#3038 - Week 6 Reading The Shanxi Bankers (Morck And Yang, 2010) - Chinese Economic History Since 1850

Empire-wide branch networks

Full array of services similar to Western banks

Most argue a purely Chinese origin i.e. parallel economic evolution

Others argue case of diffusion into Shanxi via Russia

Unique dual class of equity, managerial incentives and contracting arrangements ensured confidence in their bank drafts

• Mitigate very modern governance and agency problems

Li Daquan founded the Rishenchang (Sunrise Provident Bank) in 1823

• After observing silver shipments passing each other in opposite directions

• Saw business opportunity to replace the expensive security, wagons, and pack animals with a clearing house

The first institutions to offer a full range of banking services

Made Pingyao and nearby Qixian and Taigu counties into financial centers

Grew rapidly from 1823 to early 1840s

“During stable times, Confucian hierarchical principles and imperial edicts could enforce agreements”

Law was an insiders’ game of ritual formalism (Djankov et al. 2003; La Porta et al 2008)

Descendants of merchants were barred from civil service exams for 3 generations

Merchants were the lowest class in the Confucian caste hierarchy

Therefore banks needed their own contract enforcement system

Insiders with too few shares have insufficient incentive to maximize shareholder value – divergence of interests problem (Jensen and Meckling 1976)

• Higher insider stakes improve governance

  • Therefore some argue to compensate managers with stock or stock options (Jensen and Murphy 1990)

Large insider equity ownership leads to entrenchment

• Where if insiders or their heirs control enough votes they cannot be displaced even if that are unable to provide good management (Morck et al. 1998; Stulz 1988)

• Therefore insider stakes should be medial in order to balance the divergence of interest problems against entrenchment problems

In modern enterprises, dual class shares general magnify insiders voting power and worsens these opposing problems

• Shanxi banks offered dual class shares but with the opposite configuration, thereby correcting the issue

Grand assessment days were held at the end of each fiscal cycle (3 or 4 years) where capital shareholders decided on dividends, evaluated the performance of the management, and adjusted insiders’ expertise shareholdings appropriately

Capital shareholders had no control over the bank’s daily operations but had unlimited liability (at least until 1904 Civil Code) (Kirby 1995; Goetzmann and Koll 2005)

Managers and employees made no monetary investment in the bank (investment was their expertise)

Insiders received salaries, but these were small, so they relied on their dividends, which ultimately relied on their performance

A third class of shares, called dead shares were used whereby expertise shareholders death or retirement meant that voting rights were removed and dividends were finite

• They expired up to 8 years

If an expertise shareholder quit or was fired for cause, his expertise shares evaporated instantly

Qing China was a society where people mistrusted outsiders

• Large businesses run by professionals were disfavoured (La Porta et al. 1997)

The banks hired only from Shanxi

• Powerful governance mechanism were managers’ expertise dividends were paid to their family in Shanxi

  • Unlimited liability meant that the fate of their family was in the performance of the manager

Background checks and guarantors to ensure loyalty and honesty of the employees

• Also protected them

Carefully written employment contracts

• Capital shareholders even “taking their wives and children as hostage” (Dong 1917; Chen 1937)

Branch employees forbidden to conduct any other business activities including lending their own savings

• Granted no leave, and generally lived away from their family

  • Tight controls over contact

• Motivated hard work and honesty in an economy of endemic corruption

Complicated pension system to ensure that those who worked hard for the shareholders were handsomely rewarded

Consisted of 3 funds:

• Bad state-of-the-world insurance to pay future dividends if an act of God harmed the bank’s earnings

• A fund that paid interest to the capital shareholders and contained their deposits

  • Used for future development and expansion of the bank

• A fund to pay dividends to dead shareholders

Retiring managers had strong incentives to look to the long-run profitability of the bank and to choose and train their successors well

Bureaucrats and the feudal nobility were de facto above the law and could confiscate wealth

• Therefore Shanxi bankers were a prime target

Shanxi bankers and other merchants sought good relationships with important officials

• 1) Directly financed government

• 2) Donations to dynasty in return for honorary titles for their clients (Li 1917) and capital shareholders (Wei 1937/8)

• 3) Spent heavily entertaining officials and nobles, particularly in Beijing branches

• 4) Helped with the transfer of silver after the Treaty of Nanking required China to pay Britain $21 million indemnity in silver

• 5) During the Taiping Rebellion, the government transferred revenues through rebel territory via the Shanxi bankers

• 6) Shanxi bankers financed the movement of the Qing court from Beijing to Xi’an following the 1900 Boxer Rebellion

Shanxi’s best and brightest were well advised to forsake the Confucian civil service for careers in banking