Chinese Banking Gets a Freer Hand

China’s chronic capital problem appears to be easing, which should boost the world’s second-largest economy and cheer emerging market investors.

Thanks to state involvement in the country's banking sector, state owned enterprises (SEO) are enjoying much easier access to capital. But this improved capital flow has primarily left non-state owned small- and medium-sized businesses out in the cold in terms of getting loans. It also has given rise to a huge shadow banking sector that the government is now trying to rein in.

In February, the People's Bank of China (PBOC) and other regulatory agencies discussed new rules for unofficial lenders, such as the upstart wealth management firms that have been popping up across the country. The PBOC also conducted a “reverse repo” operation that drained liquidity from the country's financial system, leaving less capital available for lending while also causing a jump in interest rates in order to price some participants out of the market.

A few days ago, the government announced the next step in the process. Under a pilot project, five banks owned entirely by private companies will be created in Shanghai and Tianjin and in the provinces of Guangdong and Zhejiang.

Zhejiang Alibaba E-Commerce Co., a subsidiary of Alibaba (Hong Kong: 1688) which operates the country's largest e-payment system, will partner with automobile parts manufacturer Wanxiang Group to create a bank using a "small deposit, small loan" model. Each client's deposit with the bank will be capped and the amount they're allowed to borrow will be capped, allowing Alibaba to tap into its huge user base of mostly small businesses.

Social networking company Tencent Holdings (Hong Kong: 0700) will partner with Baiyeyuan Investment to create a "big deposit, small loan" bank, requiring minimum deposits to open an account while capping loan sizes.

! Financial company Tianjin Shanghui Investment and copper producer Huabei Group are pairing up to create a bank to serve only corporate clients.

The strategy to be used by the remaining two pairs – investment companies JuneYao Group (which also operates an airline) and Fosun International (Hong Kong: 0656), and electrical equipment maker Chint Group and chemical company Huafon Group – has yet to be released.

The new banks aren't a done deal yet; final approvals must be issued by the China Banking Regulatory Commission (CBRC) before they can open for business. The regulator has said that each of the banks must demonstrate financial strength and the ability to absorb losses, be controlled by Chinese nationals with most of their assets inside China and they can’t incorporate in a tax haven. All of their banks will also be subject to the same regulations as the country's large, state owned banks but have a mandate to focus their services on small businesses and residential communities.

The program is a tacit acknowledgment that as currently constituted, the country's banking system is rife with inefficiencies and biases. But true to Chinese form, rather than instituting a massive overhaul the country is experimenting with different forms of banking institutions and seeing what works best. And while government interference in the capital markets is one of the main reasons that many of the country's problems have emerged, such as a huge level of questionable private debt, the level of government control is what allows such an incremental approach.

In addition to the new banks, the government has also said that it plans to introduce a deposit insurance system to protect consumers against bank failure and each bank will be required to produce a plan for an orderly wind down in case of trouble.

Shang Fulin, president of the CBRC, has also said that banks will be given more freedom to set interest rates this year with the goal of allowing nearly total autonomy t! o set dep! osit and lending rates within two years.

These reforms are in keeping with the government's desire to create a more consumer oriented economy. With small and medium sized enterprises accounting for more than half of the jobs in the country, particularly in the interior provinces where Beijing's control isn't quite as absolute, allowing market forces a greater role in the economy will ultimately generate more productive growth.

The fact is, an improving standard of living is about all that allows the Chinese Communist Party to maintain its legitimacy and power. If the country's economy stalls, unrest is much more likely. So while China is nowhere close to becoming a truly free and open society, each step to greater economic inclusivity opens the door just a little wider.