each year
(Wang, 1999). The MOF initially agreed that the receiving banks could relocate the CCs and CDFAs
they acquired. However, the MOF did not approve any o f the applications filed by the ten domestic
banks that participated in the first wave o f t^eovers to close down or move branches they acquired
(China Times, 2003.1.27).
The only exception, the Sunny Bank, was a CC-converted bank. Sunny Bank accepted two CCs.
^ KMT’s controlling power in financial institutions includes the Fuhwa group, CDffl, Pan Asia Bank,
and Kaohsiung Business Bank (Chang, 1999). KMT invested heavily in Asia Pacific Bank so as to
meet the ownership requirement for Asia Pacific Bank to join the Fuhwa FHC (Economic Daily News,
2001.10.19).
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Nevertheless, the goal to achieve the resolution of the over-capacity problem is
suspected.
The FHC solution
The FHC Act represents a fundamental overhaul of the fmancial system in
Taiwan. It provides market and tax incentives to financial institutions to merge and
integrate. The FHC framework allows for the formation of three types of FHCs (i.e.,
banking FHCs, insurance FHCs, or securities FHCs). Among the three types, banking
FHCs are allowed to provide the widest range of financial services, and the other two
types of FHCs would face more limited business opportunities (Su, 2001). It is thus
quite attractive for banks to join or form banking FHCs and to transform the
segmented fmancial services into the model of a “universal bank^^” or a “one-stop
shopping place” scratched by the FHC blueprint. As of January 2003, eleven of the
fourteen FHCs were licensed as banking FHCs'*®.
FHCs can share the facilities, employees, back-office operations, client
information and marketing efforts among their subsidiaries. The “cross-selling”
opportunities make it attractive for FHCs to invest in information technology,
research and development, and job training so that they can be more efficient in
“Universal bank” or “one-stop shopping” means that banks, rather than providing only banking
services, offer their customers a variety of financial services so that customers can purchase all their
financial services through one provider.
The only three exceptions are Jin Sun, Fuhwa (securities FHCs) and Shin Kong (an insurance FHC).
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utilizing their resources and cultivating customers'^^ In short, the FHC solution
enhances the profitability outlook for FHC-afFiliated banks.
The FHC Act also provides tax incentives for financial institutions to form
FHCs. The FHC Act waives most taxes associated with the establishment of an FHC,
including the deed tax, stamp tax, income tax, and securities transfer tax (FHC Act,
Article 28). It also allows FHCs to consolidate into one aggregate tax reporting the
profits and losses of all subsidiaries over 90 percent held by the FHC (FHC Act,
Article 49). In addition, if the merger of the FHC’s subsidiaries is priced above their
book value, the amortization of the goodwill enjoys tax deduction for five years
(Financial Institution Merger Law, Article 17). Moreover, banks merging into an FHC
can recognize their NPL losses within the timeframe of fifteen years (Financial
Institution Merger Law, Article 17). This is particularly important to link the FHC
route to the goal of NPL removal because many banks carry large amounts ofNPLs.
The minimum capital requirement to establish a FHC is NT$20 billion (or
US$588 million) (FHC Act, Article 12). This is considered relatively low, given the
existing asset bases of most companies operating in the fmancial sector in Taiwan
(Cheng et a l , 2001). It also requires that if one fmancial group possesses total assets
of more than NTS300 billion (US$8.8 billion), the financial group must form an FHC
(FHC Act, Article 6). These requirements in capital and assets, as well as the market
and tax incentives, show the government’s intention to encourage the financial sector
to converge into the FHC governance/business structure.
It is reported that many FHCs such as Fubon, Cathay, and Hwa Nan have been spending aggressively
on upgrading their information systems to capture the profits from cross-selling (China Times,
2003.2.10).
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Integration, Differentiation, but not Consolidation
I argue that the FHC solution may not be able to bring forth consolidation to
the banking sector although it is producing integration. As of January 2003, there
were a total of sixteen domestic banks that joined the FHC framework. Those banks
became subsidiaries of the fourteen newly formed FHCs and aimed at strengthen their
competitiveness. Comparing the group of the sixteen FHC-affiliated banks with the
rest of the thirty-seven non-FHC-afifiliated ones, it is obvious that even before the
FHC potential has become materialized, the former has already been stronger than the
latter in terms of size and profitability'*^. Table 5.4 illustrates the comparison.
Table 5.4 Performance of FHC-affiliated vs. non-FHC banks, 2(
Domestic
banks
FHC
banks'^^
Non-FHC
banks
(1) Number of banks 53 16 37
(2) Income 58.6 63.5 -4.9
(3) Total assets 21,513 8,227 13,286
(4) Average bank assets
(4) = (3)/(I)
406 514 359
(5) Equity (Net worth) 1,600 767 833
(6) Average equity 30.2 47.9 22.5
(7) Net worth / Assets
(7)-(5)/(3) *100
7.44 9.32 6.27
(8)R0A (8) = (2)/(3) 0.27 0.77 -0.04
(9) ROE (9) = (2)/(5) 3.66 8.28 -0.59
Source: calculated from data on Domestic Banc Operational Performance
Quarterly Report, 2001, Central Bank of China
Unit: NTS billion
This study focuses on analyzing the impact of regulatory changes (such as the FHC Act) on the
banking sector so that banks are categorized by whether they have affiliation with FHC. The
comparison is on the level of groups (FHC vs. non-FHC). \ ^ l e the argument is that the FHC group,
on an average, is stronger than the non-FHC group, it does not claim that “all” FHC banks are stronger
than the non-FHC ones. Varieties exist within boffi the FHC and non-FHC groups.
The category “FHC banks” refer to the sixteen domestic banks that existed in 2001 and subsequently
became FHC subsidiaries before January 2003. The sixteen domestic banks are: Taishin, Dah An
(merged into Taishin in December 2001), CDIB, Hwa Nan, E. Sun, Chiao Tung, ICBC, ChinaTrust,
SinoPac, First, Jih Sun (renamed from Baodao), UWCCB, Cathay, Fubon, Taipei Bank, and Fuhwa
(renamed from Asia Pacific).
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One aspect for comparison is bank size and capital adequacy. The averaged
size of bank assets in the FHC group was NT$514 billion, comparing with a much
lower average size of NT$359 billion in the non-FHC group. The average size of net
worth for the FHC group (NT$47.9 billion) was more than double that of the non-
FHC group (NT$22.5 billion). The ratios of net worth to assets for the FHC group and
the non-FHC group were 9.32 percent and 6.27 percent, respectively, indicating that
the former was stronger in capital adequacy than the latter. Therefore, banks in the
FHC group were, on average, larger in assets and sounder in capital adequacy.
Another aspect of bank strength is profitability. The returns on assets (ROA)
for the FHC group and the non-FHC group were 0.77 percent and -0.04 percent,
respectively, with an average of 0.27 percent for all domestic banks. The returns on
equity (ROE) also showed a similar superiority in the FHC group over the non-FHC
group. Hence, the sharp differences in bank size, capital adequacy, and profitability
demonstrate clearly that strong domestic banks are more likely to form FHCs than the
weak ones.
I identify several factors attributed to the less likely participation of weak
banks in the FHC route. First, weak banks and basic fmancial institutions are
generally smaller and may not have the required capital to form FHCs. Second, it is
more difficult for them to find partners to form FHCs. Third, the establishment of
FHCs requires approval by the Ministry of Finance. The MOF will not approve an
application if the applying bank’ fmancial records or business operations are
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unsound"” . These factors thus attribute to the differentiation effect in terms of entering
the FHC route.
The FHC solution may produce another differentiation effect that strong banks,
by forming FHCs, will become even stronger, and the weak ones, weaker. FHC-
affiliated banks have the potential to capture the economies of scale, tax benefits, and
the synergies of integration. Non-FHC-affiliated banks will find it even harder to
survive. In terms of the NPL problem, FHCs have various options for handing it,
while non-FHC banks’ ability to deal with the NPL problem is limited. FHCs may
also be given better credit rating and thus have an easier time raising capital.
Qualified foreign FHCs can operate in Taiwan without setting up new FHCs
(FHC Act, Article 23). This will facilitate merging of domestic fmancial institutions
with foreign FHCs. The fact is that foreign FHCs are not particularly interested in
acquiring problematic domestic fmancial institutions even though the transactions
may be compensated by RTC (Economic Daily News, 2003.1.8). Foreign FHCs prefer
to acquire good domestic banks which, based on a survey of several domestic banks,
are absolutely “not for sale” (Caparusso, 2001). Therefore, foreign FHCs are not
likely to be a major force to consolidate the domestic financial sector.
The FHC framework also created pressure on other sectors in the financial
system. For example, many ITCs merged into FHCs in 2002-2003 (Economic Daily
News, 2003.1.28). With the support from FHCs in terms of the strong capital, wide
According to the “Review Criteria and Application Documents for the Establishment of Financial
Holding Companies,” the review criteria include basic requirements and document preparation,
soundness of business operations and management capability, adequacy o f capital, and the overall
competitiveness and potentiality.
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range of locations, and shared client base, ITCs can expand aggressively. However, an
ITC would be left behind if it did not join an FHC. The pressures of competition thus
translated into the formation of FHCs to combine companies across different sectors.
In other words, the cross-sectoral integration under the FHC framework to some
extent is serving as an alternative to bank closures, takeovers, mergers, and reduction
of capacity in workforce and branches. After the Financial Institution Merger Law
was enacted, there were very few mergers between domestic banks. Table 5.1 shows
that from 2000 to 2002 the number of domestic banks only decreased by one"^^ The
number of bank branches increased from 2,693 to 3,068. In addition, the number of
CCs and CDFAs decreased mainly because of the compulsory takeovers. Therefore,
the banking sector still shows little sign of voluntary consolidation.
In sum, there is a trend of integration for domestic banks to form FHCs and to
acquire other non-bank financial institutions. This trend of integration is accompanied
by a trend of dicbotomization (i.e., an increasing gap between the FHC group and the
non-FHC group, and between strong banks and weak ones), but not consolidation.
Consolidation Requires Government Intervention
A survey of top managers of fmancial institutions by the Taiwan Academy of
Banking and Finance bigbligbted that one of their serious concerns was that there bad
been too many FHCs competing with one another (Economic Daily News, 2003.1.25).
Regarding this concern, Lin Cbuan, Minister of Finance, insisted that market forces
would determine the optimal number ofFHCs and banks. The role of govemment is
The only merger between banks was Dah En’s merging into Taishin in December 2001.
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not one of gate-keeping but rather of maintaining market openness and competition
and making sure that the risk management and internal control mechanisms are
functioning adequately (Economic Daily News, 2003.1.4).
However, it is suggested that market competition may not necessarily result in
consolidation. The experiences of bank deregulation in the 1990s demonstrated that
weak banks could avoid market discipline through various ways until the govemment
intervened. Fierce competition resulted not in consolidation but in a gradual shift of
rent stmctures from profit-oriented rents to loss-induced ones, as the preceding
chapter argued. The FHC framework may speed up the process of separating winners
and losers. It promises winners market and tax rewards, but it cannot prevent the
losers from grabbing loss-induced rents.
To reduce the over-capacity in the banking sector and to control the problem
of rent-seeking by losers, the govemment is required to take prompt and strong
actions such as the RTC-initiated compulsory takeovers. The FHC fi’ amework has
created an environment in which non-FHC-related financial institutions, particularly
basic financial institutions, have a harder time surviving than before. To some extent,
it can be argued that the FHC solution is systematically shifting the burden to the
weak groups in the banking sector. It is the government’s intention to use market-
conforming measures for a gradual resolution of the over-capacity problem. However,
the intensified dicbotomization in the banking sector may hinder the working of
market forces and delay the needed consolidation if there are too many weak fmancial
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institutions and they choose to act collectively through “political engagements”
against the “unjust” reform policies.
5.6 ASSET MANAGEMENT COMPANIES TO RESOLVE THE NPL
PROBLEM
The Financial Institution Merger Act has a special provision (Article 15) for
the establishment and operations of asset management companies (AMCs). This is
because the NPL problem has been a major obstacle to voluntary mergers among
financial institutions, and the establishment of AMCs and a private “recycling”
market for NPLs would encourage more mergers and speed up the process of NPL
reduction. The govemment provides market and tax incentives so as to attract private
capital (both domestic and foreign) to purchase the NPLs held in the domestic
fmancial sector. However, if the dicbotomization problem between healthy and weak
fmancial institutions intensifies, the burden of NPL removal will fall heavily on the
govemment and public resources.
The AMC Framework
It is common that loans are collateral-backed'*^, but it is not easy for banks to
go through collateral foreclosure if the loans become problematic. Before the AMC
framework was enacted, banks could only rely on the court-enforced orders of
auctions to pursue the foreclosure of collaterals, which was an inefficient and time-
consuming process. It would usually take more than four years to apply and complete
It is estimated that sixty percent of the NPLs in Taiwan have real estate as collaterals (Chen, Lin,
Shia, Wu, & Wang, 2000).
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an auction process, and the deal would be, on average, less than forty percent of the
market value (Chen et al., 2000).
The AMC framework allows banks to dispose of their NPLs to AMCs in three
ways. First, a bank that wants to sell its NPLs can negotiate directly with AMCs for a
deal. FHCs can even set up AMCs and transfer the NPLs held by their subsidiaries
directly to the AMCs. The second way is through an auction process, which is the
most common way for banks to sell off their NPLs (Chang, 2003b). Third, banks can
use their NPLs as capital to form joint venture AMCs with foreign investment banks.
AMCs enjoy more flexibility than banks in dealing with NPLs they possess,
and have stronger authority provided by the Financial Institution Merger Act. For
example, AMCs can bypass the court system and sell their foreclosed collaterals
through auctions held by registered, independent third parties. Even if an AMC is not
the creditor of the first lien on a property, the AMC can request the court to rule for a
third-party auction of the underlying collateral and share the proceeds of the auction
among creditors. In case the borrower is declared bankrupt or is under reorganization,
AMCs are empowered to exercise their financial claims under NPLs without being
subject to the restrictions under the Corporate Law and the Bankruptcy Act. The
AMC route is thus considered to be an efficient alternative to the route through the
court system.
The AMC route could speed up the removal of NPLs, but it also has brought
up a serious concern that the accelerated collateral foreclosure might cause the
housing market to collapse (Economic Daily News, 2003.1.1). The government since
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2000 has provided a total of NT$800 billion in government-subsided home loans to
stimulate the demand for housing"^^. It has been estimated that sixty percent of the
NPLs in the domestic banking sector are collateral-backed (Chen et al., 2000). If the
average price for the auctions of foreclosed collaterals is forty cents per NPL dollar"^^,
a reduction of NPLs by NT$1 trillion will eventually place an extra selling pressure of
NT$60 billion on the housing market. The average prices of housing in almost all
cities had already dropped more than twenty percent from their peaks (Economic
Daily News, 2002.5.19). The government-subsidized home loan program thus became
an important policy tool to prevent the housing market from collapsing. A rising or
stable housing market also facilitates the growth of the AMC/NPL market because of
AMCs’ dependence on the profitability potential of the real estate market'*^.
AMCs in a Dichotomizing Banking Sector
A consortium of thirty-five domestic banks set up the first domestic AMC in
Taiwan in April 2001, followed by the second AMC established by the China
Development Industrial Bank. Foreign AMCs^^ have been aggressive in purchasing
NPLs from domestic banks. Domestic FHCs, such as Fuhwa, Taishin, Mega, and
^ ’The initial size o f the government-subsided home loans program was NT$200 billion for 2000 and
2001. The government added NT$200 billion to this program each year from 2001 through 2003.
^ Actual data is not available. This estimation is modified from an analysis o f AMCs by a research
team at Chung-hua Institute for Economic Research (Chen et al., 2000).
A rough estimation of the profit potential is as follows. Suppose the total cost and selling price of the
foreclosed collaterals are 30 cents and 40 cents per NPL dollar. The difference, 10 cents, would
represent a 33 percent return of the investment of 30 cents. Although the numbers are arbitrary and the
estimated return is somewhat high, a high return prospect is considered as a precondition to attract
AMCs (particularly foreign AMCs) to participate in the domestic NPL market. Based on the same
estimation of 10-cent profits per NPL dollar, the reduction of NTS 1 trillion would imply a profit
potential of NTS 100 billion in the coming years in Taiwan’s NPL market
Active foreign AMCs include Cerberus, GE Capital, Lonestar, Merrill Lynch, Salomon Smith
Barney, Morgan Stanley, and Deutsche Bank.
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ChinaTrust also planned to establish their own AMCs to manage the NPLs held by
their subsidiaries and to capture the emerging NPL market (Economic Daily News,
2002.12.4; 2003.1.6). AMCs absorbed NT$250 billion NPLs in 2002 (Economic
Daily News, 2002.12.17), and the banking sector may need to remove a total of NT$1
trillion NPLs’^ to reduce the average NPL ratio to five percent. Nevertheless, main
NPL sellers have been healthy banks and FHC-affiliated banks. By contrast, ailing
banks and basic financial institutions have not been able to take much advantage of
the AMC framework.
Table 5.5 shows a clear picture of dichotomization by comparing the FHC
banks with non-FHC banks. The overall domestic banks experienced a decline of
NT$328 billion in loans in the first nine months in 2002. Loans in the non-FHC group
declined by NT$407 billion, and banks in the FHC group expanded their loan base by
NT$79 billion. This means that, while domestic banks as a whole experienced credit
contraction in 2002, the FHC group continued to grow and took customers away from
the non-FHC group. In terms of the removal of NPLs, domestic banks as a whole
reduced NPLs by NT$60 billion. The NPLs in the FHC group decreased by NT$93
billion, resulting in substantial improvement of NPL ratios from 5.45 percent to 3.59
percent. By contrast, the NPLs in the non-FHC group increased by NT$33 billion, and
the NPL ratio rose from 9.21 percent to 10.00 percent. This was because the non-FHC
The size of NPLs in the financial sector at its peak in 2001 was about NTS 1.7 trillion (Chang, 2003a).
The total loan size in the banking sector was about NTS 14 trillion. The goal was to reduce the NPL
ratio to five-percent, which equals to NTS700 billion.To achieve this goal, NT$1 trillion NPLs need to
be removed.
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banks, on average, removed less existing NPLs and accumulated more new NPLs than
the FHC-affiliated banks in 2002.
Table 5,5 Removal of Non-performing Loans: FHC vs. non-FHC Banks
Domestic
banks
FHC
banks
Non-FHC
banks
December
2001
(1) Total loans 14,358 5,129 9,229
(2) NPLs* 1,130 280 850
(3) Bad loan reserves 220 63 157
(4) NPL ratios (%)
(4) = (2)/(I) *100
7.87 5.45 9.21
(5) Loan loss coverage (%)
(5) = (3)/(4) *100
19.45 22.6 18.41
September
2002
(6) Total loans 14,030 5,207 8,823
(7) NPLs* 1,069 187 882
(8) Bad loan reserves 229 62 167
(9) NPL ratios (%)
(4) = (2)/(I) *100
7.62 3.59 10.00
(10) Loan loss coverage (%)
(5) = (3)/(4) *100
21.39 33.2 18.88
9-month
changes
(11) Loans -328 79 -407
(12) NPLs -60 -93 33
Source: calculated from data on Domestic Bank Operational Performance Quarterly
Reports, Central Bank of China
♦Excluding Loans under Surveillance
Unit: NTS billion
It was also reported that there were twenty-one domestic and medium business
banks that carried NPL ratios higher than ten percent, as of the end of the third quarter
of 2002 (Economic Daily News, 2003.1.7). I found out that none of the twenty-one
banks were affiliated with FHCs. In short, the FHC group demonstrated substantial
improvements in selling and controlling NPLs, but the customer base and loan quality
in the non-FHC group continued to deteriorate.
The dichotomizing abilities between the two groups in coping with the NPL
problem can be attributed to the differentiation effect resulting from the FHC
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121
framework. Banks with FHC affiliation enjoy several competitive advantages in
assessing the AMC/NPL market than those does not. First, FHCs possess a stronger
capital base and a better earnings performance to absorb the losses associated with the
selling ofNPLs. Second, healthy banks have the incentives to “think of the longer
term”. They are willing to remove NPLs in the short term in exchange for improving
prospects into the future. By contrast, weak banks have difficulty escaping the
“vicious circle” of a draining of good customers and a deterioration of loan quality.
Third, FHCs can set up their own AMCs and transfer their banks’ NPLs to the
subsidiary AMCs. Fourth, healthy banks, because of their better ability in managing
their loans and NPLs, are generally in a better position to negotiate a good deal with
AMCs. By contrast, AMCs often factored higher premiums in their biddings ofNPLs
from weak banks, due to the higher uncertainty of the quality of the NPLs held by
weak banks. These differences resulted in active participation of FHCs, both as sellers
and buyers, in the emerging AMC/NPL market in Taiwan. The non-FHC group has
been participating relatively less, not to mention the segment of the basic financial
institutions, which has been even more troubled than the non-FHC group and is still
“non-existent” in the AMC route of NPL reduction. If the AMC route is not a solution
for weak banks and basic financial institutions, what will it be?
RTC Expansion and a Dual-channel Solution?
The current AMC solution is basically a “decentralized” approach in the sense
that buyers and sellers voluntarily participate in the NPL market without the presence
of State-owned AMC. One problem with the decentralized approach is that weak
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financial institutions have been participating less, as presented in the preceding
section.
In 2002, President Chen announced the so-called “258” policy goal; In 2 years,
the banking sector shall reduce the average NPL ratio to 5 percent and increase the
capital adequacy ratio to 8 percent! For the FHC group, this goal is attainable. Its NPL
ratio was 3.59 percent (as of September 2002), and the ratio of net worth to assets was
9.32 percent (as of the end of 2001). For the non-FHC group, this goal is difficult to
reach. Its NPL ratio was 10.0 percent (as of September 2002) and the capital adequacy
ratio was lower than 7 percent. To reduce the NPL ratio to 5 percent, banks in the
non-FHC group need to remove more than NT$400 billion NPLs from their balance
sheet. Without a capital injection, NPL removal will reduce their capital adequacy
even further. The average NPL ratio in basic financial institutions was higher than 15
percent at the end of 2002, and their capital is very limited. Therefore, many banks
and basic financial institutions cannot solve the NPL problem on their own. More
importantly, the NPL problem in those financial institutions, as Table 5.5 shows, has
been getting worse. The dichotomizing trend calls for government intervention in the
weak, non-FHC group.
Scholars have pointed out the advantages of setting up a State-owned AMC,
such as cost-effectiveness in consolidation of assets, simplification of bank
restructuring process, facilitation in the coordination of corporate restructuring,
efficiency in the use of scare restructuring talent, and the ability to use the
government’s authority in pursuit of quick resolution (Garcia, 1997; Hanna & Huang,
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2002). The success of systemic bank restructuring in the after-crisis South Korea
demonstrated the superiority of such a centralized approach. The Korean government
set up the Korea Asset Management Corporation (KAMCO), setting aside more than
KWl trillion (approximately 22 percent of GDP) to resolve the crisis in the financial
system. KAMCO spent KW35.6 trillion in purchasing KW89.4 trillion ofNPLs,
which was about 11 percent of the banks’ total outstanding loans (Hanna & Huang,
2002). The resolution of the NPL problem in South Korea was companied with
massive closures and mergers in the banking sector. From December 1997 to
December 1999, five of the thirty-three commercial banks and eighteen of the thirty
merchant banks were closed down, and another five banks and three merchant banks
merged into other banks (Hanna & Huang, 2002). The averaged NPL ratios were
reduced from 11.3 percent in 1999 to 4.9 percent in 2001 (Economic Daily News,
2002.7.20). The Korean experiences illustrated the necessity of government
involvement and prompt action in systemic restructuring.
Under the existing RTC framework in Taiwan, the government intervenes only
after a financial institution becomes insolvent. Although the Ministry of Finance
adopted the principle of “prompt corrective action”, RTC’s remaining budget
(approximately NT$40 billion at the end of 2002) was insufficient for the RTC to
make fiirther significant actions^^. To strengthen the banking sector in general and to
Chung Shing Bank was taken over by the Central Deposit Insurance Corporation since October 2001
and has been put up for auction since January 2002. According to the National Federation of Bank’s
Employees Unions (NFBEU), the accumulated loss in Chung Shing Bank was nearly NT$40 biUion
(Monthly Bulletins, No. 14 and No. 15, 2002, National Federation of Bank Employee Unions). To
compensate for the NT$40 billion losses, the RTC would literally empty its pocket. In September 2002,
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resolve the NPL problem in weak financial institutions in specific, the Ministry of
Finance sought to expand the funding of RTC and set up a centralized AMC
mechanism^^. Ministry of Finance’s proposal was to aggressively expand the funding
from NTS 140 billion to NTSl.05 trillion^'* (approximately 11 percent of GDP).
The expanded RTC would allocate NT$450 billion (including the original
NTS 140 billion and extra budget ofNTS310 billion) for the compensation for
compulsory takeovers of insolvent financial institutions. Adding NTS310 billion to
the existing NTS40 billion, RTC would have NTS350 to handle insolvent financial
institutions. At the end of September 2002, there were eleven banks^^ whose NPL
ratios were higher than 15 percent and levels of net worth were relatively low. Their
ability to stay solvent could be in question if macroeconomic situations got worse.
The RTC might need to provide more than NTS150 billion^^ to compensate for
compulsory takeovers in the future. The total outstanding loans extended by CCs and
CDF As were NT$360 billion and NT$550 billion, respectively. Another NT$ 150-200
the Ministry o f Finance asked the Land Bank to take over Chung Shing Bank from the hand of CDIC
(quarterly report, CBC, 24(2)).
The MOF intended not to set up a separate entity (AMC) but to have the CDIC perform the task of
compulsory purchase ofNPLs (Economic Daily News, 2002.8.10).
The MOF revised the proposed size down to NT$9,086, for the reason that the insolvency and NPL
problems had been improved during the fourth quarter o f 2002 (China Times, 2003.3.6).
The eleven banks included Bank of Oversea Chinese, Pan Asia, Chung Shing, Chinfon, Kao Shin,
Taichung Commercial, Tainan Business, Kaohsiung Business, Taitung Business, United Credit, and
Enterprise Bank ofHualien. Chung Shing and Kaohsiung Business Banks were already under CDlC’s
conservatorship.
MOF’s estimates are not available to the public. Here 1 provide my own rough estimation. The sum
of the NPLs and net worth in the eleven banks were about NT$250 biUion and NT$50 billion,
respectively. Suppose they all become insolvent and eighty percent of their NPLs would not be
recovered, the sum of their losses would be NT$200 billion, or NTS 150 billion more than their net
worth. It is noted that some of those banks may be able to stay solvent. Nevertheless, due to the fact
that those banks’ true asset quality is believed to be much worse than publicly stated and continued to
deteriorate, the needed budget for compensation may be higher than NTS 150 bilUoa For example, the
reported net losses in the Chung Shing Bank were NTS 17 billion, as of the end of 2001. To attract
bidders for the auction of Chung Shing Bank, the government offered compensation as high as NTS80
billion in late 2002 (China Times, 2003.3.6).
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125
billion or more might be needed to resolve the insolvency problem with many of the
CCs and CDF As. The other NT$600 billion would be used to set up a centralized
AMC mechanism for the compulsory purchase ofNPLs from weak but solvent
financial institutions (Economic Daily News, 2003.2.23). In other words, the MOF
intended to establish a dual-channel solution to the NPL problem in the sense that
solvent financial institutions would have both private (decentralized) and public
(centralized) channels to sell their NPLs.
The Ministry of Finance would use the centralized AMC mechanism as a
“credible threat” to impose the “258” goal on all financial institutions. It is expected
that strong banks will continue to be the main players at the decentralized market,
while the temporary, centralized channel will take care of the NPLs in weak banks
and basic financial institutions within the timeframe of two years.
This RTC-expansion proposal received serious criticisms and disagreements in
legislative meetings. Legislators’ concerns included the size of funding and the
possibility of moral hazards. Given the current government budget deficit, the
NTS 1.05 trillion was “way too much” (Economic Daily News, 2003.1.11). However,
it is argued that, except for the reason of “budget squeezing^^”, the proposed size for
RTC expansion is not inadequate for the resolution of the current NPL problem in
Taiwan’s banking sector, as this study has estimated earlier.
I also argue that the problem of moral hazards can be minimized. There are
two issues regarding moral hazards. One issue is that the RTC’s compulsory purchase
Budget squeezing refers to the effect that the expansion of one budget item may squeeze out budgets
available for other items, given the government budget constraint.
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ofNPLs would distort the prices in the private AMC/NPL market and create rent-
seeking loopholes for financial institutions to capture rents through the selling of
NPLs into the public hand at prices above fair market values (Economic Daily News,
2002.7.28). This concern is valid. Yet, I argue that, comparing with the serious NPL
problem calling for a prompt resolution, the rents are temporary and worth paying. By
contrast, further delays will make the resolution of the systemic NPL problem much
more costly. Besides, the rents can be controlled and minimized by setting up the
price of compulsory purchases ofNPLs close to fair market values. The other issue is
the operations and governance of the RTC. Complaints on RTC include the
insufficiencies in operational transparency, supervisory mechanism, assets-valuation
mechanism, and compensation standards (Economic Daily News, 2003.1.4). These
criticisms are constructive and may lead to the strengthening of the operations and
governance ofRTC. In fact, several legislators have been drafting a new proposal to
address these concerns^*.
So far I have argued that it is necessary to expand the RTC fund and to set up
a centralized AMC mechanism to deal with the NPL problem in weak financial
institutions, particularly in the segment of CCs and CDF As. The question is whether
the government is able to use the centralized AMC mechanism to implement firm exit
policies on weak financial institutions. Korean experiences demonstrated the
importance to reduce capacity in the banking sector. The challenge for Taiwan’s
government is to impose firm exit policies on the banking sector should the RTC be
^ Legislators Liu Yi-ju (PFP) and Huang De-fii (KMT) were promoting this negotiation and received
support from more than fifty legislators (Economic Daily News, 2003.1.4).
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127
expanded. Without consolidation, an expanded RTC would give the banking sector a
temporary relief but not a structural improvement.
Lee Yong-shan, Minister of Finance, announced MOF’s plan that the
expanded RTC would reduce the number of domestic banks from fifty-two to fifteen
through mergers and closures within the next two years (Chinese L.A. Daily News,
2002.9.9)! He highlighted that banks with adequate capital would be encouraged to
merge among themselves into larger and more competitive ones, while those without
adequate capital would exit the market through the RTC mechanism.
However, this goal is very difficult to achieve, for several reasons. First,
CDF As would not exit the market. By contrast, they sought to establish a new bank to
assist them (see Section 5.8 for detailed analysis). Second, strong banks are less
willing to acquire weak ones except for the reason that the acquisitions will allow
them to get more branches than the regulatory limit of six new branches per year^^.
Differences in the assessment of asset quality and net worth of banks may also hinder
merger deals^°. Third, the centralized AMC mechanism is more effective in targeting
the NPL problem rather than the over-capacity problem. The government’s ability in .
forcing bank closures or mergers has been in question (Chinese L.A. Daily News,
2002.9.9). Although the MOF intended to tie the centralized AMC mechanism with an
exit policy, it is not impossible for financial institutions to “catch the carrot but
avoid/delay the sticks”. The Ministry of Finance has been very reluctant to bear the
For example, ChinaTrust announced that it was seeking to acquire one or two banks and relocate the
acquired branches to the northern part of Taiwan (Commercial Times, 2003.2.18).
“ For example, Bank of Chinese Overseas estimated its accumulated losses were NT$8 billioa Shin
Kong FHC, after reviewing the documents of Bank of Chinese Overseas to explore the possibility of
mergers, believed that its losses amounted to NT$19 billion (Economic Daily News, 2002.6.26).
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128
blame for bank employee laid-offs^’. The politics of blame avoidance also hindered
the government’s commitment in the resolution of the over-capacity problem. Fourth,
facing the dichotomizing trend and intensified competition, weak banks may not be
able to improve their competitiveness from mergers among themselves. To the
contrary, mergers among weak financial institutions may result in bank failures^^
(Wang, 1999).
5.7 REFORM DRAWBACKS
In addition to the unsuccessful attempt ofRTC expansion discussed in earlier
sections, the Chen government encountered another two major drawbacks in 2002: the
regulation regarding the organization of the Financial Supervisory Council (FSC) as
well as the reform of CDF As.
A Battle over the Financial Supervisory CouncU
The task of bank examinations is shared among three agencies: MOF, CBC,
and CDIC, and it is the MOF’s authority and responsibility to demand corrective
measures or impose sanctions on banks if problems were found in bank examinations.
As financial holding companies are becoming more and more integrative and
innovative, it became increasingly difficult for the divided supervisory agencies to
perform effective supervision. The establishment of a Financial Supervisory Council
® An example was the auction of Chung Shing Bank. The Ministry of Finance preferred “whole bank
purchase and assumption (P&A)” to “partial P&A” of bank assets (Economic Daily News, 2002.5.16).
This is in part because employee contracts would also be transferred through the whole bank P&A
transaction.
“ Pan Asia Bank acquired the Kaohsiung Tenth CC in 1997. Chung Shing Bank acquired the Tainan
Second CC in 1998. The two banks failed subsequently.
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(FSC) was considered as the most important step to strengthen the government’s
supervisory capability by unifying various supervisory authorities into one entity. The
Council would become the sole authority with integrative capabilities to supervise all
financial institutions. However, the FSC regulation confronts power politics played by
bureaucrats, political parties, and factions. The political complexities made the
negotiations and passage of this regulation extremely difficult. Several factors were
behind the battle on the FSC regulation.
One factor was related to the bureaucratic reform and hierarchy arrangement
between MOF and FSC. The Executive Yuan intended to make the FSC an
independent institution under the Executive Yuan. However, the MOF, fearing that
FSC would marginalize MOF, preferred the establishment ofFSC under MOF (Huang,
1999). The FSC regulation also implied a substantial restructuring among various
government agencies, integrating them into the four bureaus under FSC: Bureaus of
Examinations, Banks, Securities & Futures, and Insurance (Commercial Times,
2002.12.11). The MOF’s supervisory functions would be performed by FSC. The
current Bureau of Money and Finance in MOF would be restructured as the Bureau of
Banks under FSC. As Legislator Chen Shua-shen described with some exaggeration,
the fonctions of MOF would be relegated to tax-related affairs®^. The fear of being
marginalized and uncertain results of bureaucratic restructuring thus made MOF less
63
Meeting Minutes, Legislative Yuan Communique, 92(3).
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cooperative in the bureaucratic reform and the FSC regulation than other issues'’ '*
(United Daily News, 2001.6.25).
The second factor was related to the composition of the nine councilors in FSC.
Based on the draft of the FSC Act, the FSC would consist of nine members
(councilors), with the term of four years. There is no limit on how many terms each
member can serve. The draft FSC Act set the limit of the percentage of members’
same-party-affiliation to less than one half, for the consideration of partisan balance.
Legislators from MKT and PFP were strongly opposed to this design, arguing that the
incumbent party (DPP) could easily control the whole FSC by selecting four members
from DPP and other members outside but supportive of DPP. In other words, it would
be legitimate to have a Council without members from PFP and KMT. To secure their
parties’ participation in the Council, PEP and KMT legislators insisted the alternative
principle of “party representation” regarding the composition ofFSC^^ (Commercial
Times, 2002.12.11). They argued that the principle of party representation could help
“depoliticize” the FSC by making it unable to be controlled by any single party.
However, the goal to depoliticize FHC might not be achieved through party
representation either. To the contrary, the independence and effectiveness ofFSC
would be in question should extensive negotiations among political parties be
involved in the FSC’s decision-making process.
^ The Executive Yuan asked MOF and CBC to as early as 1995. It took three years to come to the
conclusion that FSC be set up not under MOF but under Executive Yuan (Huang, 1999).
One way to build the principle of party representation into FSC is to specify in the FSC Act the
minimum numbers (or percentages) of members from major political parties.
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The third factor was the power politics between the President and the
Legislative Yuan regarding the percentage of government representation and the
appointment process ofFSC members. Legislator Lee Tung-hao (PFP) pointed out
that the draft FSC Act defined five of the nine members to be government
representatives^^ (Economic Daily News, 2002.12.12). In addition, the FSC members
would be nominated by the Executive Yuan and appointed by the President*"^. In other
words, the Legislative Yuan would be excluded from the decision-making process of
appointing FSC members. Given the power the FSC could possess in affecting the
financial system, legislators insisted that the Legislative Yuan should approve the
appointment ofFSC members (Economic Daily News, 2002.12.12). However, the
Executive Yuan insisted the appointment ofFSC members by the President so as to
maintain the FSC’s operational independence. Considering the existing close
relationships between legislators and financial institutions, I argue that the Executive
Yuan’s concern is justifiable.
The fourth factor was the potential impact of the FSC regulation on local
factions and CDF As, due to the close relationships between a number of legislators
and local factions. They generally perceived a zero-sum game between two
regulations; the FSC Act and the Agricultural Finance Act. Passage of the FSC Act
will reduce the space negotiating for provisions favorable to CDF As in the
Agricultural Finance Act (see next section for detailed analysis on the issue of the
draft Agricultural Finance Act). In addition, it is estimated that more than three
The five government representatives include Chair (Prime Minister), two Vice Chairs (Jrom
Executive Yuan), Deputy Governor of CBC, and a Senior Director fi'om MOF.
The Fair Trade Commission adopts the same appointment process.
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fourths of the CDF As’ NT$600 billion outstanding loans were made to non-farmers^*
(Economic Daily News, 2002.11.25). While the loans to non-farmers became a main
channel of extracting and transferring financial sector rents, the FSC would take away
the responsibility of examinations from the CBT and substantially limited rent-
seeking activities at CDFAs. Moreover, the draft FSC Act provided the FSC the
authority of investigation. Some legislators feared that this provision would be
misused to hammer local factions without the respect for privacy (United Daily News,
2002.12.113).
In sum, the FSC regulation reflected the negotiated nature of reforms. State
autonomy in pursuing the reform to supervisory unification was constrained by the
politics of bureaucratic reform, inter-party politics, the battle between the President
and the Congress, and the central/local politics. These factors complicated the scope
of negotiations.
Failures in Reforming the Agricultural Finance
On October 29, 2002, more than ten thousand members of farmers’ or
fishermen’s associations demonstrated in front of local governments to express their
dissent to the current reform measures for the agricultural finance (Chinese L.A. Daily
News, 2002.10.30). One month later, on November 23, more than one hundred
thousand people demonstrated on streets again. The tremendous pressure of the two
demonstrations caused the resignation of Minister of Finance and chairman of the
® Membership in farmers’ associations is required to get loans from CDFAs. The membership can be
given to either farmers or-sponsors of farmers’ associations. In other words, non-farmers can get access
the CDFAs by acquiring membership with the category o f sponsors.
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Council of Agriculture, in addition to apologies from President Chen^^. It also put the
government’s financial reforms to a halt. The Executive Yuan responded by three
major policy changes; (1) the “NPL-based restrictive rule” (explained later) would not
be enforced on CDFAs, (2) a bank dedicated to agricultural finance would be
established, and (3) CDFAs would not be taken over by commercial banks; instead,
the government would facilitate future compulsory takeovers of insolvent CDFAs by
the new agriculture bank or other farmers’ and fhshermen’s associations.
To explain the farmers’ strong rebuttals, Feng Chan-chun, then chairman of
the Council of Agriculture, believed that the government “misjudged” the situation
and underestimated the scale of resistance and the farmers’ ability in political
mobilization (Chinese Daily News, 2002.11.22). Agreeing with this “misjudgment”
explanation, I point out that the “no-carrot” or “stick-only” strategy the Chen
government used on the reforms of agricultural finance was the main cause for the
massive rebuttals and the inevitable policy changes. In the following, I will analyze
the major reform measures for CDFAs the government had adopted prior to the
farmers’ and fishermen’s rebuttals, arguing that those measures failed to provide
incentives for the farmers’ and fishermen’s associations to facilitate a gradual path of
reforms.
The basic reform approach the government adopted to deal with insolvent
CDFAs was to coordinate takeovers by commercial banks, as the two waves of
compulsory takeovers illustrated. The RTC compensated for the receiving banks but
® On November 22, one day before the scheduled second demonstration. President Chen, attempting to
stop the demonstration, made apologies in a conference meeting with representatives of farmers’
associations (Chinese Daily News, 2002.11.22).
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not the farmers’ and fishermen’s associations. The logic was that, since the net worth
of those CDFAs was negative, farmers’ and fishermen’s associations actually
“gained” by getting rid of their credit departments. However, this approach cut off the
most important funding source for farmers’ and fishermen’s associations. In addition,
while the FHC reform measure provided tax incentives and cross-selling opportunities
for hanks with FHC affiliation, there were no comparable, incentive-based measures
for CDFAs.
CDFAs faced a number of disadvantages in competing with banks. The
declining agricultural sector would soon encounter strong foreign competition under
the WTO framework. The government had not provided a clear framework for
agricultural finance; instead, MOF seemingly intended to solve the problem with
CDFAs using the same strategy as it did with CCs, encouraging CDFAs merge into
banks or convert into banks through mergers among CDFAs™. A crucial difference
between CCs and CDFAs was that CDFAs were the main providers of agricultural
financial services (Chen, 1996). It would thus be a serious policy mistake to eliminate
CDFAs without providing an alternative framework for agricultural finance^ \
The reform measure of the “NPL-based restrictive rule” was announced on
August 22, 2002, triggering the explosion of massive anger in farmers and fishermen.
™ An example was that seventeen CDFAs in the Taipei County planned to merge together to form a
new bank (Chinese L.A. Times, 2002.9.9).
The NPL-based restrictive rule on CDFAs reflected MOF’s relative ignorance on agricultural finance,
despite the COA’s warning about the importance of CDFAs on agricultural finance. COA preferred to
the status quo, but MOF insisted to separate CDFAs from farmers’ and fishermen’s associations (Kuo,
2001). The Executive Yuan originally intended to aimounce and apply this rule to all financial
institutions so as to avoid the blame of “singling out” CDFAs. However, in MOF’s aimouncement, this
rule applied only to CDFAs. According to a senior official at MOF, the CDFA-only, NPL-based
restrictive rule might be announced “by mistake” and “by accident” (Economic Daily News,
2002.11.19).
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The “NPL-based restrictive rule” required that CDFAs with NPL ratios higher than 10
percent were restricted from making new loans. In addition, CDFAs were not allowed
to take in new deposits should their NPL ratios were above 25 percent (Chinese L.A.
Daily News, 2002.9.20). Given the averaged NPL ratio was about 18 percent in 2002,
the “NPL-based restrictive rules” would immediately affect more than two thirds of
the CDFAs (Economic Daily News, 2002.11.19). The restriction on new loans would
cause credit contraction and worsen the NPL ratios in the affected CDFAs. Contrary
to the farmers’ expectation that the government would come up with a new
framework to resolve the problem with agricultural finance, the NPL-based restrictive
rule was a death sentence for most CDFAs.
The main appeal of farmers’ and fishermen’s demonstrations was; Support
financial reforms, oppose elimination of farmers’ and fishermen’s associations! This
was a smart play of discursive politics, for the underlying intention for the farmers’
and fishermen’s associations was to leverage the demonstrations in influencing the
process and outcomes of the regulatory reforms toward their best interests. This
appeal received support from KMT, People First Party (PFP), and the Taiwan
Solidarity Union (TSU). James Soong and Lee Teng-hui (chairmen of PFP and TSU,
respectively) criticized that the government’s true intention behind the reforms of
CDFAs was to get rid of farmers’ and fishermen’s associations (Chinese L.A. Daily
News, 2002.11.18; China Times, 2002.9.13).
The National Self-help Association of Farmers and Fishermen made a number
of demands and the government made significant concessions. Negotiating intensively
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with the MOF, the Council of Agriculture, seven local governments, and
representatives of farmers’ and fishermen’s associations, the Executive Yuan first
announced on October 19, 2002 “four promises and five reward measures” in
attempting to soothe down the escalating anger and the scheduled nation-wide
demonstrations (China Times, 2002.10.20). The “four promises” included; (1)
financial services to farmers and fishermen shall not be reduced, (2) farmers’ and
fishermen’s associations shall continue to exist, (3) well-operated CDFAs shall
continue to exist, and (4) the financial reforms of the farmers’ and fishermen’s
associations shall continue. The “five reward measures” provided ease of restrictions
so as to encourage CDFAs to comply with the NPL-based restrictive rule. These
promises and reward measures seemed to be too vague to soothe down the grievance.
The first demonstration launched as planned, and the second wave of demonstration
was also in schedule.
On November 18, 2002, one week prior to the scheduled second big
demonstration. Prime Minister Yu Shi-kun further announced that MOF would not
enforce the “NPL-based restrictive rule” on CDFAs and emphasized that the
government had no intention to eliminate farmers’ and fishermen’s associations
(Chinese L.A. Daily News, 2002.11.18). He also promised to earmark a special fund
ofNT$100 billion for compensating agricultural losses resulting fi'om imports
competition. President Chen agreed to hold a national conference on agricultural
finance. The conference, held on November 30, 2002, recommended setting up a
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137
national bank^^ dedicated to agricultural finance and providing assistance to CDFAs,
creating a special law for agricultural finance, and making Council of Agriculture the
competent authority of agricultural finance (United Daily News, 2002.12.1). These
concessions represented an overturn of the earlier reform direction and a great success
for farmers’ and fishermen’s associations in securing various explicit and implicit
rents in terms of government’s injection of capital to strengthen the agricultural
finance, generous subsidization for agricultural losses, and the continuation of the
existing CDF A system.
The concession to create a new national agriculture bank was highly
controversial. On the one hand, it was a government’s “promise” made to the farmers
and fishermen as a crucial part of the new fi*amework for agricultural finance. On the
other hand, it might worsen the problem in agricultural finance and the banking sector
as a whole. It was warned that a bank dedicated to agricultural finance would be
extremely difficult to survive because of the concentration of sector-specific risks the
bank would face^^ (Kuo, 2001). From the viewpoint of farmers’ and fishermen’s
associations, this new bank could provide a cost-sharing mechanism between the
government and them because of the government’s ownership in the bank.
The National Self-help Association of Farmers and Fishermen demanded the
government to own forty-nine percent of the new agriculture bank, and the farmers’
and fishermen’s equity in the agriculture bank should be less than twenty percent.
This is to make sure that the government is “on their side”. The Executive Yuan and
Instead of converting the Cooperative Bank into the agriculture bank, MOF later decided to create a
new bank (China Times, 2003.1.27)-
For example, livestock or corps may be wiped out by the spread of diseases or natural disasters.
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the MOF, however, insisted that the government share of ownership being restricted
to twenty percent, and the share of farmers’ and fishermen’s associations being more
than fifty percent (China Times Evening News, 2002.12.1). The MOF’s goal is to
reduce the government’s share of “hostage” and to increase the incentives for bank
performance by increasing the ownership share of the farmers’ and fishermen’s
associations. While the negotiations on shares of ownership are expected to continue^'^,
the owners of the new agriculture bank may become victims of rent-seeking, moral
hazard problems, and loss-transferring from CDFAs to the bank.
In sum, the reform of CDFAs started with two waves of aggressive
compulsory takeovers and the implementation of an NPL-based restrictive measure.
This reform policy, due to its lack of positive incentives for compliance, induced
farmers’ strong rebuttals and ended up with concessions and reform retreats. This
bumpy process illustrated the negotiated nature of banking sector reforms, as well as
the importance of financial sector rents in facilitating a gradual reform path. Without
adequate incentives in exchange for cooperation, financial reforms could become a
political disaster and total failures.
5.8 SUMMARY AND CONCLUSIONS
In this chapter, I reviewed the non-performing loan problem and regulatory
problems in Taiwan’s banking system in the late 1990s. I analyzed a number of major
The Executive Yuan attempted to delay the legislative process o f the Agricultural Finance Act (and
the creation of the promised agriculture bank) by not submitting its own version o f draft law for
legislative reviews (Chinese L.A. Daily News, 2002.12.19).
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139
reforms in the banking sector under the leadership of the Chen Shui-bian government
since 2000.
First, I examined the performance and regulatory environment of the banking
sector. Focusing on the NPL problem, I identified the overall supervisory loopholes in
terms of information transparency and related-party lending. I argued that the delays
in closing those supervisory loopholes and reforming CDFAs, were due to the
existence of a KMT-centered collusive, rent-seeking network. These delays, together
with the bust of the bubble economy, attributed to the shift of the rent types from
profit-oriented rents toward loss-induced rents.
Second, I reviewed the major reform achievements, including the
establishment of the Restructuring Trust Corporation (RTC), financial holding
companies (FHCs), and asset management companies (AMCs). I found out that these
achievements were mainly incentive-based, market-conforming reforms. The
establishment ofFHCs and AMCs allowed banks to pursue profit-oriented rents in the
forms of tax benefits, cross-selling revenues, indirect subsidization through the
housing market, and “NPL-recycling” opportunities. I pointed out that the FHC and
AMC reforms were successful because they offered substantial tangible benefits to the
banking sector.
Third, I discussed the unsuccessful attempts in expanding the RTC,
establishing the Financial Supervisory Council (FSC), and reforming agricultural
finance. The drawbacks in the FSC and CDF A reforms, contrasting to the incentive-
based FHC and AMC reforms, illustrated the extreme difficulty in pursuing a “stick-
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only” reform policy. The FSC reform is crucial to strengthen and integrate the
government authorities’ capabilities in supervising the financial sector; however, this
regulation was delayed for several years by the power politics involving the
government itself, political parties, and local factions. The drawback in the reform of
CDFAs was due to the absence of positive incentives in the reform measures. The
“stick-only” reform strategy toward basic financial institutions was unfeasible because
those highly networked associations were capable of acting politically and
collectively to demand “carrots” and avoid “sticks”.
The contrasting results between reform achievements and drawbacks
demonstrated the importance for the government of creating positive incentives and
adopting a “carrot-and-stick” strategy for reforms. This strategy can also allow the
government to effectively cope with the various groups that were affected by the
reforms. I found out that various groups such as local factions, farmers’ and
fishermen’s associations, and bank employees sought aggressively to secure the
benefits (job security and retirement pensions) they had enjoyed. The new
government made substantial concessions to satisfy those demands. These findings
lent support to my argument that the constraint of individual rationality (i.e., no
politically powerful groups shall be hurt by the regulatoiy changes) is a crucial
political constraint in the process of financial reforms.
Fourth, I analyzed the establishment ofRTC and the drawback in trying to
expand its funding base. While NT$140 billion was acceptable, NT$1 trillion was not.
This outcome reflected the negotiated nature of reforms in determining the scale and
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141
scope of government intervention in the banking sector. The crisis-hit South Korean
government adopted a centralized approach with the provision of government fiinding
equal to 22 percent of GDP to proceed a systemic restructuring of its banking sector.
The Korean financial crises of 1997-1998 served as painful but unprecedented
opportunities for the Korean government to get on with needed reforms and
commitment of public resources. In this regard, the Taiwanese government had to
work on the structural reforms with the absence of a devastating banking crisis.
Fifth, I found out that market-conforming reforms (the FHC and the
decentralized AMC mechanisms) resulted in widened gaps of profitability, capital
adequacy, and asset quality between the group of FHC-affiliated banks and the group
of non-FHC banks and basic financial institutions. In addition, there was little sign
that weak, non-FHC financial institutions could resolve the NPL problem by
themselves. Moreover, this dichotomizing trend was anticipated to continue, and the
weak group would not exit the market without government intervention. Delays in
addressing this problem would only make it worse and the inevitable restructuring
efforts more costly. These findings lent support to my argument that both government
intervention and market-conforming measures are needed for the structural reforms
and consolidation of the banking sector.
Last but not the least, I found out that fundamental changes in the political
system dramatically altered the governmental attitude and actions toward the
resolution of problems in the banking sector. The removal of the provincial level of
government paved the way for the long-delayed privatization of State-owned banks.
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The new government’s commitment to structural reforms was attributable not only to
the seriousness of the problems in the banking system but, more importantly, to the
shifting of power in the political system. The shift in power allowed the new
government, one not so deeply embedded in the existing problems, to try to
aggressively move Taiwan out of the mess of four decades of one-party domination
by the KMT.
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CHAPTER SIX
ANALYSIS OF TAIWAN’S PATH TOWARD BANKING SECTOR
LIBERALIZATION
This chapter aims to provide an analysis of Taiwan’s banking sector
liberalization presented in Chapters Three to Five. I start with an analytical summary
of the three preceding chapters. Then I connect the findings with the model presented
in Chapter Two.
6.1 ANALYTICAL SUMMARY OF CHAPTERS THREE TO FIVE
In Chapter Three, I reviewed the structural characteristics of the banking
system in Taiwan during the 1970s and 1980s. Under President Chiang Ching-kuo’s
developmentalist authoritarian leadership from the mid-1970s to 1987, the KMT
controlled both the political system and the financial system. The banking sector was
very restrictive and characterized by State monopoly, institutionalized autonomy of
the central bank, and the existence of an active informal credit market. The
government acted like a conservative guardian over the restrictive banking system, I
identified various types of financial sector rents and pointed out that the dominant
type was interest rate-based rents. The Chiang Chin-kuo government controlled the
interest rates and created profit incentives for the banks to expand their deposit bases.
In order to promote economic growth, the Chiang government also adopted a number
of preferential loan programs for exports, machine-imports, medium and small
businesses, and the establishment or advancement of strategic industries. In short, the
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role of financial sector rents in the Chiang Chin-kuo period was to promote economic
growth. Rent-seeking activities were limited to the local level.
I also analyzed how powerful capitalists attempted to influence the Chiang
government to deregulate the banking sector. In the case of the Tsai family, their
attempts at power brokering ended up backfiring, with a crackdown on the family’s
political network and tightened regulations resulting. This reflected the strength of
State autonomy under the developmentalist party-State, which was capable of taking
decisive action to manipulate the political system and the financial system.
To sum up, it was found that under the Chiang Ching-kuo’s leadership the
deregulation of the banking sector was very limited. The government had great
control over the banking sector and set the interest rate spread as financial sector rents
to motivate the bankers to perform.
In Chapter Four, I discussed the banking sector liberalization policies under
President Lee Teng-hui’s leadership from 1988 to 2000. The institutionalized
autonomy of the central bank was basically intact, while the banking sector underwent
deregulation and witnessed expansion and intensified competition. It was found that
the substantial financial deregulation was taken place without adequate strengthening
of the supervisory capabilities over the domestic banks. I explained that the KMT,
facing increasing political competition from the Opposition/Democratic Progressive
Party (DPP), leveraged the financial deregulation process for political support and the
expansion of its own enterprises. The KMT itself became a major rent-seeker and
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colluded extensively with local factions and big business groups. I identified the
dominant type of financial sector rents in this period as relational finance.
I pointed out that the overall autonomy of the Lee regime was weakened as a
result of political and economic liberalization as well as the emergence of the KMT-
centered, broad-based rent-seeking network. I explained that the KMT’s reliance on
local factions made it difficult for the Lee government to pursue structural reforms
and to close rent-seeking loopholes. I also highlighted how relational finance
gradually resulted in a debt accumulation process, a shift of rents from profit-oriented
to loss-induced, and a troubled banking system that dipped into a near-crisis situation.
In sum, Lee Teng-hui was portrayed as a political leader who leveraged financial
liberalization for his political gains.
In Chapter Five, I reviewed the reform efforts undertaken by the new (Chen
Shui-bian) government from 2000, when the DPP finally upset the KMT’s stronghold
on political power in Taiwan. The new government’s commitment to structural
reforms was attributable not only to the seriousness of the problems in the banking
system but, more importantly, to the shifting of power in the political system. The
shift in power allowed the new government, one not so deeply embedded in the
existing problems, to attempt to move Taiwan out of the mess of four decades of
KMT cronyism.
The focus of banking sector liberalization in this period was on restoring
regulatory, financial, and operational soundness to the banking system. I examined the
major achievements in the establishment of the Resolution Trust Corporation (RTC),
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146
financial holding companies (FHCs), and asset management companies (AMCs). I
also reviewed reform drawbacks in the expansion of RTC, the establishment of
Financial Supervisory Council (FSC), and the reform of agricultural finance. I
explained that the unsuccessful reforms of FSC and agricultural finance were
attributable to the absence of positive incentives in them. By contrast, the FHC and
AMC reforms were successful because they offered market opportunities and tax
benefits. These contrasting results demonstrated the importance for the government of
creating positive incentives and adopting a “carrot-and-stick” strategy to effectively
cope with the various groups that were affected by the reforms.
I highlighted that the dominant type of financial sector rents in the period of
structural reforms was and will be governmental compensation for the losses
recognized in bank restructuring. The questions were whether the bureaucracy had the
ability to implement effectively its reform plan, as well as whether the scale and
measures of reforms were justifiable and approved by the legislature. I emphasized
that market-conforming reform measures (i.e., the establishment of FHCs and AMCs)
intensified the trend of dichotomization in the banking system between FHC-affiliated
banks and those without FHC affiliation. The success of structural reforms in the
future will depend on how the government copes with basic financial institutions and
banks without FHC affiliation.
In sum, Taiwan’s path toward banking sector liberalization was interwoven
with the process of political democratization. The interaction between the political
system and the banking sector was thus critical for the understanding of the whole
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picture. Political democratization reduced the state autonomy from social forces and
rent-seeking influence. The main theme of financial liberalization became a process of
negotiations with and compromise to a number of players related to the banking sector.
The interplay among those players ultimately determines the general character of
reform policies and outcomes.
Table 6.1 encapsulates my analysis of the Taiwanese case from Chapters
Three to Five.
Table 6.1 Taiwan’s Path Toward Banking Sector Liberalization: An Analytical
President/Leader
Chiang Ching-kuo
(1978-1988)
Lee Teng-hui
(1988-2000)
Chen Shui-bian
(2000-present)
Political System
Authoritarian
party-State
Democratic initiation
Democratic
consohdation
State Autonomy
- bureaucracy
- bargaining power
- political support
Strong
Strong
Strong
Strong
Strong/Medium
medium
Strong
strong/medium
Medium
Medium
Medium
Medium
Banking System
Restraint Deregulation Re-regulation
Liberalization
Strategy
Restriction
Collusive
deregulation
Carrot-and-stick;
Market-conforming
Regulatory reforms
Regulations tightened
(1985)
Markets opened
(1989)
Integration and
Consolidation
(2001)
Dominated Rent Type
Interest rate spread Relational finance Loss
compensation
Level of Rent-seeking Local/Medium National/High National/Medium
6.2 CONNECTING EMPIRICAL FINDINGS WITH THE MODEL
A simple model is developed in Chapter Two to capture the interplay between
the government and the bankers. The model is meant to be heuristic rather than
general. In this session I intend to access to what extent does the Taiwanese case fit
into the model’s assumptions and propositions.
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First, the banker’s and the incumbent’s utility functions^^ represent the
preferences of each player. The incumbent is assumed to prefer liberalization but is
subject to the rent-seeking influence from the banker. The banker is assumingly a rent
seeker, maximizing the sum of rents and operational incomes. Empirically, the
Taiwanese government pursued banking sector liberalization since the early 1980s,
and the path was permeated with rent-seeking influence. Lee Teng-hui used the broad-
based rent-seeking network to enhance his political support. Chen Shui-bian was also
subject to the rent-seeking forces and had to make substantial compromise while
pursuing regulatory reforms in the banking sector.
Second, the parameters in the banker’s and the incumbent’s utility functions
capture the politico-economic characteristics of financial liberalization. The C(a)
function, for example, represents the incumbent’s cost of rents (a). It is assumed in the
model that the first and second derivatives of the C function are positive, implying the
increasing marginal costs of rents. In other words, it means that the higher the existing
rents, the more difficult for the government to make another increase in rents. The
Taiwan’s case fitted with this assumption if only the interest rate spread is considered
as rents. Taiwan’s banking sector witnessed a gradual reduction in interest rate
spreads after the money market was established in the late 1970s and the interest rate
control was gradually removed in the 1980s.
However, the financial sector rent, in its broad definition, accumulated
throughout the 1980s and 1990s in other forms. Rents in the forms of relational
” Please refer to Equations 2.1 and 2.2 in Chapter Two, page 43.
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finance and compensation for losses rose as the interest rate spreads reduced. This
empirical finding gave us an insight to re-interpret the C function in the model. The C
function, in fact, represents the incumbent’s cost associated to the “tangible” part of
financial sector rents. In the period of Lee Teng-hui, the damages of relational finance
were not so tangible to the public until the Chang-hwa Fourth Credit Cooperative
crisis in 1995 and the Asian financial crisis in 1997-98.
In the period of Chen Shui-bian, the government was required to provide
funding to compensate for the losses accumulated in the banking sector in the forms
of capital inadequacy, non-performing loans, and bad debts. The financial sector rent
in the form of loss compensation was on the public’s eyes because the budget required
the legislature’s approval. It became very difficult for the legislature and the public to
approve such a huge amount of money to be put into the bankers’ pocket. This
reflected that the new government might be associated with a new C function.
Third, in the incumbent’s utility function, the (m^E) represents the benefit the
incumbent perceived from the rent-seeking transfer provided by the banker. The PE
represents the rent-seeking expenditures used for political engagement, and the m is a
coefficient. In the period of Chiang Ching-kuo administration. President Chiang
adopted various ways to confine rent-seeking activities of local factions. The officials
at the central bank and the Ministry of Finance could hardly be bribed. The Cathay
and the Tenth Credit Cooperative crises demonstrated the will of Chiang to
crackdown the attempt of capturing the financial policies by a few capitalists. The
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conservative financial policies and measures were adopted to insure financial stability.
Hence, it was found that the rent-seeking expenditures were low.
In the period of Lee Teng-hui, however, the rent-seeking forces increased, and
it also became much easier for the factions and capitalists to influence the government
and to grab financial sector rents fi"om the public and private financial institutions.
The most common way for the faction elites to capture rents was to use their relations
(with the KMT, the government, and the financial institutions) and get preferential
loans. These loans were based mainly on relations but not on the merits of projects or
the ability of repayment. Those loans might be put into profitable projects and become
value-enhancing, or be spent on political campaigns as rent-seeking expenses and
become economically and socially wasteful. It was very difficult to estimate the
amount of this type of rents because it involved the application and loan-granting
procedure as well as quality of loans.
The emergence of a broad-based rent-seeking network among the KMT,
industrial capitalists, and factions implied that the rent-seekers could be more
“efficient” in grabbing the financial sector rents. Through the network, rent-seekers
could get political loans more easily than before and at lower cost. Besides, the rents
in the form of relational finance were harder to be detected by the public. This was
particularly true while the banking sector underwent deregulation. New markets and
financial institutions were established in the name of deregulation, but the adequate
supervision, governance, and accountability mechanisms were not in place. In
addition, some critical reform projects were delayed, including the reforming of basic
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financial institutions, the privatization of State-owned banks, and the implementation
of information transparency in the banking sector. As a result, the banking sector was
accumulating not-performing loans and bad debts, and many industrial groups hided
the losses off their balance sheets until the liquidity problem emerged.
In the Chen Shui-bian’s era since the year 2000, the government made
substantial efforts to enhance the information transparency and operational
accountability in the banking sector. New standards of classification and reporting of
non-performing loans were implemented. In addition, the investigation and
prosecution of financial crimes were prioritized. Moreover, due to the fact that many
basic financial institutions were deeply associated with rent-seeking problems and
local factions, the government undertook measures to reform basic financial
institutions: two waves of compulsory takeover of problematic ones and the
unsuccessfiil attempt of reforming the regulations governing basic financial
institutions. These efforts, nevertheless, represents the government’s intention to
make it more difficult for the rent-seekers to capture financial institutions and grab
rents.
Fourth, the collusion proposition developed in Chapter Two suggests that, if
the collusion conditions based on individual rationality are met, the financial rents and
rent-seeking activities will be persistent in the country undergoing banking sector
liberalization. The Taiwanese case of banking sector liberalization supports this
proposition. Banking sector deregulation after the late 1980s witnessed rent-seeking
collusion between politicians and bankers. In addition, the main theme of structural
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reforms under the Chen Shui-bian leadership was, using the concept of collusion, to
reduce the collusion set. The government provided new regulatory framework (that is,
the financial holding company regulation) to promote innovation and integration in
the banking sector. All of those reform efforts by the Chen Shui-bian government can
be interpreted as the attempt to alter the parameters in the incumbent’s and the
banker’s utility functions so as to make it more attractive for the banker to invest in
operational improvements rather than rent-seeking engagements. Specifically, the
financial holding company and asset management company regulations resulted in
increases of overall profitability (i.e., p) as well as returns on technological
improvement (i.e., k) in the banking sector. In addition, to prevent the moral hazard
problem of “betting for resurrection” and to enhance the international competitiveness
of domestic banks, the Ministry of Finance used the strategy of “carrots and sticks” to
direct domestic banks to meet the requirement of capital adequacy. Banks lacking
capital adequacy were disciplined by a number of operational restrictions, while
sufficiently capitalized banks were rewarded by less control on their business
expansion and product innovation. Problematic financial institutions were also subject
to compulsory takeovers under the regulation of Resolution Trust Corporation. The
exit of weak financial institutions from the market will presumably enhance the
profitability of the existing strong ones.
Fifth, scholars in the field of regulatory rents and rent-seeking pointed out the
difficulty and complexity to analyze and estimate the quantitative linkages between
rent-seeking expenditures and rents. One way to overcome this difficulty is to
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153
simplify the analysis by using models to discuss some scenarios that are most
representative and informative. This study followed the research strategy used by
Shleifer and Vishny (1998) assuming that the regulator and the regulated sector
internalized their collusive interactions and pursued their joint utility. This study
followed the work of Shleifer and Vishny and made the coalition proposition
representing the scenario that the incumbent and the banker pursue their joint utility
with the assumption that the individual utilities are fully transferable. The coalition
proposition suggests that, in the process of banking sector liberalization, the
incumbent and the banker might form a rent-seeking coalition and pursue the
maximization of the joint utility. This would result in the increase in the amounts of
rents and rent-seeking expenditures above the levels prior to liberalization. This
implies that rent-seeking activities may be more intensive than the situation under
financial restraint.
The coalition proposition is supported by the Taiwanese case. The politics of
deregulation played by Lee Teng-hui illustrated the emergence of a rent-seeking
coalition among the dominating political party (KMT), local factions, and industrial
groups. The lifting of ban on the establishment of new banks since 1991 created
opportunities for the KMT politicians, local factions, and business elites to
“cooperate” in forming new banks. In the 1990s, the KMT also aggressively expanded
its ownership and network in business enterprises. In 1998, the KMT owned three
banks, three securities companies, and many enterprises in a wide range of industries.
Those companies and enterprises enjoyed privilege simply because the KMT had
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154
privileged access to the governmental information, policy-making process, and
resources. Moreover, the government delayed the reform of basic financial institutions,
despite that more and more basic financial institutions were increasingly captured by
local factions as “cash cows”. Basic financial institutions thus became a major rent-
seeking field. It was thus argued that deregulation gave the KMT opportunities to
form a KMT-centered rent-seeking coalition and to benefit itself from economic gains
and political support.
Sixth, the existence of an incumbent-banker rent-seeking coalition makes it
difficult for the incumbent to reform the banking system. It is because the incumbent
relies on the coalition for political support and the political ties are very difficult to be
untied. As a result, the rent-seeking coalition tends to delay reform attempts and result
in continuous deterioration of the operational and financial soundness of the banking
sector. The crisis proposition thus suggests that the coalition’s rent-seeking activities
be unsustainable and prone to crises. This proposition is similar to the structural
rigidity argument (Moon and Rhyu, 2000).
The Taiwanese case lent support to the crisis proposition. In Chapter Five I
provided evidence on loopholes in supervising relational finance, non-performing
loans, and basic financial institutions. In addition, the 1990s witnessed a continuous
deterioration of financial soundness in domestic banks (Table 5.2). In 1995, the
Chang-hua Fourth Credit Cooperative scandal triggered a near systemic crisis with a
total of sixteen runs on credit departments of farmers’ and fishermen’s associations.
This dramatic incidence shocked the Taiwanese government and the whole society.
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155
However, the reform of basic financial institutions was not advanced until Chen Shui-
bian became the President. To the contrary, the Lee Teng-hui administration made to
local factions a number of concessions on the governance of basic financial
institutions so as to exchange for the local factions’ support in major elections. The
increasing rent-seeking activities and the delay in banking sector reforms were main
causes to the “home-brewed” financial crisis since the second half of 1998 (Huang,
1999). The Lee Teng-hui administration created a broad-based rent-seeking coalition
that drove the domestic financial sector into debt accumulation and banking crises.
Those crises, in turn, shocked the public’s confidence in Lee Teng-hui’s leadership.
The Taiwanese path toward banking sector liberalization demonstrated the dialectic
interplay between economy and politics. Financial crises served as shocks to the
political system and resulted in shift in power, which implied the removal of major
obstacles for major reforms in the financial system.
In summary, this study developed a simple game-theoretical model to capture
the strategic interactions between the incumbent and the regulated sector in the
process of banking sector liberalization. The Taiwanese case supported the model’s
assumptions and propositions. The study of the Taiwanese case also advanced the
understanding of the interplay between banking sector liberalization and political
democratization. Nevertheless, the Taiwanese case demonstrated that political
processes of negotiations and confrontations are very complicated and a two-player
model might not be able to capture the complexity of the interactions among the
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156
major players involved in the liberalization process. This requires further research and
modification of the model.
6.3 CONCLUSIONS AND DISCUSSIONS
In this chapter, I provided analytical summaries of the preceding three
chapters on the empirical processes of Taiwan’s banking sector liberalization. I also
made connections between empirical findings and the model I developed in the study.
It is suggested that the empirical findings support the model’s major assumptions and
propositions.
This study found out that Taiwan liberalized the banking sector within the
confines of State autonomy. This explained why the Taiwanese path toward banking
sector liberalization was smoother than other countries’ experiences such as Mexico
with the context of substantial decline of State autonomy. In fact, financial
liberalization and political liberalization in Taiwan began simultaneously in mid
1980s. This study found out that major changes in the political arena often led to
policy changes in the path toward financial liberalization. Although it is difficult to
thoroughly evaluate the importance of presidency with regard to financial
liberalization, it is emphasized in this study that President Lee Teng-hui has played a
critical role in the banking sector liberalization process.
The focus of this study is not on the debate of whether the developementalist
Taiwan should liberalize its banking system. Rather, the relevant question is why
Taiwan experienced a gradual liberalization path with certain “turning points” at the
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1 5 7
junctures of presidency. This study tried to answer this question by analyzing the
nature of Taiwanese State autonomy and the changes in the relationships between the
government and the banking sector. It is found that the State autonomy remained
relatively intact throughout the last twenty years of liberalization, and this might be
attributed to the historically endowed institutional arrangements regarding the
authority and governance of the central bank, as well as the State’s ownership in the
banking sector. In addition, the turning points in banking sector liberalization are
analyzed from the aspect of domestic politics, and it is found that major changes in
the domestic political sector substantially altered the settings of the game played out
in the process of banking sector liberalization.
This study found that the role of financial sector rents changed over time, from
the promotion of economic growth prior to banking sector liberalization, to the
exchange for political support by local factions and industrial groups during the
period when the banking sector was liberalizing and Lee Teng-hui was the President,
and to the facilitation of restructuring in the banking sector after the Asian financial
crisis and Chen Shui-bian became the President. In fact, the changing forms and roles
of rents reflected the dynamic relationships between the State actors and the private
actors in the banking system. On the one hand. The Taiwanese case demonstrated the
continuity of the process of gradual liberalization. On the other hand, such a
continuous process witnessed discontinuities associated with major changes in the
political sector. The Taiwanese case thus enriched the understanding of the political
functions of financial sector rents.
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158
CHAPTER SEVEN
CONCLUSION
7.1 LESSONS LEARNED
This study began with two related questions that why Taiwan’s banking sector
liberalization since the late 1980s has emphasized deregulation without
simultaneously strengthening the supervisory and regulatory infrastructure, and how
the Taiwanese government was able to obtain the needed capabilities for the reform of
the banking sector and prevention of a systemic crisis from happening. It is found that
the characteristics and institutional arrangements of the pre-liberalizing banking
system were crucial in determining the capabilities and constraints of the Taiwanese
State in governing the process of banking sector liberalization. Prior to liberalization,
the Taiwanese banking system was characterized by conservative monetary policies,
strong autonomy of the central bank. State ownership of the formal banking sector,
and an active informal curb market. These features provided the Taiwanese
government with strong capabilities in relaxing its control of the banking sector and
pursuing financial liberalization with substantial stability.
One important conclusion that emerged from my analysis is that the timing,
sequencing, and measures of the major regulatory reforms in the banking system were
to some extent attributable to major changes in the political system. The banking
sector deregulation came immediately after Lee Teng-hui became the President and
succeeded in the political battle against the conservative group within the Kuomintang
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159
(KMT, the nationalist party). Privatization of State-owned banks was delayed for
years, until the provincial level of government was being eliminated. Also,
comprehensive structural reforms came after the power shift from the KMT to the
Democratic Progress Party (DPP). These findings reflect the view that embedded
State autonomy was significant, and they verify the political contingency view of
financial liberalization. It would be interesting to apply this political contingency view
to a comparison of the Taiwanese case with other cases and to an analysis of path
dependence in terms of how political reforms lead to financial reforms.
Another significant value of my study is that it presents the possibility of using
game theory modeling techniques to capture the rent-seeking dynamics in banking
sector liberalization and to explain why liberalization is prone to debt accumulation
and systemic crisis. For one thing, my study incorporates insights from theories of
regulation into a game theory model. The model fits well into the empirical analysis
of the Taiwanese case. The model can also serve as a useful tool for further cross
country quantitative/qualitative comparative analyses on banking sector liberalization.
Secondly, my study broadens the scope of financial sector rents and enriches the
understanding of the role of rents in the liberalization process. My study emphasizes
how the types and sizes of financial sector rents may change from one period to
another as the liberalization process continued. The Taiwanese case showed that
deregulation resulted in a shift of the types of financial sector rents from interest rate
spread to relational finance and subsequently to loss compensation. I estimated that
the interest rate-based financial sector rents in the period of financial restraint was
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160
about 4-4.5 percent of total outstanding loans. It was also estimated that
approximately NT$1 trillion of government funding was needed to restore the
financial and structural soundness of the banking system. The loss-induced rent of
NT$1 trillion represents 7.6 percent^^ of the NT$13.2 trillion outstanding loans in the
banking sector.
My analysis of the Taiwanese case suggested that the emergence of a broad-
based rent-seeking network was a main factor accountable for the near-systemic-crisis
situation in Taiwan since 1998. The State’s autonomy gradually declined along with
the liberalization process. The government found it increasingly difficult to exercise
the discretionary power it used to enjoy. Interventions increasingly required
institutionalized legitimacy. The reason that Taiwan actually prevented a systemic
crisis was attributable to the historically conservative orientation of its monetary
policies, the institutionalized autonomy of the central bank, and the State ownership in
the banking sector. These characteristics allowed the Taiwanese government to
maintain a relatively high degree of bargaining power over the private sector, despite
the fact that the KMT regime was trapped in a rent-seeking network. The private
sector in Taiwan was more decentralized than that of Japan or Korea. In this regard,
Taiwan benefited from a relative strong State capacity and a weak private/business
sector.
It is noted that the interest-rate spread represented an annual income for the banking sector, while the
government’s loss compensation to the banking sector was estimated as a one-time assistance.
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161
7.2 THE TAIWANESE CASE IN COMPARATIVE PERSPECTIVE
From Taiwan’s standpoint, one of the most important and interesting
comparative questions is that of how the Taiwanese government can prevent Taiwan
from following the Japanese path and, instead, solve the problems in the financial
system in an effective and prompt way. My study of the Taiwanese case emphasized
the importance of State autonomy and financial sector rents, and indicated that
Taiwan has been characterized by a State-dominated, risk-averse banking system, a
decentralized economy, and the KMT’s centralized leadership. By contrast, scholars
have pointed out that Japan had been a country with a privately-owned, relation-based
financial system and economy (Pempel, 1998), as well as a decentralized dominant
political party (Liberal Democratic Party) (Richardson, 1997). Comparing Taiwan
with Japan, Taiwan’s autonomy is higher in its bureaucratic independence as well as
the government’s bargaining power over the private sector. Taiwan and Japan
similarly deregulated their banking systems without structural reforms. However,
Taiwan was different in terms of its relatively decentralized private sector, the less
dense bank-firm relations prior to deregulation, and the practice of more caution in
international capital mobility. All these unique features were evolved in the history of
political and economic development and embedded in the institutional arrangements
of the State. Therefore, comparisons of structural reforms between Taiwan and Japan
must recognize the historical and institutional differences between the two
developmental states.
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1 6 2
With respect to financial sector rents, the Japanese financial system was
characterized by the relation-based “main bank system.”^^ Main banks maintained
ownership and managerial relationships with their corporate borrowers, and the banks
and firms often belonged to the same keiretsu. The relation-based keiretsu and main
bank system played a distributive/re-distributive role in the Japanese economy. The
financial liberalization in Japan opened up the bond market and the euro market, but it
did not touch the linkages between government, banks, and firms (Weare &
Smolensky, 1999). While the banking sector deregulation in Taiwan intensified the
practices of relational finance that sought rents mainly in the domestic economy, the
financial liberalization in Japan resulted in relation-based firms and banks seeking
rents in both the domestic and international markets. The Korean currency crisis of
1998 was also mainly the result of domestic banks imprudently seeking low interest
rates in the international credit market. Therefore, the Taiwanese case can shed light
on a comparative analysis of the relationship between financial sector rents and
liberalization. The success of structural reforms depends critically on the
government’s ability in confining rent-seeking activities and in making financial
sector rents productive.
7.3 COPING WITH THE DICHOTOMIZING BANKING SECTOR
One of the most important issues regarding the future of the structural reforms
in Taiwan’s banking sector was the trend of dichotomization—between the group of
’ ’ ’ ’ Scher (1997) provided a detailed analysis o f Japanese main bank system and the relationship between
the main banks and their firms (Scher, 1997).
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163
strong banks affiliated with financial holding companies (FHC), on the one hand, and
the group of weak banks without FHC affiliation and basic financial institutions on
the other—in their abilities to improve their profitability, asset adequacy, and asset
quality. I argued that the market-oriented FHC reforms and the establishment of the
asset management companies were accountable for the intensification of this
dichotomizing trend. There was a tendency for strong financial institutions to join
FHCs and get stronger, and weak financial institutions to be left behind and get
weaker. However, I pointed out that the group of weak financial institutions was not
insignificant. The majority of the three hundred seventeen basic financial institutions
and at least one third of the fifty-two domestic banks belonged to this economically
weak but politically strong group. Farmers and local faction leaders demonstrated
their capabilities in mobilizing collective action against the government’s reform
measures that attempted to force weak basic financial institutions out of the market.
Therefore, a central question concerning the future of the banking sector liberalization
in Taiwan is the extent to which the issue of banking sector dichotomization is played
out politically.
The Taiwanese case in general supported the market-centered view that the
goal of regulatory reform is to move from a model of state-led economy to a model of
market-led economy (OECD, 1999). This view asserts that efficiency will be the
highest when the developmentalist role of government is minimized. However, my
analysis of the banking sector dichotomization in Taiwan challenges the market-
determinist view. In particular, the problems of non-performing loans and lack of
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164
competitiveness in the credit departments of farmers’ associations can hardly be
resolved by market forces without government intervention. These problems require
the government to play an active role in both the banking sector and the agricultural
industry. First, the government may facilitate basic financial institutions in improving
their competitiveness. Second, the government may try to identify a strategic niche for
Taiwan’s agriculture as the domestic and international agricultural markets opened
under the Iframework of World Trade Organization (WTO), and to assist farmers to
improve their productivity and competitiveness. This requires the government to link
the reform of agricultural finance with the repositioning of Taiwan’s agricultural
industry. Third, the government may provide both “carrots” and “sticks” to facilitate
capacity reduction in the segment of basic financial institutions. All of these tasks call
for the government’s active involvement in searching for innovative and effective
policy measures so that the widening gap between banks and basic financial
institutions can be gradually reduced.
In addition, the government needs to cope with the gaps in operational
capabilities between the FHC group and the non-FHC group. Since the government is
still a major shareholder in the banking sector, the government can be a facilitator,
partner, or sometimes leader in the banking sector to bridge those gaps. Moreover, the
government must monitor carefiilly the economic and financial integration between
Taiwan and the mainland China. All of the aforementioned tasks require the
government to utilize its developmental capacities in coordinating the project of
upgrading and consolidation in the banking sector. Therefore, banking sector
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165
liberalization, at least in the Taiwanese case, does not necessarily imply the retreat of
the developmental State. The liberalization project continues to require the
government to play an active role in the economy.
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Creator Lee, Leemen (author)

Core Title Carrots or sticks: The Taiwanese government's contrasting policy approaches to banking sector liberalization

School Graduate School

Degree Doctor of Philosophy

Degree Program Political Economy and Public Policy

Publisher University of Southern California (original), University of Southern California. Libraries (digital)

Tag Economics, Finance,OAI-PMH Harvest,political science, general

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Permanent Link (DOI) https://doi.org/10.25549/usctheses-c16-517882

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