New China Banking Regulatory Guidelines: Supervision Raised to Minimize Risks of Domestic Banks

Kevin Zhou, partner at GFE Law Office [KZ]

David Zou, senior partner at Boss & Young [DZ]

CLP: What are the main reasons behind the government's move to issue these Guidelines?

DZ: The regulation is issued mainly in reaction to the recent development of Chinese banks, which have become financial controlling groups through equity investment into other financial institutions as well as business diversification to include insurance, securities and funds. This development significantly raised the total risks of a banking group and the risks and impact on the banking group brought by the banking group's affiliates.

KZ: The Chinese government has realized that the opening-up of the banking industry not only has brought positive impacts on China's financial system but also has created some risks. Its purpose to issue the Guidelines is to improve the quality of banking supervision. It seeks to strengthen its banking supervision to prevent the potential risks.

AZ: Pursuant to the Banking Supervision Law of the PRC, the mechanism of consolidated statements shall be deployed to supervise the banking financial institutions. We understand that the Guidelines are intended to furnish a Chinese governmental agency – the China Banking Regulatory Commission [CBRC] – with the powerful instrument to stringently supervise and monitor the banking industry and prevent and minimize risks involved.

LZ: The Chinese banking industry has made remarkable developments in re-modeling its business operation. Many foreign investors have become shareholders of Chinese banks through equity investments, and a lot of Chinese banks have become publicly-listed companies in domestic or overseas stock exchanges in order to obtain diversified capital-raising sources. In the meantime, more and more banks are reaching beyond their traditional business scope and into such new areas as investment banking-related business, financial leasing and fund management, etc. [...] Most recently, CBRC and China Insurance Regulatory Commission jointly issued a notice which permits banks and insurance companies to hold shares of each other. At the same time, more and more Chinese banks are becoming stakeholders of overseas banks or financial institutions, one prominent example being the acquisition of shares of the Standard Bank by the Industrial and Commercial Bank of China. This compositive operation strategy, which itself is undergoing adjustments and producing variations, has made it necessary to improve the manners of supervision.

CLP: What are your initial thoughts on the Guidelines on Oversight of the Consolidation of Statements? Does more need to be done?

AZ: The Guidelines have three notable aspects: Firstly, the consolidation of statements is different from the one to be prepared from the accounting perspective. In addition to certain accounting standards such as cash flow, equity status and so on, the Guidelines would broaden the scope of supervision by adding various risk indicators such as capital adequacy, credit risk and market risk. Secondly, the Guidelines apply to banking groups which, however, are broadly defined as commercial banks incorporated in China and their affiliates inside or outside China. In addition, although the Guidelines do provide certain quantitative and non-quantitative criteria to narrow down the coverage, CBRC is given under the Guidelines the discretion to determine the scope of banking groups based on the equity structure and the nature and assessment of risks. Lastly, the Guidelines have provided CBRC with more avenues to supervise the consolidation of statements of banking groups, including market access, on-site inspection, off-site surveillance, risk assessment, communication with external auditors, and information sharing and coordination with foreign regulatory authorities.

DZ: This is a good preventative move to strengthen the regulatory supervision over the banking industry and to monitor and avoid potential major risks to banking groups. The Chinese banks experienced fast growth in the recent years. However, the management skills and risk control measures of these banks may have lagged behind [...]. This regulation is still at its trial stage. Many of the requirements demand improvement in the banking infrastructure system. The insurance and securities industry regulators should also follow suit to adopt consolidation of statements requirements in order to better implement the regulation. The banking groups also need to get prepared.

LZ: Being the first in China to set forth in full range the operational matters of consolidated supervision, the publication of the Guidelines will mark an important progress in the development of financial supervisory in China.

Understandably, on the other hand, “being the first” does not equal “being perfect”. As the financial market is changing fast, it is probably unreasonable to expect the Guidelines to be a full-fledged one. Indeed, the CBRC has published the Guidelines only as a provisional rule. We believe that the Guidelines will become more operative and mature as the Chinese banking industry and CBRC has gained more experience.

CLP: What major changes have you seen or would you expect to see in the banking industry as a result of these Guidelines?

KZ: The major change that I have seen is that China is raising the effectiveness and professionalism of supervision in the banking industry. According to the Guidelines, banking supervisors have the authority to review and reject any proposals to transfer significant ownership or controlling interests in existing banks to other parties. Banking supervisors also have the authority to establish criteria for reviewing major acquisitions or investments by a bank. On the other hand, it is the banking organizations' responsibility to provide banking Supervisors with financial information regarding their activities and financial position at regular intervals and this information must be verified periodically. By following those international standards, it will be very helpful for Chinese banking Supervisors to conduct effective supervision.

DZ: Chinese banks will need to improve their corporate governance and information transparency, invest more in infrastructure, cooperate more with the banking regulators both in China and abroad, and establish effective firewalls among the parent bank and its various subsidiaries and affiliates within the banking groups.

AZ: With respect to the government's efforts to exercise consolidated supervision power on the banking industry, this is the first time for the government to issue a set of comprehensive rules to strengthen its supervision of the banking industry.

Before the Measures for Administration on Consolidated Financial Statements to Supervise Foreign-funded Bank were issued on March 2004 (Foreign Bank Rules), there had been no rule particularly addressing the legal issue of consolidated supervision. Different from the Foreign Bank Rules, the Guidelines apply to all commercial banks incorporated in China and their affiliates. With the enactment of the Guidelines, the Chinese government is able to regulate the consolidation of statements in a more systematic and comprehensive way for all bank groups within its jurisdiction.

CLP: How do the Guidelines compare to those in other countries? Is China now in line with international standards?

KZ: The Guidelines were made by referring to many international standards such as the Core Principles from the Basel Committee on Banking Supervision, Financial Modernization Act from the US and the Banking Ordinance from Hong Kong, and others. As we can see, many principles of the Guidelines were from the above international standards. There is no doubt that the Chinese government is taking great efforts to have their legislation meet international standards.

DZ: China is following international practice. Its regulatory standards become more in line with international standards. The regulation is also a revamp of China's existing provisions scattered in different regulations and rules.

LZ: When it enacts the Guidelines, CBRC borrows heavily from the rules and provisions of the Basel Commission and other countries (developed or developing ones) of similar nature. For example, the definition of Consolidated Supervision in the Guidelines is similar to that in the relevant rules of the Basel Commission and the Financial Services Authority of the UK. We think the Guidelines are in line with the international practices in principle and framework. At the same time, this is done by CBRC without losing considerations on the specific market circumstances of China.

CLP: In what way has the promulgation of the Guidelines impacted your practice?

AZ: Given that the Guidelines are newly promulgated, we have received inquiries from our clients on this particular issue, and we are in the process of assessing the impacts of the Guidelines on our clients' practice and operation either inside China or outside of China.

KZ: I believe that the Chinese banking industry is becoming more internationally standardized. Lawyers who are familiar with the domestic laws and have a good understanding about the international rules and standards will be in great demand in this market.

DZ: The regulation will certainly give more business to accounting firms. However, law firms will also benefit from the enhanced requirements of banking supervisions.

LZ: The Guidelines were published in February of 2008, and the effect on our practices largely remains a matter to be seen. Along with our predictions above about the effects on the banking industry, we believe it is also a good opportunity for us to expand our practice into such areas and assist the banks in ensuring compliance with the new requirements, especially when they attempt to step in a new business field.

CLP: Are the Guidelines clear enough?

LZ: The content of the Guidelines includes: general provisions; the scope of supervision; essential aspects of the supervision (including the capital ratio, the exposure to the important clients, connected transaction, other risks); modes of supervision; cross-border supervision; the intra-group consolidation of statements management; and other provisions. Therefore, it has made out a framework which covers most of the important factors. The Guidelines are a pilot one, and therefore we believe that the CBRC will pay more attention to the development of the market and the banks' feedback and make further amendments and supplements based on the practical results of its implementation.

KZ: I think the Guidelines are clear. However, as mentioned, the Guidelines are still for trial implementation. It takes time for the banking supervisors to determine if the new Guidelines are suitable for the Chinese banking operation system.

DZ: The regulations are only the beginning of many changes to come. Their full implementation requires further clarification, complementary rules and guidance from the regulators directly.

AZ: There are many technical issues that need to be further clarified, but in general, it has provided a good coverage and principles in terms of dealing with many aspects of such exercise.

CLP: Do the Guidelines conflict with the requirements for China's WTO membership?

LZ: We do not think that the Guidelines conflict with the requirements for China's WTO membership. The CBRC has followed international practices in this area and will reinforce its cooperation with supervisors from other countries. We think this is a good thing both to China and to foreign investors and their home countries.

CLP: Are lawyers who advise on this better off if they have a banking background? Or, is a banking background necessary to properly offer counsel to clients?

LZ: A banking background is doubtlessly helpful for counsel advising the banks. However, the banking industry in China is growing so fast that it is impossible for even bankers to keep up with all developments in all banking fields, not to mention for a lawyer. The consolidation of statements is related to the accounting rules, which may be very complicated for a lawyer to have a comprehensive understanding of. Therefore, it is a must for a lawyer to be committed to continuous communication and discussion with banks and the supervisors in order for her professional services to be valuable to her bank clients.

KZ: I would say that it is helpful to offer counsel on this kind of matters to clients if the lawyers have a banking background, but it is not necessary. It is more important for the lawyers to have enough experiences of dealing with the government and also have good understanding about the international rules and standards.

CLP: How will these Guidelines benefit your clients?

LZ: The Guidelines provide for the principles of consolidated supervision, the supervision target and modes, the requirements in respect of the shareholders of the banks, the requirements on the internal management rules with a view to accommodating the consolidation of statements, etc. These provisions may not immediately result in a direct enhancement of business performance by the banks, but in the long run this system will help banks to set up and perfect their internal control and risk management and lead to the healthy and sustainable development of the banks and the financial markets.

KZ: I hope that the Chinese government's supervision work over the banking industry will become more comprehensive, detailed and professional after the promulgation of the Guidelines, and that the Chinese banking system will become more secured so that our clients could benefit from the fair and standardized market environment.