Abstract

Since the rural finance reform in 2007，village and township banks（VTBs）have covered vast rural areas in China，especially the poor areas in central and western China.They have effectively increased the supply of financial services for “agriculture，rural areas and farmers” and for micro and small enterprises（MSEs），and to a large extent，reached the expected policy aims.However，diseconomies of scale become a huge obstacle for the development of VTBs as the competition in rural financial market fiercely increasing.Scalization development is an important way to break through the development predicament of VTBs.China’s financial regulatory authorities attach great importance to the scalization development of VTBs，keep improving policies，and conducted pilot projects for the scalization development of VTBs.There have been four kinds of management models for the scalization development of VTBs.The first one is to set up a headquarter office of management for VTBs or to set up a relatively independent business unit for the management of VTBs in the main initiating bank（hereinafter referred to as the headquarter office of management model）.The second is to establish an independent financial holding company or investment & management VTBs（hereinafter referred to as the investment & management VTB bank model）.The third one is to set up prefecture-level head office for the county level branches of VTBs（hereinafter referred to as the prefecture-level head office model）.The last one is “multi-county，one-VTB” model.

The above four models all contain the features of sharing economy.In the sharing economy，members do not need to own but can use the same resource to share the cost of the resource，to increase the net revenue of each member and improve the resource utilizing efficiency.The sharing economy gets rid of the dilemma that a single user cannot afford to access the resource or that it is not economical to access and use the resource alone.Instant messaging technologies such as the Internet in the digital era make it possible to share across regions and across physical barriers.Under the four scalization development management models of VTBs，each VTB and its branches can jointly utilize the professional services provided by the headquarter office of management，investment & management VTB，prefecture-level head office，head office of “multi-county one-VTB” or third-party service platforms.It solves the problem of diseconomy of scale of individual VTB，to realize intensive management，professional service and scalization development of VTB.

Incremental reform is the basic logic of China’s rural finance reform after 2007，which increases the competition of rural financial market by adding new rural financial institutions，to improve the effective supply of rural financial services.However，since 2016，the annual growth rate of the number of VTBs has dropped to less than 10% and continues to decline.It can be seen that the period of rapid growth of the number of VTBs has come to an end，and the further healthy development rely mainly on the stock reform.At the same time，the problem that some poor counties still have not been covered by VTBs should be solved during the stock reform.The core of stock reform is to improve efficiency and quality of development.The sharing scalization development is necessary for the high-quality development of VTBs.

In this report，we focus on the analysis of the economies of scale of the sample VTBs and their social performances.Meanwhile，by studying three typical cases，we analyze the economies of scale and social performances of the four above-mentioned scalization development models of VTBs.The data used in this report mainly come from the questionnaire collected from the VTBs surveyed for the “China Village and Township Banks Comprehensive Business Development Ranking” jointly organized by the organizing committee of China VTBs Forum and Chinese Association for Promoting County and Township Economic Exchange.We also use the information obtained from the field study of our research group，and the data released by China Banking and Insurance Regulatory Commission and the People’s Bank of China.The theoretical analysis framework in this report is based on the theory of economies of scale and the double bottom line of micro-finance institutions（financial performance and social performance）.We combine both the normative analysis and the positive analysis，and adopt simple regression method and typical case study method.

Since 2010，China’s financial regulatory authorities have continuously issued policies to help VTBs improve their management efficiency and expand the business operation scale to improve their sustainable development capability.Among them，the most important is the policy promoting the four models.By the end of 2019，China already had 11 VTBs applying prefecture-level head office model，the first round of pilot program of “multi-county，one-VTB” model had been conducted in 15 provinces，the first investment & management VTB had been opened.While promoting the scalization development of VTBs to realize the business sustainability，the financial supervision authorities have also continuously improved the policies concerning VTBs’ market positioning，that is to support rural areas and small businesses and serve within the county market，to ensure the realization of the policy objectives for VTBs.

By the end of September 2019，1，633 VTBs had been set up，covering 1，296 counties（cities and banners）in 31 provinces，amount to 70.6% of counties in China.According to the registration addresses of 1630 VTBs collected online by our research group，90.43%（1474）of them concentrate in the east of Hu’s Line（Aihui-Tengchong Line），2.15%（35）are located in the counties that Hu’s Line passes through，and 7.42%（121）are located in the west of Hu’s Line.The number of the latter two cases amount to less than 10% in total.Hu’s Line reflects the characteristics of China’s economic geography and population distribution.It can be seen that the distribution of VTBs is also closely related to population distribution and economic geographical characteristics.This can be called the “Hu’s Line distribution” feature of VTBs.

At the end of 2018，the VTB legal person institutions accounted for 41.30% of that of all the small and micro rural financial institutions，their business outlets accounted for 6.83%，their employees and overall asset accounted for 9.74 % and 4.37% respectively.At the end of 2018，VTB overall deposit balance in China reached to 1.18 trillion yuan，the overall loan balance is 0.94 trillion yuan.A total of 11.146 million loans，or 4.69 trillion yuan，were issued to 6.585 million rural households and MSEs.The loan balance of rural households and MSEs accounted for 91.18% of all the loan balance of VTBs.The average loan balance per account fell to 340，000 yuan，keeping the decline for six consecutive years.These data show that，on the whole，VTBs adhere to the market positioning of supporting rural areas and small businesses，but the individual scale is small.

Economies of scale generally refer to the phenomenon that the long-run average cost decreases and the returns increase with the expansion of a firm，which reflects the improvement of productivity when reaching the optimal output.The opposite to economies of scale is the diseconomies of scale，which refer to the increasing average cost and diminishing of marginal returns when the scale of a firm exceeds certain limit，or the inability of making necessary fixed asset investment when the firm scale is too small，and the high average cost and low return because of the difficulty to recover the huge fixed cost even if it invests.

Economies of scale includes internal and external economies of scale.The former relies on the improvement of resources allocation inside a firm and the use of the new technology to reduce the long-run average cost of production and improve the efficiency of organization and operation.The latter relies on specialization and cooperation among enterprises and improve regional distribution to make efficient use of production factors and public facilities，and thus reduce the production cost for each enterprise.

The existing studies in China and abroad have shown that the expansion of the business scale of small and medium-sized commercial banks can bring about economies of scale，such as the decrease in operating cost per unit and the increase in revenue per unit.There are two ways for commercial banks to achieve economies of scale.The first is the extensive development，that is to expand the geographical scope of the business，increase the scale of assets，and to increase the number of customers.The second is intensive development，that is to improve the serving capacity and expand the boundary of economies of scale and thus the business scale by improving the efficiency of operation and management.In the digital era，fin-tech has become an important or indispensable means of intensive development.For small and medium-sized commercial banks，the intensification and specialization are important means to realize intensive development，that includes both organizational process reengineering and application of advanced technologies.However，due to their small scale and limited development space，they are unable to independently undertake the huge investment in the construction，operation and maintenance of the financial technology system，and are in the predicament of diseconomy of scale.

Sharing economy means that many people consume the same goods or services together，and is an economic model of sharing among different individuals.Sharing enables the resource owner to gain more benefits without or with little additional cost，and enables its users to make use of the resource without or at little cost.In the sharing economy，the cost of owning and using resources is shared between the owner and the user，which increases the benefits of both the owner and user and improves the efficiency of resource utilization.Moreover，as the number of users and the using frequency increase，the marginal cost of resource utilization can be reduced gradually and approaches zero.Therefore，sharing results in economies of scale and is a process of joint creation of value.

The four models of scalization development of VTBs also contain the characteristics of sharing economy.Under the models of headquarter office of management and investment & management VTB，each VTB is an independent legal entity with independent economic interest.Under the prefecture-level head office model and the “multi-county，one-VTB” model，although branches are not independent legal entities，each branch operates within its own county area and becomes a relatively independent profiting unit due to the policy restrictions that locally absorbed deposits should be mainly used locally.Therefore，under these four models，those investments that are essential for achieving economies of scale but are unable or difficult to be paid by VTBs or their branches is made by the headquarter office of management，investment & management VTB or head office.These investments may involve strategic management，process optimization，product development，middle and back office system service，technical support，and employee training，among others.VTBs or their branches can use these resources and pay for their use.Since each VTB can only operate in its registration area and there will be no competition between each other，therefore，the sharing will not cause competition for the same resource but solves each individual VTB’s problem and enhance their own competitiveness in their county.In this way，the sharing economy of VTBs has been formed.

In this report，we measure the economies of scale effect of VTBs by examining the changes in return on assets and cost-revenue ratio as business grow and scale.If return on assets are rising and cost-revenue ratios are falling，there will be economies of scale effect.We use both measures for benefit and efficiency，namely the return on assets and cost-revenue ratio.Since VTBs are constrained by the market positioning policy of “serving county market and supporting rural areas and small businesses”，it is necessary to investigate the social performance brought by economies of scale.Three group of indicators for social performance are adopted in this report.The first is the breadth of coverage indicator，measured by the number of loan customers.The second group of indicators are the depth of coverage indicators，measured by the proportion of farmer borrowers and MSE borrowers and the average loan balance per account.The third group of indicators measure the concentration degree of supporting rural areas and small businesses，which come from the “Notice on Promoting Village and Township Banks Adhering to Positioning and Improve the Capacity of Serving Rural Revitalization” issued by China Banking and Insurance Regulatory Commission in 2019，including the proportion of overall loan balance，the proportion of new local loan accounted in new increased loanable funds（due to the lack of data，loan-deposit ratio is used in lieu of the latter indicator）.

According to the regression result of the financial data of sample VTBs，we find that expanding loan scale will reduce cost，increase revenue and improve operation efficiency，indicating that the sample VTBs have not yet reached the ideal state of economies of scale.By analyzing the sample VTBs’ social performance，we found that the enlargement of asset scale can result in the expanding of financial service coverage，including the increase in branch numbers，the loan customer numbers，and the increase in loan balance of the farmers and MSEs.However，this may not deepen the coverage depth.That is to say，they may serve some bigger and stronger customers instead of smaller ones.

According to the case study of the Guishang Village and Township Bank（Guishang VTB）which applies the prefecture-level head office model in Guangyuan Prefecture，Sichuan Province，the Rongdu Village and Township Bank（Rongdu VTB）which applies the “multi-county，one-VTB” model in Jiaokou County，Shanxi Province，the Xingfu Investment & Management Village and Township Bank（Xingfu VTB）which transit to investment & management VTB model from the headquarter office of management model，we find that there will be both economies of scale and better social performance under all these four models.In general，the scalization development of VTBs in China have the following characteristics in common.First，the scalization development of VTBs follow some order，that is，generally transit from extensive development to intensive development.Of course，this order is not one-way and irreversible，it is just that extensive development plays the major role at the early stage，and later shifts to intensive development dominant.The former is the premise and foundation of the latter，and the latter is the necessary condition for the further development of the former.Second，none of Guishang VTB，Rongdu VTB and Xingfu VTB stick to a single scalization development model.Guishang VTB applies both prefecture-level head office model and “multi-county，one-VTB” model.The “multi-county，one-VTB” model in Rongdu VTB is embedded in the headquarter office of management model and is supported by its main initiating bank.Xingfu VTB not only is developed from the headquarter office of management in its main initiating bank，but also manages a VTBs which applies prefecture-level head office model，the Enshi Xingfu VTBs.Third，at present，the scale of VTBs is generally small，which is far from reaching the upper limit of possible economies of scale.Moreover，the development of fin-tech continues to expand the boundary of economies of scale，so there is still a large room for the scalization development of VTBs.Fourth，all the scalization development models of VTBs have shown positive social performance，they enlarge the coverage of financial services，increase the number of loan customers，strengthen the ability of supporting rural areas and small businesses，and help to promote the realization of policy objectives.

The conclusions of this report are as follows：

1.The scalization development models of VTBs all have shown to some extent the economies of scale effect or the potential for reaching economies of scale，improved the sustainable development capability of VTBs and promoted the development of VTBs in the central and western China，helped to break the current “Hu’s Line distribution” state of VTBs，and improved the financial service coverage and credit supply in central and western China characterized by low financial coverage rate and lack of credit supply.

2.Constrained by their own capacity，market environment and policies，it is not easy for VTBs to achieve economies of scale.Compared to the policy requirements for the VTBs to stick to the market positioning，there are still great rooms for them to improve social performance when they realizing scalization development.

3.It is necessary that the policy on scalization development of VTBs stipulates that the deposits of new established institutions should mainly be used locally.Therefore，the dispersed spatial distribution of VTBs and capital will not change fundamentally in a short period of time.

4.Different models of scalization development have different potential for achieving economies of scale.The prefecture-level head office model and “multi-county，one-VTB” model will lead to internal economies of scale mainly through extensive development，and the former has more potential than the latter to achieve economies of scale and better social performance.The headquarter office of management model and investment & management VTB model featured by intensive development，have more potential of realizing both persistent external and internal economies of scale，and also provide better conditions for improving social performance.

5.Different scalization development models can be combined，but the combination should follow a certain order.

6.The sharing scalization development of VTBs is not a simple change in organizational structure and management，but involves the reengineering of organizational and business processes，as well as the comprehensive application of financial technology.

7.During the scalization development，the top management should not only carry out centralized intensive management to control risks，but also maintain the relative independence of the branches and meet their diverse and individualized needs according to the business characteristics of branches or VTBs they hold.

8.In the digital era，the sharing economy is an inevitable trend，and the sharing fin-tech service platform is an important way for VTBs to overcome the diseconomies of scale.Capable headquarter office of managements for VTBs and investment & management VTB can build their own platform，and also export service capabilities.In the future，professional fin-tech service platform companies will also play a big role in the sharing scalization development of VTBs.

Based on the above conclusions，we suggest to encourage and support VTBs to explore and innovate new development models based on the existing scalization development model to achieve high-quality development.We propose the following policy suggestions.

1.Encourage VTBs applying prefecture-level head office model to deepen services in rural areas，and encourage and support them to participate in the pilot program of “multi-county，one-VTB” model，to achieve economies of scale，and at the same time improve the breadth and depth of financial services coverage in poor areas.

2.Allow VTBs which participate in the “multi-county，one-VTB” pilot program to set up branches in non-adjacent poor counties，to support them to achieve economies of scale as soon as possible，and cover the remote and poor areas with no financial services，and increase the effective credit supply in these areas.

3.Allow outstanding headquarter office of managements or investment & management VTBs to participate in the merger，acquisition or reorganization of those VTBs not hold by them，and to participate in the “multi-county，one-VTB” pilot program，to reach the economies of scale and expand the coverage of VTBs.

4.Improve the supporting policies on the scalization development of VTBs.First，provide the fiscal and tax preferential policies according to that for the newly established VTBs.Second，the central bank can implement targeted cuts in the required reserve ratio for the main initiating bank to encourage it increase capital support for VTBs，or give special credit support to VTBs on the central bank’s re-loan for supporting rural areas and small businesses to improve their ability to provide loans for farmers and MSEs.The third is to relax regulatory standards so that VTBs can operate，survive and achieve policy objectives better.For example，when setting MPA assessment indicators，it is necessary to distinguish between large and small banks and relax restrictions on VTBs.

5.Always remember the original policy goal，and strengthen the monitoring and supervision of the market positioning policy of “supporting rural areas and small businesses” and serving the county region.The first is to formulate clear，effective and operable regulatory measures in the pilot program of prefecture-level head office and “multi-county，one-VTB” model to ensure that all or most of the funds absorbed by new branches are used locally.Second，the promoting of the headquarter office of management model and investment & management VTB model should be achieved neither at the cost of reducing the number of legal persons in VTBs nor by transforming merged or self-owned VTBs into branches.Third，improve the policy for VTBs’ adhering to their positioning.For example，the average loan balance should be determined according to the local regional GDP per capita.

6.Encourage and support the development of fin-tech service sharing platforms for VTBs.Qualified headquarter office of management for VTBs or investment & management VTBs may be allowed to establish specialized fin-tech service companies to provide services to VTBs not hold by them.At the same time，the development of professional fin-tech service platform companies that mainly serve VTBs should also be encouraged.