China's banking sector has traditionally served as a party-controlled feeding trough for its inefficient, unprofitable state-owned enterprises (SOEs), most of which were technically insolvent. The process was simple – extend a loan to an unqualified SOE applicant, then write off the loan as a bad debt when it failed to repay. This situation is beginning to change, and Chinese banks are attracting the attention of foreign banks that are beginning to view them as investment opportunities rather than potential competitors. Nevertheless, China's banking industry is beset by several problems.

1. SOE Lending: The importance of the Chinese banking sector as a source of domestic capital is hard to overstate. Mainland China's stock markets are anemic compared to the behemoths of Hong Kong, Tokyo and New York, and China's bond market is virtually nonexistent. That leaves banks as the only major source of over-the-table domestic funding for private enterprises. Yet SOE lending continues to siphon off a good part of banking capital, notwithstanding that China's stock markets were largely designed to provide SOEs with an alternative source of funding. Many domestic companies have resorted to the underground institutional loan sharks with their high interest rates, or rely solely on retained earnings for funding. Even though SOE loan defaults have declined dramatically at some banks for recent loans, the industry as a whole is still experiencing a hangover from imprudent lending under earlier, more politicized lending policies.

2. Corruption: There is a crackdown underway, but corruption is rampant in many sectors of the Chinese economy and the government is always cracking down on corruption in this or that industry. Meanwhile the cycle continues. It is tempting to predict that only the threat of bankruptcy due to foreign competition will ever be enough to create the political will necessary for consistent enforcement of the law.

3. Decentralization: China's banking sector looks fairly centralized on paper, but the hidden problem is the de facto independence from headquarters of far-flung branches. China's branch banks have been used to operating with a much greater independence than is the rule in the West (thus contributing greatly to the corruption problem), and any attempt to assert control from HQ is bound to be met with spirited local resistance.

The moment of truth is coming up fast, however, as China's WTO commitments require it to fully open its banking and insurance markets to foreign competition next year. The government is responding by introducing a host of new regulations to rationalize lending practices and by cracking down on internal corruption (whether the new regulations will actually be followed by the branch banks is a question that only time can answer). Banks are responding by listing with IPOs on overseas markets and with American-style “downsizing”, closing branches and laying off staff.

Foreign banks are responding by investing billions of dollars into Chinese banks, surprising in light of the above problems. Furthermore, they are acquiring minority stakes that are unlikely to ever offer them operational control, in some cases mainly for the purpose of securing access to distribution networks for insurance, credit cards, and investment products after 2007.

Nobody wants to see China's banks wither in the wake of foreign competition - not even their foreign “competitors”, because a Chinese banking crisis would have a significant negative effect on the entire world economy.