Innovation: Learning from China’s Banking System

Wouldn’t it be great if you could walk into your local bank branch not to get a loan to help fund your new business idea but to get an equity investment? You wouldn’t have to mortgage your house to get the money. Instead, you would only need a great idea and a business plan showing how you would make your idea work.

A new type of American bank should be created to fulfill such a need. The U.S. government may want to take a page from China’s banking model. Chinese banks are divided into different categories. Some are private, while others have large stakes owned by the government. The policy banks are state-owned and have been carrying out specific government mandates since 1994. The China Development Bank, for instance, was set up to make loans for infrastructure projects, and the Agricultural Bank of China made loans directed at farmers. While it took a confluence of factors to spur the largest economic development in human history, Chinese policy banks did play a central role [in that growth] by funding such strategic government initiatives as construction of the Three Gorges Dam, the largest dam in the world. Such feats wouldn’t have been possible had the banks simply been allowed to make loans to individuals and small companies based on short-term profit.

Likewise, the U.S. could set up banks that focus on specific U.S. policies such as job growth through innovation. Innovation bank branches could be opened across the country in offices vacated by bankrupt companies. Unemployed workers in every sector could finally get a shot at becoming entrepreneurs with an equity investment from the government. The government would in turn receive a share of the profits.

Banks Investing in Entrepreneurs

Does this sound too good to be true? Not really. Angel investors and venture capitalists have been making investments in entrepreneurs for decades. From Fairchild Semiconductor (FCS) to Facebook, these entrepreneurs with venture capital investments have generated millions of jobs for Americans by turning their ideas into some of the biggest and most influential companies in the world. Innovation and the entrepreneurial spirit have made America great and the envy of every nation.

Now that the world is in a financial crisis, we need more innovation and entrepreneurial spirit than ever before, inventing new ways to prolong life, save energy, clean the environment, and create the millions of other products and services that people want and need. However, just as the world needs more researchers, inventors, and entrepreneurs to carry out such important roles, the money available to them is small compared with the recent government bailouts of failed financial institutions such as Citibank (C). The initial public offering market, a way in which many young companies get badly needed financing to operate and grow, completely evaporated at the end of 2008. Money to fund research at major universities has been slashed as endowments such as Harvard’s lose a third of their value. Yet roughly $3 billion in 2008 was invested in the green technology sector, which comprises alternative energy, recycling, power supplies, and conservation companies funded through venture capital. By comparison, the total cost of the U.S. government bailouts of the U.S. financial institutions have amounted to about $5 trillion.

Tim Geithner and others (such as Hank Paulson) have argued they are propping up insolvent banks so that they can lend to such entrepreneurs.

This is an inaccurate characterization because today’s bank lending in almost all cases requires existing cash flow and collateral that most entrepreneurs starting up do not have. Furthermore, if there are banks that conduct entrepreneurial lending, they are small, specialized banks that are not receiving the large Troubled Asset Relief Program (TARP) funds from Treasury. Companies the size of Goldman Sachs (GS) and JPMorgan Chase (JPM) that have received large sums of government money service other multinational corporations, not entrepreneurs. Finally, angels and venture capitalists do not use loans from banks to make investments; they use their own equity capital to make equity investments. Thus, rather than propping up failed financial institutions, the government should increase funding to inventors, scientists, and entrepreneurs over and beyond the paltry amount supplied by venture capitalists if President Barack Obama is sincere about investing in the long-term, sustainable prosperity for the U.S.

Taking a Chance on New Ideas

An innovation bank could be set up to increase scarce resources to entrepreneurs and inventors that they otherwise would not receive because their ideas or projects may be deemed too long term or too risky by private investors. According to PricewaterhouseCoopers, the percentage of first-time venture capital financing was only 20% of all VC investments in 2008, meaning that most of these investments are not with entrepreneurs with new, untested ideas or products. More than 90% of proposals landing on the desks of venture capitalists get rejected, and a great majority are turned down because VCs are profit-seeking entities with a low tolerance for risk. Like hedge funds, they run in herds and often make the mistake of rejecting an idea just because no one else has already funded it.

They have also relatively short time horizons because they want to bring companies public or sell them to conglomerates as soon as possible in order to realize a profit. So an idea with merit will get rejected if it’s going to take longer than five years to become a viable business due to the advanced research required. A large opportunity lies in helping these rejected entrepreneurs turn their dreams into reality.

A government-sponsored bank would raise concerns of fraud and corruption, as evidenced by the examples of Fannie Mae (FNM) and Freddie Mac (FRE). Probably no institution is free from the vulnerability of some degree of waste. However, such waste and corruption can be minimized by structuring the right incentives and punitive measures. For instance, a possible guideline for the government to provide an equity investment in a startup may require the entrepreneur to put a significant financial stake in the company and provide proof that the idea works, like having a working prototype and patent. To ensure that innovation bank investors work for the public interest, they may be required to allocate a set percentage or number of investments in specific sectors—such as clean tech—and receive bonuses tied to the success of their investments while also being subject to clawbacks of their bonuses if their investments sour quickly.

Overseeing the portfolio and operations of such a bank would require an independent, qualified, and objective group. A possible model is to create a rotating panel of professors and scientists who don’t have conflicts of interest, are bound by confidentiality agreements, have the expertise to evaluate the technology, and are selected by governors in each state. While the actual product or service may not be disclosed to the public, names of companies or entrepreneurs and the amounts they received from the government should be disclosed in the spirit of transparency.

Americans may not like the idea of the government picking winners and losers as the U.S. strays ever further from a free market model. But the government is already picking winners and losers through the multiple bank and auto bailouts. The question is no longer whether Americans will stick with free market capitalism, but rather who will benefit from the government largess. Until now the answer has been the large failed companies that have legions of lobbyists badgering Congress to support them—while entrepreneurs have received no equity shares because they have no money or voice in Washington. But the future doesn’t have to be a repeat of the past. Politicians can still choose to continue throwing good money after bad, or they can invest in new ideas and products that lead to a promising future. It’s time to urge them to make the right choice.

Ann Lee is an adjunct professor teaching economics and global affairs at New York University. She has also taught at Beijing University and Pace University and is a former investment banker and credit derivatives trader.

Originally published at Business Week and reproduced here with the author’s permission.

5 Responses to "Innovation: Learning from China’s Banking System"

  1. NFrazier   March 17, 2009 at 12:43 pm

    No matter what happens, some businesses will have to fail and the income streams to those that financed them will be affected.Rather than looking at who is the most unprofitable and has the highest debt and allowing them to fail, businesses, banks, and governments have gone into a massive holding pattern of spending down remaining lines of credit until they will be forced to fail. This does appear to be a wasteful approach.Using these remaining financial resources to set up solvent lending institutions to entrepreneurs with patents and good business plans instead seems to be a far better approach. Another variant of this idea is the Hall-Woodman-Bulow good bank solution. This general approach could even be extended to the insurance industry.

  2. Guest   March 20, 2009 at 3:21 am

    In my “good banks” proposal the idea is also to have mutual and cooperatives banks borne out of the insolvent ones, broken up, so to operate more at local level. Of course government can be the catalyst and guarantor of these operations but the new good banks not necessarily have to be state-owned. It’s just a matter of business plan and mission…M.G. in Progress – The Unbearable Lightness of Being an economist

  3. Robert Devine   March 29, 2009 at 6:17 am

    While i understand and applaud the desire tp provide more funding to early stage entrepreneurs – especially in the science & technology space – the Chinese banking system can only be described as a deeply flawed model for entrepeneurial bankingI’ve been based in Beijing for over 10 years and have had extensive dealings with the local banks … they are a great wealth-destroying institutions (unfortunately Wall Street can now be described in the same way) … investing 40% of GDP for a return of 8-9% annual GDP growth is not efficient investing. The reason: Chinese Banks allocate national savings almost exclusively to State-Owned or -Sponsored Enterprises , which are frequently landing platforms for retiring officials and other politically influential people.There is NO start-up bank capital available, and bank loans are available generally only to private companies that have cash flow AND mortgageable assets (ie real estate, which explains why every company in China owns real estate .. a rank misapplication of capital)private business in China has been successful DESPITE the banks, not because of them … private startups are universally funded by informal social financial networks (ie friends, family & clan).the large dams etc projects invariably pencil out to poor or negative returns and in any case, if they are in the public good, should be funded by govt infrastructure investment not by commandeering private savingsrgdsRobert Devine

    • Ann Lee   March 29, 2009 at 4:09 pm

      Dear Mr. Devine,Thanks for your note. I appreciate hearing your thoughts on the matter, and I don’t disagree with your point of view. I actually was not suggesting that we follow the Chinese banking model. Rather, I was suggesting that we borrow the idea of mandating certain financial institutions (whether we call them banks or not is beside the point) to provide capital on the basis of priorities based on the public interest. American wealth has not been created through savings but rather equity investments. If this is the case, forcing the banks to provide capital to entrepreneurs with legitimate ideas and business plans will create more economic growth than the current government policies of bailing out banks because these banks are not lending to Main Street. Instead, they are gaming the system by using taxpayer dollars to buy even more toxic assets (and averaging down) since they currently earn a higher return from those than making new loans that have capped interest rates.Best regards,Ann

  4. HKInvestor   April 2, 2009 at 5:57 am

    Ann,By relating your idea to Chinese banks, I think that makes it easy to misconstrue what you are proposing. If I understand you correctly, are you proposing a VC fund set up by the US Government to drive innovation? One can call it a bank but it doesn’t take deposits, it has no real liabilities and your idea is really on using public funding for VC investments that are not economically driven.If this is the case, then one has to ask the question if the current VC model is failing, and if so, why is a Government model better. From what you have stated above, I can’t see any failings in the private VC market. Yes, only 20% of all VC investments are in first time ventures. Yes, 90% of proposals get turned down. But why are these signs that the current VC market is failing or not carrying outs its function of allocating capital to entrepreneurs? Turning back to your bank comparison, not all loan applications get approved and these are usually for good reasons. The fact that loan applicants get turned down is NOT a sign of failure of the system in allocating capital. [As a matter of fact, I would argue that these are HEALTHY signs of a good banking system but this is a discussion for another time] Subprime customers are more high risk and as a result, has a higher rejection rate. VC is high risk since new businesses have very high failure rates and as a result, has higher rejection rates. Maybe you are looking at some additional data, but I just can’t see the failures here on these figures alone. From the PWC report, it actually looks like the VC industry is pretty healthy in 2008. There weren’t much exits but the investment pace continues to be healthy and is not any different from the previous 6 years. (Pg 15 of “The exit slowdown and the new venture capital landscape” published by PWC in Sep 08) The prima facie evidence suggests that the VC market continues to make investment and that the pace is not affected by the financial crisis.As for whether a Government model is better, I gather from your article that it is better for the following reasons: 1) fund projects too risky for private investors, 2) fund projects too long term for private investors, 3) VC has low tolerance for risks. I am not in a position to comment on these but I would have thought the private market would be in a much better position to address these than a Government entity. The biggest problem that I have with the Government model is that it is not economically driven. As a Government entity, how is it going to determine what is the appropriate trade-off or risk/reward? Should it underwrite to a 15% or a 40% return? How would they put a valuation on a company? By bringing more capital and a lower risk threshold to the VC market doesn’t necessarily create more successful ventures. If the tech bubble years are any guide, it will just create a lot of empty promises and failures down the road. I haven’t studied these public venture efforts but I do know that Taiwan, Korea and some other countries have special programs to lend to SMEs and most of these turn out to be disasters.I share your concern that the Government is inserting itself into the lending market and is picking winners and losers among big banks and other financial institutions. It is certainly a step in the wrong direction. But to use that as an excuse to make additional mistakes and use public capital to invade the venture market when it is functioning properly seems to be an additonal step in the wrong direction that is best avoided.