Commercial Banks and Subordinated Bond Issues

Background to the Procedures

Worldwide competition among commercial banks over the past two decades has led to a dramatic drop in the ratio of capital to risk-weighted assets (also called capital adequacy ratios). To strengthen the banking industry, the Basel Accord of 1988 sets a minimum capital adequacy ratio of 8%, with a tier 1 or core capital adequacy ratio of 4%. Core capital is generally composed of common shares and "disclosed" reserves after post-tax earnings. Tier 2, or subordinate capital, has a wider scope. It can be general loan-loss reserves, other hidden reserves, revaluation reserves, certain hybrid capital instruments and subordinated term debt (like bonds). The Basel Accord requires that at least 50% of an institution's capital consist of core capital. Despite the government's efforts to impose international standards, Chinese commercial banks' capital adequacy ratios are still very low.

The Details

The Procedures allow a commercial bank to issue subordinated bonds and to take on subordinated debt. In China, bonds and debts are treated differently and are separately regulated. Raising subordinated debt (excluding bonds) is subject to different regulations and rules issued by the CBRC. Payment of a commercial bank's subordinated bonds claims takes priority after that of a bank's other debts but before that of their equity capital. Upon approval from the CBRC, commercial banks' subordinated bonds can be treated as subordinate capital. In accordance with the Procedures, the CBRC will be in charge of evaluating issuer's qualifications and the People's Bank of China will supervise the issuance and trading of subordinated bonds in the inter-bank bond market.

The issuance of subordinated bonds is subject to the PBOC's final approval. The Procedures specify five qualifications for commercial banks to issue subordinated bonds, including a five-category loan classification system and a core capital adequacy ratio no less than 5% of for public issuance (4% of core capital adequacy ratio for private issuance). Subordinated bonds can be issued publicly or privately in the inter-bank bond market. Subordinated bonds can be traded in the inter-bank bond market. However, privately placed subordinated bonds can only be traded among those bondholders. This is intended, at least partially, to prevent an issuer from converting a private placement into a public issuance. The Procedures also provide the possibility of shelf registration.

The Procedures provide that an issuer shall appoint an underwriter group to sell its subordinated bonds. Underwriting subordinated bonds can be performed through a firm undertaking, best efforts undertaking or invitation to bid. The Procedures further set out the basic qualifications for underwriters, the disclosure obligations at the issuance and ongoing disclosure obligations of the issuer.

The Procedures provide that the National Treasury Bond Registration and Settlement Centre (the Centre) shall be the custodian and registrar of subordinated bonds. Therefore, the payments, transfers and, practically, the granting of security interests (if any) involving the subordinated bond shall be settled through the Centre.

Comments

The Procedures allow Chinese commercial banks to raise capital in a very short time. It is estimated that more than Rmb60 billion in subordinated bonds will be issued by Chinese commercial banks this year, and Rmb240 billion in the next two or three years. Obviously, by issuing subordinated bonds, the Chinese authorities hope to raise state-owned commercial banks' capabilities in competing against foreign banks and further resisting risks to the entire banking industry. However, subordinated bonds can only help to increase commercial banks' subordinated capital and will not in any event affect their core capital. Actually, since the 1988 Basel Accord, many global commercial banks have used subordinated bonds only as a temporary tool to supplement capital and have not allowed subordinated debts levels to reach more than 40% of total capital. Relying on issuing subordinated bonds as the main means of raising capital raises long-term stability concerns.

The Procedures allow a commercial bank to hold another commercial bank's subordinated bonds. Although as stated by officials from the PBOC and CBRC, inter-bank holding of subordinated bonds is not prohibited by the Basel Accord and the Procedures set a limit of such inter-bank holding, to allow a commercial bank to hold another's subordinated bonds still raises deep concerns, especially considering the fact that in China, after insurance companies, commercial banks are the second largest group of purchasers of subordinated bonds. Risk for a single commercial bank will probably be reduced, but not for the entire banking industry. On the contrary, the entire banking industry sustains more risk than before.

The Procedures apply to commercial banks and policy banks. However, since the Procedures were issued to help state-owned commercial banks to increase capital adequacy ratios and add more capital, as stated by officials from the PBOC and the CBRC in a public interview, it is expected that, at least in the near term, foreign-invested commercial banks in China could have difficulty issuing subordinated bonds.