China's banking sector has made phenomenal strides. More than 100 banks act as go-betweens for savers and borrowers in every corner of this huge country, up from just a handful when economic liberalization began, in 1978. Last year foreign banks took stakes worth $18 billion in China's biggest banks—moves reflecting the extent of the sector's maturation as well as optimism about its prospects. Rapid growth hasn't been painless, however. Since the end of 2001 the government has been digging banks out of a mountain of nonperforming loans, which will ultimately cost Chinese taxpayers an estimated $215 billion, and possibly far more.

Research by the McKinsey Global Institute comparing the performance of China's banking system with international benchmarks shows that although the country's banks have come a long way, they are not yet out of the woods.¹ Chinese banks still lend too much of their money to underproductive state-owned enterprises (SOEs)—a problem that leaves them particularly vulnerable to changes in the economic climate and hinders the country from achieving its stated regulatory goals. China's government can certainly afford to bail out the banking sector again should the need arise. But it would be far better for the economy, and especially for the taxpayers (who foot the bill for bank bailouts), if regulators could accelerate the pace of reforms that encourage banks to lend more productively.