Improving Debt Provisioning by Chinese Financial Institutions: New Ministry of Finance Rules

· Asset impairment provisions, which are provisions allocated by a financial institution to cover potential losses when the estimated recoverable amount of a debt or equity asset is lower than the book value thereof.⁴

GENERAL PROVISIONS

For general provisions, the Provisioning Measures require a financial institution to make allocations at the end of each year at a certain percentage of the balance of assets on which the financial institution bears risk and may incur losses. The Provisioning Measures suggest that, in principle, the balance of general provisions should not be less than 1% of the year-end balance of its risk assets. Each financial institution, however, is permitted to determine the specific percentage allocated to its general provisions by comprehensively considering the potential risks and other relevant factors.⁵ Compared to the previous MOF rules, which imposed a mandatory requirement for each financial institution to set aside at minimum 1% of its year-end balance of risk assets⁶, the Provisioning Measures allow financial institutions to exercise greater discretion in determining the appropriate level of general provisions. Since such provisions are counted as supplementary capital of commercial banks⁷, a bank that wishes to improve its capital adequacy ratio may choose to increase its general provisions.

The Provisioning Measures provide that general provisions allocated by a financial institution are a constituent of shareholders' equity and therefore shall be treated as a post-tax distribution of profit.⁸ Previously, general provisions were treated as a pre-tax deduction. While this change in financial treatment is not expected to have significant impact on the level of general provisions, it will result in increases in financial institutions' operating profit before tax, net profit and shareholders' equity.⁹ In addition, this change is expected to increase the income tax payable by financial institutions and reduce the distributable profits for shareholders.

ASSET IMPAIRMENT PROVISIONS

In determining asset impairment provisions, a financial institution is required to conduct quarterly reviews of its debt and equity assets, analyze their recoverability and, in accordance with the principle of prudence, make reasonable estimates of potential losses that it may incur on these assets.¹⁰ Asset impairment provisions include loan loss provisions, bad debt provisions and provisions for the impairment of long-term investments. The Provisioning Measures set out the following specific requirements for each category of the asset impairment provisions.

Loan Loss Provisions

The Provisioning Measures allow financial institutions to set aside two types of loan loss provisions: specific provisions and special provisions. Specific provisions are provisions allocated by a financial institution based on possible loan losses determined after the risk classification of its loans in accordance with the People's Bank of China's Guiding Principles for the Classification of Loan Risk. A financial institution is empowered to make reasonable determinations of the ratio of capital to be allocated to a specific provision, based on the potential risks of its loan assets and the possibility of recovering such loan assets. The Provisioning Measures, however, set out the following guideline provisioning percentages for different categories of loans:

· 2% for loans classified as "special-mention";

· 25% for loans classified as "substandard";

· 50% for loans classified as "doubtful"; and

· 100% for loans classified as "loss".

For loans classified as "substandard" or "doubtful", the provisioning percentage may fluctuate within a range of 20% of the respective 25% and 50% ratios listed above.¹¹

Special provisions are provisions set aside for all loans in a specific country, region or industry. Although a financial institution is allowed to exercise discretion in reasonably determining the percentage of special provisions based on the extent of its loan asset risk and the possibility of recovering such loan assets, it is expected that the overall level of special provisions may be significantly affected by the PRC government's macro-economic policies. Such provisions therefore are expected to be particularly affected by those policies enacted from time to time to curb excessive bank lending to certain sectors, such as those that were recently applied to the real estate and steel sectors.

Bad Debt Provisions

The Provisioning Measures require financial institutions to make provisions for underlying assets including interbank deposits, interest receivables, dividend receivables, operating lease receivables and other receivables. A financial institution may classify the underlying assets by referencing the Guiding Principles for the Classification of Loan Risk to determine the provisioning percentage. Such provisioning must take into account not only this risk classification, but also considerate past experience, the financial conditions and cash flows of the debtor and other relevant information.¹²

Provisions for Impaired Long-term Investments

Other than (i) securities investments using the lower of cost and market value method, or fair value method, to determine period-end values, or (ii) investments in PRC treasury bonds, financial institutions shall make provisions for all long-term debt and equity investments that become impaired. The Provisioning Measures provide guidelines for determining whether provisions for impaired long-term investments should be made.

For long-term investments where a market value is available, the determination for impairment provisions may be based on the following indications:

· The market value has been lower than the book value for two consecutive years;

· Trading in the investment has been suspended for one year or more;

· The investee experienced significant losses during the year in question;

· The investee has incurred losses for two consecutive years; or

· The investee is undergoing restructuring or liquidation or has other indications that it may not sustain operations.

For long-term investments where no market value is available, a financial institution may determine impairment provisions based on the following indications:

· Changes in the political and legal environment affecting the operations of the investee, which may cause the investee to incur significant losses;

· Changes in market demand for an investee's products or services, causing a severe deterioration in an investee's financial position;

· Material changes in the technology of an investee's industry, resulting in the investee losing its competitiveness and causing serious deterioration in its financial position; or

· Other circumstances indicating that an investment may not be able to generate meaningful economic benefits.¹³

ENFORCEMENT

The Provisioning Measures require each financial institution to make timely and sufficient non-performing debt provisions based on the underlying risks of respective assets. A financial institution failing to make sufficient allocations to its non-performing debt provisions is prohibited from distributing its post-tax profit.¹⁴ By imposing this prohibition, the Provisioning Measures aim to address the rather common practice of under-provisioning among Chinese financial institutions.

In addition to the aforementioned, a financial institution is required to provide the relevant financial authority with information on its non-performing debt provisions within 30 days of the end of each quarter. Such information must include: (i) information on the categorization and classification of assets for which the provisions were made, the method of evaluating the underlying risks, the provisioning percentages and changes thereto; and (ii) information on changes in the balance of the non-performing debt provisions, including respective balances at the beginning and the end of each quarter and provisions, reversals and write-offs made during the quarter.¹⁵

For the branches and offices of the financial institutions that are under the supervision of PRC central government, the Provisioning Measures also empower the MOF's financial inspectors residing in the relevant region to supervise their allocations to non-performing debt provisions. The MOF inspectors may take rectifying measures if any such branch or office fails to allocate sufficient capital to its non-performing debt provision as dictated by the Provisioning Measures.¹⁶

ANOTHER STEP FORWARD

The adoption of the Provision Measures is a further step forward in the PRC government's efforts to modernize China's financial system and improve the provisioning practice among Chinese financial institutions. By gradually introducing technical regulations, such as the Guiding Principles for the Classification of Loan Risks, the Capital Adequacy Rules and the Provision Measures, the PRC government appears to be aiming to both upgrade its financial regulatory system to international standards and to improve the market-oriented lending and provisioning practice among Chinese financial institutions. In the long run, the continued focus of the MOF and the CBRC on the implementation of appropriate rules related to risk assessment and provisioning by Chinese financial institutions should significantly improve the quality of financial statements of Chinese institutions. Moreover, requiring appropriate disclosure and provisioning for poor lending or other business decisions should gradually cultivate a business culture of risk management that will likely be much more effective than policy directives in curbing risky lending practices.

Endnotes

1 On December 25, 2001, the People's Bank of China promulgated the Guiding Principles for the Classification of Loan Risk. Since then, all commercial banks in the PRC have been required to classify their loans under a five-category system. The five categories are: pass, special-mention, substandard, doubtful and loss.

2 On February 23, 2004, the China Banking Regulatory Commission promulgated the Measures for the Administration of Capital Adequacy Ratios of Commercial Banks, which were largely based on the Basel Capital Accord and, for the first time in China, set forth a precise mechanism for calculating and regulating capital adequacy of PRC commercial banks. See DeSombre, M.G., and Chen, W., 'New Capital Rules Bring China's Banking Regulation up to Global Standards', China Law and Practice, April 2004, pp. 12-16.

3 Measures for the Administration of Debt Provisioning by Financial Institutions, Article 2.

4 Ibid, Article 3.

5 Ibid, Article 5.

6 See the Ministry of Finance's Measures for the Evaluation of the Disposal of Non-performing Assets by Financial Asset Management Companies, issued January 1, 2002, Article 8.

7 Measures for the Administration of Capital Adequacy Ratios of Commercial Banks, Article 12.

8 Measures for the Administration of Debt Provisioning by Financial Institutions, Article 12.

9 It is estimated that the implementation of the Measures for the Administration of Debt Provisioning by Financial Institutions will increase the net profits and shareholders' equity of the commercial banks listed on Shanghai Stock Exchange by 19.1-39.8% and 17.1-24.8%, respectively. See, 'MOF Issued the Measures for the Administration of the Provisioning by Financial Institutions for Doubtful Debts', Economic Observers, June 27, 2005.

10 Measures for the Administration of Debt Provisioning by Financial Institutions, Article 5.

11 Ibid, Article 6.

12 Ibid, Article 7.

13 Ibid, Article 8.

14 Ibid, Article 9.

15 Ibid, Article 10.

16 Ibid, Article 11.