New Capital Rules Bring China's Banking Regulation up to Global Standards

Basel I and China's New Minimum Capital Requirements

The Capital Adequacy Procedures are based firmly on the minimum capital requirements stipulated in Basel I. The CBRC deliberately chose not to adopt the more complex, risk-sensitive and flexible capital adequacy provisions in Pillar I of Basel II. The CBRC closely followed the drafting process of Basel II and concluded that the requirements in Basel II would only marginally improve the risk sensitivity for Chinese banks, but would increase overall capital requirements.⁴ Moreover, the CBRC concluded that Basel II is more about risk management than capital regulation in the context of emerging market economies such as China.⁵ Most of China's commercial banks are not the "internationally active banks" addressed in Basel II and the risk management (in particular, the operational risk management), and internal rating systems of Chinese banks need to be significantly improved to meet the Basel II standards.⁶ In addition, the significant challenges for even internationally active banks in implementing Basel II likely influenced China's decision to remain on Basel I.⁷

The Procedures also recognize the significant undercapitalization of many Chinese banks and provide a transition period through the end of 2006 for Chinese commercial banks⁸ to overcome any under-capitalization. As mentioned above, January 1 2007 is the date by which China is to fully open its commercial banking sector to foreign competition, and the CBRC is focused on improving the competitive ability of Chinese banks by that date.

Capital Adequacy Ratios

The Capital Adequacy Procedures reiterate the 8% minimum capital adequacy ratio required under the Commercial Banking Law and introduce a 4% minimum core capital adequacy ratio.⁹ Commercial banks are required to calculate and measure their capital adequacy on the basis of "adequate provisions for various losses, including loan losses".¹⁰

The Procedures require commercial banks to maintain their capital at a level sufficient to cover credit risk and market risk. They do not address the Basel II concept of operational risk.¹¹ The banking regulators in China have apparently decided at least for the foreseeable future to address operational risk through other targeted regulatory initiatives.¹² Accordingly, the formulas for capital adequacy ratio and core capital adequacy ratio only incorporated risk-weighted assets and capital charges for market risk, but not any capital charge for operational risk proposed in Basel II. Arithmetically, the relevant formulas are as follows:¹³

Capital adequacy ratio =

(total capital - deductions)

(risk-weighted assets + 12.5 x capital charge for market risk)

Core capital adequacy ratio =

(core capital -deductions)

(risk-weighted assets + 12.5 x capital charge for market risk)

Under the Capital Adequacy Procedures, total capital is split between core capital (referred to as Tier 1 in Basel I) and supplementary capital (Tier 2 in Basel I), the components of which are generally in line with Basel I. Core capital consists of paid-up capital/common stocks, reserves, capital surplus, retained earnings and minority interests. Supplementary capital consists of revaluation reserves, general loan-loss reserves, preference shares,¹⁴ convertible bonds and long-term subordinated debt.¹⁵ In calculating total capital, the amount of supplementary capital to be included may not exceed that of core capital and the amount of long-term subordinated debt may not exceed 50% of core capital.¹⁶ By including convertible bonds and long-term subordinated debt in supplemental capital, the Procedures broaden the avenues available to PRC commercial banks to improve their capital bases. Even prior to the promulgation of the Procedures, reports had surfaced about applications by certain Chinese banks to issue debt;¹⁷ it is likely that such applications will increase in 2004. In fact, the Bank of China and Shanghai Pudong Development Bank both revealed their plans to issue subordinated bonds shortly after the promulgation of the Capital Adequacy Procedures.¹⁸

Risk Assets Weightings

The Procedures require commercials banks to deduct specific provisions from the book value of loans when calculating risk-weighted assets in accordance with the risk weightings for various claims.¹⁹ For on-balance sheet assets, the Capital Adequacy Procedures provide four basic scales of risk weightings (0%, 20%, 50% and 100%),²⁰ which fall under Basel I's risk weights framework. The main categories of on-balance assets are claims on central governments and central banks, claims on public-sector entities (not including commercial companies), claims on domestically incorporated financial institutions, claims on financial institutions incorporated in other countries or regions, and claims on non-bank business enterprises and individuals. For off-balance sheet items (including categories such as commitments and contingencies), the Procedures also adopt Basel I's system of credit conversion factors, under which the conversion factors are applied to the nominal principal amount of exposure to produce a credit equivalent amount that, in turn, is weighted according to the corresponding weights of the counterparty.²¹

In determining risk weights for claims on sovereigns and overseas banks or public-sector entities, the Capital Adequacy Procedures adopt Basel II's approach to use credit ratings of external credit assessment institutions (ECAI) to replace Basel I's OECD club rules that make distinctions between OECD and non-OECD counterparties. If the rating for the sovereign or region is no lower than S&P's rating of "AA-",²² the foreign central government and central banks, foreign banks or securities firms, and public-sector entities invested by the foreign central government in such sovereign or region will enjoy more favourable risk weights.²³ Such ECAI approach is not applied to the Chinese central government itself, however, whose long- and short-term foreign currency sovereign credit ratings by S&P currently stand at only BBB+/A-2.²⁴ The 0% risk weight for claims on the Chinese central government denominated in both domestic and foreign currency, and the 50% risk weight for claims on domestic public-sector entities invested by the Chinese central government set forth in the Capital Adequacy Procedures,²⁵ essentially treat the Chinese central government as if its rating were AA- or higher.

A major change from the previous calculation of risk-weighted assets is that the Procedures remove favourable risk weights for claims on non-bank financial institutions and large state-owned enterprises (SOEs). The requirement by the CBRC that commercial banks treat SOEs the same as other business enterprises is clearly a positive move in controlling commercial banks' potential credit risks associated with the loans to SOEs. In this regard, the Capital Adequacy Procedures will also encourage commercial banks to treat SOEs and private enterprises more equitably. However, in a candid effort to facilitate state-owned banks' ongoing reforms to reduce their mounting levels of non-performing loans (NPLs), the Capital Adequacy Procedures provide a 0% risk weight for claims on specific debts issued by the domestically incorporated financial asset management companies (AMCs) to purchase the state-owned banks' NPLs.²⁶

The Capital Adequacy Procedures also eliminate any favourable risk weights for claims secured by property, real estate and residential buildings. Following on the PBOC's Notice to Further Strengthen the Regulation of Real Estate Lending Business²⁷ and the CBRC's proposed Guidelines for Commercial Banks' Risk Management of Real Estate Lending,²⁸ we now have a further indication that the Chinese government is focused on preventing excessive bank lending to the over-heating real estate sector in China.

Capital Charges for Market Risk

The Procedures adopt the 1996 Amendment to Basel I and introduce capital charge requirements to cover market risk. Consistent with the Basel I definitions, market risk is defined as the risk of losses in on- and off-balance sheet positions arising from movements in market prices.²⁹ The CBRC's decision to include market risk components recognizes the significant increase in trading activities of Chinese commercial banks in recent years. In light of the increased complexity of applying the market risk weightings, however, the Procedures only apply the market risk capital charge to commercial banks whose trading position exceeds the lesser of 10% of the bank's total on- and off-balance sheet assets or Rmb8.5 billion.³⁰ Commercial banks exempted from the capital charge requirement still need to report their market risk position to the CBRC on a quarterly basis. The CBRC will then decide whether such otherwise exempted banks should be subject to the capital charge requirement and set aside capital for market risks in accordance with the Capital Adequacy Procedures.³¹

Incorporation of Supervisory Review Process and Market Discipline from Basel II

Notwithstanding its decision to shun most of Pillar I of Basel II regarding capital adequacy, the CBRC decided to adopt significant portions of Pillar II and Pillar III of Basel II related to supervisory review and information disclosure. This selective adoption of portions of Basel II is consistent with previous indications given by CBRC officials ³² and, according to CBRC officials, also consistent with the views of the Basel Committee.³³ Therefore, the Capital Adequacy Procedures include a number of fairly detailed rules to improve the supervisory process and information disclosure at Chinese commercial banks.

Supervisory Review of Capital Adequacy

The supervisory review provisions in the Capital Adequacy Procedures are largely based on Pillar II of Basel II (i.e., supervisory review process) and Chapter IV of China's Banking Regulation Law(中华人民共和国银行业监督管理法).

The Procedures provide that the board of directors or president (if no board of directors exists) of each commercial bank is responsible for capital adequacy management, and the senior management is responsible for the implementation thereof.³⁴ Commercial banks are each required to report their respective capital adequacy status to the CBRC. The CBRC is given the supervisory power to review and evaluate banks' capital adequacy through on-site examination and off-site surveillance, and the CBRC has the power to require a capital adequacy ratio higher than the minimum ratio for a particular bank in consideration of such bank's high risk profile and low risk management capability.³⁵

In addition, the CBRC classifies commercial banks into the following three categories on the basis of their capital adequacy status:

· adequate capitalized banks (capital adequacy ratio 8% and core capital adequacy ratio 4%);

· undercapitalized banks (capital adequacy ratio
< 8% or core capital adequacy ratio < 4%); and

· significantly undercapitalized banks (adequacy ratio <4% or core capital adequacy ratio < 2%).³⁶

For each category, the Capital Adequacy Procedures authorize the CBRC to take certain intervention and/or corrective actions:

· for adequately capitalized banks, the CBRC may, in order to prevent capital adequacy from falling below the minimum levels, adopt intervening actions such as requiring banks to improve risk management and enhance risk controls, and restricting banks from engaging in high risk activities;³⁷

· for undercapitalized banks, the CBRC will take corrective actions including, but not limited to,

· issuing a supervisory letter of notice and requiring the recipient bank to submit and implement an acceptable capital restoration plan within two months of the notice date,

· requiring banks to reduce risky assets and restrict asset growth, the purchase of fixed assets and dividend payouts,

· restricting banks from opening new branches or starting new products, and

· requiring a bank to suspend all but low-risk activities;³⁸ and

· for significantly undercapitalized banks, the CBRC may take further actions in addition to the corrective actions for undercapitalized banks, including requiring the removal of senior management, taking over the banking institution, facilitating the restructuring and even closing such institution.

Since most of China's commercial banks currently do not meet the minimum capital adequacy ratios, it appears that the CBRC may begin wielding its supervisory power over most commercial banks from March 1 2004, the effective date of the Capital Adequacy Procedures. This can be anticipated even though the minimum capital adequacy requirements will not be fully implemented until January 1 2007. It is unclear how aggressive the CBRC will be in wielding its power to enforce corrective action for undercapitalized banks. It is likely that the CBRC will tread softly at the initial stages in light of the political sensitivities accompanying the ongoing reforms in the banking sector.

Just after the CBRC's promulgation of the Capital Adequacy Procedures, the People's Bank of China also announced that it would, from April 25 2004, raise the ratio of deposits held as reserves by 0.5% for commercial banks failing to meet the minimum 8% capital adequacy ratio.³⁹ The purpose of this increased deposit ratio is to help ensure that such undercapitalized banks have enough cash set aside to cover bad loans, while also decreasing the ability of such banks to continue speculative lending.

Disclosure Requirements

The information disclosure requirements⁴⁰ in the Procedures are generally in line with the framework of Pillar III of Basel II (i.e., market discipline) and supplement the general rules in Information Disclosure by Commercial Banks Tentative Provisions issued by the PBOC on May 21 2002.⁴¹ Commercial banks are required under the Capital Adequacy Procedures to disclose information covering the following areas: (1) the objective and policies of risk management; (2) the scope of application of such policies; (3) capital; (4) capital adequacy ratios; and (5) credit risk and market risk. Prior to any disclosure, all such information must first be approved by the board of directors of the bank and also submitted to the CBRC. The Procedures require banks to make disclosures on an annual basis within four months of the end of each accounting year. In addition, the information must be disclosed at major operating sites of the commercial bank and made available to the bank's shareholders and relevant stakeholders.

A Dramatic Step

The Capital Adequacy Procedures are a dramatic step in the modernization of the PRC banking system and may represent the most sophisticated and technical regulations ever issued by the Chinese government. They also demonstrate the conviction of the CBRC to address head on the capital adequacy problem among Chinese commercial banks.

By imposing international standards of capital adequacy, the Procedures aim to end the under-provisioning that is a rather common practice among Chinese commercial banks and believed to be the single largest distorting factor in calculating capital adequacy. As a result, it is well understood that the implementation of the Procedures will cause a further drop in the capital adequacy ratios of Chinese commercial banks. According to an estimate by UBS, risk-weighted assets at Chinese commercial banks will increase by an average of 30-35%, and capital adequacy ratios are likely to decrease by an average of 1.5-2%.⁴² Since such a decrease will only reflect the imposition of a more precise measurement process rather than a decrease in actual capital, the decrease in the capital adequacy ratios is actually a positive development. As Liu Mingkang, the Chairman of the CBRC, has stated: "A low but reliable capital adequacy ratio is better than one that is high but less meaningful."⁴³

In order to meet the minimum capital adequacy requirements by January 1 2007, Chinese commercial banks will be forced to accelerate the disposal of NPLs and improve asset quality on one hand, and to raise significant capital on the other hand. As a result it is likely that the next few years will see very significant activity involving both the asset and capital sides of the equation, many of which are likely to involve foreign investors. In addition, it is also likely that the Capital Adequacy Procedures may contribute to a reduction in the rate of loan growth as commercial banks in China focus more on asset quality than quantity.

Endnotes

1 The CBRC had indicated that these Procedures would be issued in 2003. See "The Responses to the Press by the Senior Official of the China Banking Regulatory Commission on Issues Relating to the New Capital Accord," August 14 2003, available on the CBRC's website at www.cbrc.gov.cn.

2 Since 1999, the Basel Committee has been working on Basel II, the proposed new capital adequacy framework to replace Basel I. It is expected that Basel II will be finalized in mid-2004 and implemented by the end of 2006 in G10 countries. Basel II consists of three mutually supportive pillars: minimum capital requirements (Pillar I); supervisory review process (Pillar II); and market discipline (Pillar III). Copies of consultative papers of Basel II are available on the Basel Committee's website at www.bis.org/bcbs.

3 The five-category loan classification system replaces a four-category classification system that had been in use in the PRC since 1988. In the four-category system, default loans could be classified as performing even when a borrower had ceased operation due to financial difficulties. See the PBOC's Notice to Fully Implement the Five-category Loan Classification System, December 19 2001, available on the PBOC's website at www.pbc.gov.cn.

4 In 2003, the third quantitative impact survey (QIS3) participated in by five Chinese banks (representing 48% of the total assets of all financial institutions in China) showed that total risk-weighted assets would increase by 9.02% using the standardized approach, which would cause an estimated 1-2% decrease in the average capital adequacy ratio. See letter from Liu Mingkang, the Chairman of the CBRC, to Jaime Caruana, Chairman of the Basel Committee on Banking Supervision, July 31 2003, available on the CBRC's website at www.cbrc.gov.cn.

5 See ibid.

6 "Senior Official of the China Banking Regulatory Commission (CBRC) Speaking to the Press on the Newly-issued Administration of Capital Adequacy Ratios of Commercial Banks Procedures," February 27 2004, available on the CBRC's website at www.cbrc.gov.cn.

7 A recent KPMG survey of 294 financial institutions in 38 countries has found that about 10% of banks are still establishing their Basel II teams, while only 8% have reached the testing and validation phrase. The complexity of collecting data and high compliance costs are cited as the main reasons that have slowed banks' preparation for Basel II. See "Lenders Slow to Meet Basel II Guidelines," South China Morning Post, March 25 2005.

8 The Capital Adequacy Procedures apply to commercial banks incorporated in China, including Chinese-funded commercial banks, solely foreign-funded commercial banks and Sino-foreign equity joint venture commercial banks. See Article 2 of the Capital Adequacy Procedures.

9 The Capital Adequacy Procedures, Article 7.

10 Ibid, Article 4.

11 Operational risk is covered in Basel II and defined as the "risk of losses resulting from inadequate or failed internal processes, people and systems or external events", which includes legal risk but excludes strategic and reputational risk. See "Consultative Document, The New Basel Capital Accord," July 31 2003, p. 120, available on the Basel Committee's website at www.bis.org/bcbs.

12 For example, the PBOC issued the Internal Control of Commercial Banks Guidelines on September 18 2002.

13 The Capital Adequacy Procedures, Article 11.

14 The possibility of issuing preference shares has been an option since promulgation of the PRC Company Law in December 1993. To date, however, no companies in China have issued any preference shares and it is unclear whether any company will be permitted to make any such an issuance without additional regulatory guidance.

15 The Capital Adequacy Procedures, Article 12. Detailed definitions of each of the components of core capital and supplementary capital are set forth in Annex 1 to the Capital Adequacy Procedures.

16 Ibid, Article 13.

17 The four state-owned commercial banks have reportedly been filing applications annually in recent years to increase their capital by debt issuance, but none have been approved. See "Capital Adequacy Hike in Pipeline," China Daily, February 3 2004.

18 See "Bank mulls bond plan for pilot restructuring," China Daily Hong Kong Edition, March 31 2004; "Chinese Bank Plans Debt Issue," The Asian Wall Street Journal, March 31 2004.

19 The Capital Adequacy Procedures, Article 16.

20 Detailed risk weights of on-balance sheet assets are set forth in Annex 2 to the Capital Adequacy Procedures.

21 The Capital Adequacy Procedures, Article 27. Annex 3 to the Procedures sets out detailed credit conversion factors for off-balance sheet items and the adjusted treatment for exchange rate, interest rate and other derivative contracts.

22 The CBRC indicated that the use of S&P's rating in the Capital Adequacy Procedures does not express the choice of any ECAI by the CBRC. See the Capital Adequacy Procedures, Article 49.

23 The Capital Adequacy Procedures, Article 17.

24 S&P raised its long- and short-term foreign currency sovereign credit rating on China to "BBB+/A-2" from "BBB/A-3" on February 18 2004. See S&P's "Credit Report on the People's Republic of China", published February 26 2004, and available on S&P's website at www.standardandpoors.com.

25 The Capital Adequacy Procedures, Article 19.

26 Ibid, Article 22.

27 The PBOC notice was issued on June 5 2003 but faced strong resistance from the real estate industry. A summary of the notice is available on the PBOC's website at www.pbc.gov.cn.

28 The CBRC's proposed guidelines were published for public comment on February 26 2004, a copy of which is available on the CBRC's website at www.cbrc.gov.cn.

29 The Capital Adequacy Procedures, Article 28.

30 Ibid, Article 30.

31 Ibid, Article 31.

32 See supra note 5.

33 CBRC officials indicated that the Basel Committee would encourage the countries that choose to remain on Basel I to look into the principles of Basel II, and especially to strengthen the Pillar II and Pillar III. See supra note 6.

34 The Capital Adequacy Procedures, Articles 33 and 34.

35 Ibid, Articles 35, 36 and 37.

36 Ibid, Article 38.

37 Ibid, Article 39.

38 Ibid, Article 40.

39 This new requirement, however, will only apply to shareholding commercial banks, city commercial banks and foreign banks. State-owned banks are exempt. See the PBOC's Decision to Implement a Differentiated Deposit Reserve Ratio System, March 25 2004, available on the PBOC's website at www.pbc.gov.cn.

40 The Capital Adequacy Procedures, Articles 42-46.

41 A copy of the Tentative Provisions is available on the PBOC's website at www.pbc.gov.cn.

42 See Chen Changhua, "The Gain and Loss of Listing Banks in the Banking Reform," Caijing Magazine, March 20 2004.

43 See Liu Mingkang, "Testing Times Lie Ahead for Supervisors," The Banker, December 2 2003.