Striving for banking system stability

September 03, 2011 | BY

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New measures from China's banking regulator aim to prevent financial institutions from becoming over-leveraged, and they provide a clear framework on accountability and detailed guidance rules on disclosure

The China Banking Regulatory Commission (CBRC) issued the Measures for the Administration of the Leverage Ratio of Commercial Banks (中国银行业监督管理委员会商业银行杠杆率管理办法) (the Measures) on June 1 2011, which will go into effect from January 1 2012. The Measures will become a major regulatory tool for supervising commercial banks and other non-bank financial institutions under the jurisdiction of the CBRC. It is drafted largely on the basis of the relevant part of Basel III and follows the internationally-recognised approach to addressing the issue of over-leverage, which was highlighted during the 2008 financial crisis. Therefore, the Measures are a transplantation of international regulatory norms into the PRC regime, with necessary adjustments to suit the PRC market and market participants' needs.

There are a few salient features of the Measures that are worth analysing in further detail:

First, the Measures provide a clear framework of accountability. The board of directors has the ultimate responsibility for managing the leverage ratio of the bank, while the senior management is responsible for the implementation task. If a bank's leverage ratio is below the minimum regulatory requirement (4% on either a consolidated basis or a non-consolidated basis), the CBRC has the power to require that bank to increase the first-tier capital, to control the increase of balance sheet and off-balance-sheet items, and to reduce the scale of such assets. In case the bank fails to rectify the issue or presents a material threat to the sound operation or the benefits of depositors and other customers, the CBRC's measures may be escalated to order the suspension of certain businesses or refuse to approve new businesses of that bank, to restrict the distribution of dividends and other incomes, to refuse to approve the establishment of new branches, to order the controlling shareholder to transfer the equity interests or shares in that bank or restrict the relevant shareholders' rights, and to order the adjustment of directors or senior management or restrict their powers. Moreover, an administrative penalty may be imposed on the bank as well. It is interesting to see whether and how enforcement will be applied in practice. The Measures only set up a framework of accountability, but the implementation of this framework remains a challenge.

Secondly, the Measures follow the key elements of Basel III in respect of leverage ratio regulation, including the calculation of leverage ratio, the constituents of the numerators and denominators in such calculation formula and the disclosure rules. From a comparative law perspective, transplantation of foreign concepts and norms into the host country's legal system is far beyond a task of translation. It is easy to translate, but without understanding the history, evolution and rationale of such concepts and norms, as well as the costs and benefits of their application in the bespoken context of the host country, the transplantation may be easy to fail. It is less sensitive in terms of banking regulation because more or less a universal language is now used across the continents and regulators have consensus on most technical points. Probably for the CBRC, the most efficient way to introduce a regulatory tool into the PRC is to follow international norms. However, we need to critically follow up with the implementation of the Measures in the PRC market and analyse the impact on Chinese financial institutions before labeling it a successful transplantation of international norms.

Thirdly, the Measures are closely intertwined with the capital adequacy ratio regulation. The calculation of the first-tier capital and the reductions must follow what the capital adequacy ratio regulation provides. The methodology for adjusting balance sheet assets and off-balance-sheet items is also based on such capital adequacy ratio regulation. The Measures provide that derivatives should be calculated by the current exposure approach and other balance sheet assets should be calculated by deducting the relevant provisions. While the calculation of the balance of balance sheet assets cannot take into account any credit risk mitigation measures (for example, collateral, guarantee and credit derivatives), the adjustment may be made on the basis of netting for repos and derivative transactions.

For off-balance-sheet items, they must be converted to some definitive figures for the purpose of calculation. To achieve this objective, the Measures provide that any unconditionally revocable commitment should be converted at the credit conversion factor of 10%, while any other off-balance-sheet item should be converted at the credit conversion factor of 100%. It is worth noting that the Measures expressly refer to the terms of “netting” (for repos and derivative transactions) and “unconditionally revocable commitment” (as a type of off-balance-sheet item). These concepts are relatively new under PRC law. For example, although netting is widely used in derivative transactions, there is no statutory definition for this key term so far. However, the CBRC's Basel-related rules keep using this term, which will eventually help the formal recognition of this concept under PRC law. For an unconditionally revocable commitment, the Measures define it as a commitment by the bank which may be revoked at any time without prior notice or any condition and without any dispute, litigation or other costs to the bank, which must be set out in the relevant agreements in writing. The significance of this term is not only the scope of “revocable” commitments but also the deduction for the meaning of “irrevocable” commitments (as its opposite definition).

Fourthly, the Measures provide clear guidance on the disclosure rules. Banks need to set up a target leverage ratio not lower than the statutory threshold (4%). They must submit to the CBRC the leverage ratio sheet (non-consolidated and consolidated) on a periodical basis. A consolidated sheet will be submitted semi-annually, and a non-consolidated sheet will be submitted quarterly. The disclosed information shall at least include the leverage ratio, the amount of first-tier capital, the deductions from the first-tier capital, the balance of after-adjustment balance sheet assets, the balance of after-adjustment off-balance-sheet items and the balance of the aggregate of after-adjustment balance sheet assets and off-balance-sheet items. The information on leverage ratio must be disclosed by commercial banks within four months after the end of one financial year. If there is any special reason for not being able to meet this deadline, they must apply to the CBRC for delaying the disclosure at least 15 working days before such deadline. The banks are obliged to ensure that shareholders and stakeholders will have prompt access to such information, and must disclose such information in its principal operation premises.

Last but not least, the Measures set out a transition period for banks to implement the leverage ratio requirement. For those “systematically important banks” designated by the CBRC, the Measures' requirements must be implemented by the end of 2013; for other banks, the deadline will be the end of 2016. If one bank fails to reach the minimum leverage ratio during this transition period, it should report to the CBRC and prepare an action plan.

In summary, the Measures will play a key role in the CBRC's prudential regulation of banks and non-bank financial institutions in the PRC. The regulatory objective is to prevent a bank or a financial institution from becoming over-leveraged during the process of operation and threatening the safety of the banking system. It has to work in combination with other regulatory tools (for example, capital adequacy ratio) under the prudential regulation regime. It also imposes additional requirements on banks which will have to carefully study the rules and prepare the implementation. It is necessary to track the development in this area over the next 12 months and see if the CBRC will issue more implementing rules or guidelines to help banks and non-bank financial institutions under its jurisdiction adjust the model of operation by taking into account the leverage ratio requirement.

Zhang Xin, Global Law Office, Beijing

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