Evaluating financial fragility: a case study of Chinese banking and finance systems

The stability of global financial systems is intrinsically fragile due to their complexities. This inherent fragility poses significant risks, particularly within the banking sector, where instability can trigger wider economic crises and hinder sustainable development. The vulnerability of banking systems is a key aspect of overall financial vulnerability. Several key indicators are commonly used to assess banking system fragility, including non-performing loans (NPLs), return on total assets (ROTA), liquidity ratios, and capital adequacy ratios. These indicators reflect the overall health and resilience of banks and their capacity to withstand shocks. A robust banking system is crucial for smooth economic operations; reducing NPLs, mitigating financial risks, and maintaining efficient bank operations are vital for the stability of China's economy. Extensive research exists on bank fragility, with studies exploring the impact of various factors such as loan interest rates (Yu et al., 2015), liquidity risk (Djebali and Zaghdoudi, 2020), capital adequacy (Hajar and Habib, 2020), and liquidity risk's interaction with competitive pressures (Smaoui et al., 2020). Other studies have examined the influence of asset levels, liabilities, and financial leverage on bank risk (Haan et al., 2020), the effect of credit derivatives (Halili et al., 2021), and the negative impacts of NPLs on lending and bank stability (Serrano, 2021). The positive correlations between bank capital, profitability, and reduced fragility have also been demonstrated (Kanga et al., 2020). Financial system fragility indices are significant due to their strong links to national economies and policymaking. Accumulated financial vulnerability can lead to inevitable crises if not managed effectively, causing significant economic harm. Therefore, effective monitoring and alternative indicators for measuring financial vulnerability are necessary. This paper proposes a new evaluation index to assess financial system fragility in China, focusing on the banking sector and incorporating a range of factors including GDP growth rate, real interest rate, inflation rate, M2 growth rate, cash savings rate, credit growth rate, return on assets, and foreign investment scale. Previous research indicates that factors such as low market concentration, low interest rates, high inflation, and GDP decline can trigger financial risks and vulnerabilities (Laura et al., 2015). Bank business diversification can increase instability (Kim et al., 2020a, 2020b), and tight monetary policy can contribute to financial fragility (Sushanta and Ricardo, 2013). Macroeconomic conditions, wealth distribution, regulatory policies, and foreign trade all influence financial system stability (Fabio and Claudio, 2014; Mitkov, 2019; Danilo, 2020; Georgiadis and Zhu, 2021). This study contributes by proposing a novel evaluation index and applying it to assess the fragility of the Chinese banking system using cross-sectional data on 15 banks, analyzing the indicators of ROTA, liquidity ratio, capital adequacy ratio, and NPL ratio. It also uses longitudinal data to calculate the overall financial system fragility score from 2007 to 2022, analyzing the impact of economic conditions on the overall system.

The paper reviews a substantial body of literature on financial fragility, focusing on the role of various factors in assessing bank vulnerability. It highlights studies examining the impact of loan interest rates, liquidity risk, capital adequacy, and the competitive pressures on bank stability. The literature also covers the influence of asset levels, liabilities, financial leverage, credit derivatives, and the negative effects of non-performing loans. The positive relationship between bank capital, profitability, and reduced fragility is noted, along with the importance of financial system fragility indices in economic policymaking. The authors mention previous research on the interplay of factors such as market concentration, interest rates, inflation, and GDP growth in triggering financial risks and vulnerabilities. The influence of bank business diversification, monetary policy, macroeconomic conditions, wealth distribution, regulatory policies, and foreign trade on financial system stability is also discussed, setting the stage for the proposed methodology.

The study employs factor analysis, a statistical method used to identify underlying factors among a set of observed variables. The primary goal of factor analysis is to reduce the dimensionality of data by grouping correlated variables into fewer, unobservable factors. The authors apply this technique to assess the fragility of the Chinese banking system using four indicators: ROTA, liquidity ratio, capital adequacy ratio, and NPL ratio. Before performing factor analysis, the data were standardized, and transformations were applied to ensure that lower scores indicated better performance (i.e., lower fragility). The Varimax rotation method was used for factor rotation to enhance the interpretability of the factors. Three principal components were extracted, collectively explaining 92.88% of the variance. The methodology then extends to analyze the financial system fragility at a broader level using four subsystems: (A) Economic and environmental fragility (B) Financial market early warning fragility (C) Financial monitoring fragility (D) Financial outward-oriented fragility. Each subsystem is comprised of multiple indicators (see Table 1). The degree of fragility for each subsystem is calculated using formula (2), which involves averaging the numerical values of each index within the subsystem. A weighted average, using formula (3), is then applied to combine the subsystem scores into a composite financial fragility index (FFII). The weights assigned are 1 for the economic and environmental subsystem, and the financial outward-oriented subsystem, and 2 for the financial market early warning, and the financial monitoring subsystems. The data utilized for this analysis are sourced from multiple official sources, including the China Statistical Yearbook, China Financial Yearbook, China Macro Statistics Database, and the National Bureau of Statistics. The overall financial fragility level for China is then calculated over the period 2007-2022.

The analysis of bank fragility in 2018 reveals that the Bank of Ningbo exhibits the lowest fragility score, primarily due to its higher ROTA, capital adequacy ratio, and lower NPL ratio. Conversely, China Minsheng Bank displays the highest fragility score, attributable to a lower capital adequacy ratio and a higher NPL ratio. Figure 1 provides a graphical representation of the fragility levels across the 15 banks, showing a clear range in vulnerability. The analysis of the overall financial system fragility from 2007 to 2022, presented in Figure 2, reveals three significant periods of increased fragility: the first, from 2007-2009, is attributed to the global financial crisis and associated regulatory challenges; the second, in 2015, reflects substantial financial market volatility; and the third, coinciding with the COVID-19 pandemic from 2019 onwards. Figures 3, 4, 5, and 6 present the trends for each of the four subsystems: economic and environmental fragility, financial market early warning fragility, financial monitoring fragility, and financial outward-oriented fragility respectively. In terms of the economic and environmental fragility, the trends show a period before 2011 mostly within the 'normal' range and a shift to 'safe' after 2011. The financial market early warning fragility index indicates significant fluctuations, corresponding to periods of heightened risk. The Financial monitoring fragility shows relatively low levels, generally within the safe range from 2007 to 2022, indicating effective regulatory oversight. Finally, the financial outward fragility indicates a decreasing trend over the studied period but remaining in the normal range.

The findings highlight the importance of considering both micro-level (individual bank) and macro-level (overall financial system) perspectives in evaluating financial fragility. The substantial variation in fragility scores among Chinese banks underscores the need for differentiated regulatory approaches and targeted risk management strategies. The identified fluctuations in overall financial fragility, linked to major global and domestic economic events, demonstrate the interconnectedness of financial systems and their sensitivity to external shocks. The relatively stable trend observed in financial monitoring fragility suggests the effectiveness of regulatory efforts and prudent fiscal and monetary policies in maintaining stability. Conversely, the observed fluctuations in financial market early warning fragility emphasize the continued need for robust early warning systems and proactive risk management measures. The findings emphasize the value of a comprehensive evaluation index system incorporating diverse factors influencing financial system fragility.

This study provides a comprehensive evaluation of financial fragility in China's banking and financial systems using a novel index system. It highlights the vulnerabilities of individual banks and identifies critical periods of increased system-wide fragility, offering valuable insights for policy formulation. The study recommends proactive policy measures focusing on thorough market investigation for policy development, prudent use of economic means, transparent policy implementation, effective communication with market entities, and careful risk assessment in bank non-interest income business development. Further research might explore regional financial risk management, stability of financial markets, and the impact of financial market stability on financial vulnerability.

The study acknowledges several limitations. First, it notes that the depth of analysis regarding the stability framework of China's banking system could be enhanced. Second, it recognizes that data limitations may have affected the construction of the indicator system. Third, due to the pre-pandemic focus, future research should incorporate data covering the period after the pandemic to provide a more comprehensive understanding of the financial system's resilience and adaptability in the face of unprecedented events. The selection of 2018 data as a representative year may not fully capture dynamic shifts in bank fragility.