Liu Mingkangfs New Paradigm
Make no mistake: A sea change is occurring in the Chinese banking
sector. A new age is dawning.
For observers of Chinafs gradualist model
of reform, this statement will elicit skepticism, if not preemptory
dismissal. Is it not true that
rarely does anything change fundamentally—and little changes quickly—in the
bureaucratized Chinese state?
Certainly, rapid, fundamental (i.e.,
systematic) reform is rare in China.
But rapid, systematic change in the banking sector is clearly the
objective and—we assert—the likely result of new policies and regulations
promulgated by the China Banking Regulatory Commission (CBRC) in 2004.
The analogous tectonic shift in regulatory
practice was U.S. Fed chairman Paul Volckerfs decision in 1979 to target
monetary aggregates instead of interest rates, a decision that delivered shock
treatment to an overheated, inflationary economy. Liu Mingkang, chairman of the CBRC, may have been thinking
of Volcker when he supervised the drafting of the CBRCfs gRegulation Governing
Capital Adequacy of Commercial Banks,h promulgated on February 23, 2004.
A New Regulatory Regime: From Funding Constrained to Capital Constrained
In explaining its new regulatory ethos to
Chinese bankers, CBRC has described its aims to create an environment in which
gcapitalh rather than gfundingh is the key constraint on the operations of
banks. For Chinese bankers,
nothing could be more profoundly different from their accustomed modus operandi, and more challenging.
For at least the past twenty years, Chinese
bank managements at all levels have been focused overwhelmingly on a single
activity: gathering deposits if¶¼jB Yearly business development targets
(and salary bonuses) often began and ended with the single metric. The reason was simple: without a functioning gmoney centerh
money market through which banks could source funds, asset growth was
exclusively driven by and dependent upon deposit growth. Also, with transfers of funds between
bank branches (or from branches to head offices) largely constrained by Central
Bank policies that effectively required funds to remain within provincial
boundaries, each provincial branch and each level of subordinate sub-branches
were essentially required to self-fund their activities. In the way that, under planned economic
systems, administrative rules, however uneconomic, are adopted as operating
policies by production units, Chinese bank managements have traditionally
applied the self-funding modus operandi
throughout their networks. Each
branch and sub-branch, then, became an gislandh in which its ability to raise
deposits determined its business operations, and the gsuccessh of its managers. Within the limited reporting required
of sub-branches to provincial branches, to head offices, deposit raising has
always been the key metric.
Against this system, regulation took its
most fundamental and effective form, in mandating a maximum loan-to-deposit
ratio. Complying with this ratio (currently
75 percent) was the key constraint on bank business development. It has been the one ratio consistently
enforced with vigor by the regulator (the Peoplefs Bank of China until the
establishment of CBRC last year).
Under the loan-to-deposit ratio regulatory
constraint, bank capital was not a focus of regulation, and capital adequacy
was not a particular constraint.
In reality, everyone knew that capital and capital adequacy were largely
meaningless concepts within a system where tax and other regulations, as well
as the convenience of regulators and managers, precluded proper recognition of
and provisioning for loan losses, and the writing down of other non-performing
assets. More fundamentally, capital
and capital adequacy were not an issue because the banks were perceived by all
concerned to be wholly underwritten agencies of the state.
The Consequence of Funds Constrained
Regulatory – Unconstrained Growth and Low Capital Efficiency
The practical consequence of the gfunds
constrainedh regulatory and management ethos in Chinese banking has been, at
various times, including 2003, breakneck growth in both deposits and loans,
inattention to asset quality, the build up of non-performing loans (NPLs), and,
over time, the technical insolvency of virtually the entire banking
The dynamic of frenetic deposit gathering
and loan growth has contributed on a macro-level to, at yearend 2003, the
worldfs highest credit/GDP ratio of 146 percent; and, more worryingly, the
steady decline in the return on capital investment seen in China in recent
years. This decline—whose profound
effects will be felt in the years ahead--has caught the attention of policy
makers in Beijing.
Entering CBRCfs New, Capital Constrained
It is against this that CBRCfs intention to
regulate banks based on capital adequacy constitutes such a revolutionary
departure, and establishes a new paradigm for Chinese banking. Of course, from a global
perspective, this is not a new paradigm of bank regulation. Rather, it is the ethos and methodology
of Basel system that has prevailed since the mid-1980s and which is being
refined in the new Basel II framework.
In one sense, then, the CBRCfs new approach can be seen as simply bringing
Chinese banking into conformity with the ethos and practice of global
But, for China, the implications and
effects of the new system are sure to be profound. The effects on the banks and on Chinafs economy as a whole
will be deeply felt during the period of transition (from this year to January
2007, at least), and will become a key variable in the economy thereafter.
Elements of CBRCfs New Regime
The CBRCfs new regime is a comprehensive
program designed to:
1) achieve integrity and veracity of the books of banks through more
stringent provisioning requirements for losses;
2) more conservatively reflect risk by increasing risk weightings
for various asset classes, and particularly removing the privileged position
(highly discounted risk weighting) previously accorded to local government
3) inclusion of non-loan assets in the purview of provisioning
and capital adequacy requirements;
4) requirement for capital to cover market risk as well as credit
risk, and off- as well as on-balance transactions (reflecting Basel
5) clear definitions and limitations for Core Capital and Total Capital
adequacy, with deductions from capital for intangible and encumbered
assets such as goodwill and real estate investments;
6) rules for issuing and accounting for quasi-equity supplementary
capital, particularly subordinated debt;
7) new requirements for disclosure, including public disclosure
of financial results and capital adequacy; and
8) new CBRC powers and policies for supervisory review of
capital adequacy and intervention.
gRegulation Governing Capital Adequacy
of Commercial Banksh
The most important and comprehensive of
these regulations is the February 23, 2004 gRegulation Governing Capital Adequacy of Commercial
Banks.h Many of the elements of
the new system are included in this regulation. Although specifically directed at gcommercial banksh (i.e.,
excluding by definition, policy banks, and such institutions as rural credit
cooperatives), the regulation is in substance actually directed at all of
Chinafs commercially oriented banks, including, in the near term, at least two
of the four large SOE banks (Bank of China and China Construction Bank, which
are in the process of converting to commercial banks under the PRC company law;
to be followed in 2005 or 2006 by Industrial and Commercial Bank of China); and
immediately 11 shareholder banks; and 112 city commercial banks, such as Bank
of Shanghai. Foreign bank branches
(e.g., branches Citibank, Deutsche Bank, etc.) are required to follow the
regulation in calculating the risk-weights of their RMB denominate assets. In effect, then, the regulation is
directed at all of Chinafs most important banking sectors and institutions.
Key elements and specific requirements
include the following:
Commercial banks must meet minimum
capital adequacy requirements by January 1, 2007. The banks must draft and implement a feasible phase-in plan
to comply with the requirements during transition period (i.e., March 1,
2004-December 31, 2006).
The required minimum capital adequacy
ratios shall be no less than 8% for total capital and 4% for core capital.
Capital adequacy ratios are based on risk-weighted
assets (as defined by the regulation) and adequate provisioning for
various losses, including loan losses.
Capital must be sufficient to cover credit
risk and market risk.
Banks that cannot reach and maintain
the minimum level will have to curtail business.
Capital adequacy ratio = (total
capital – deductions) / (risk-weighted assets + 12.5 * capital charge for
Core capital adequacy ratio = (core
capital – deductions) / (risk-weighted assets + 12.5 * capital charge for
Core capital shall consist of paid-up
capital/common stocks, reserves, capital surplus, retained earnings and
Supplementary capital shall consist of
revaluation reserves, general loan loss reserves, preference shares,
convertible bonds, and long-term subordinated bonds.
The amount of supplementary capital
shall not exceed 100% of core capital.
Long term subordinated debt capital shall not exceed 50% of core
Deductions from the total capital base
when calculating capital adequacy ratio:
Equity investments in unconsolidated
financial institutions; and
Equity investments in commercial real
estate (not used by the bank itself) and equity investments in business
Deductions from core capital when
calculating the core capital ratio:
50% of equity investments in
unconsolidated financial institutions; and
50% of equity investments in
commercial real estate (not used by the bank itself) and 50% of equity
investments in business enterprises.
Specific provisions shall be deducted
from the book value of loans when calculating risk-weighted assets.
Claims on the Chinese government
Claims on central governments and
banks where rating for sovereign is below AA- 100%
Claims on public sector entities
by central govts
were rating is AA- or higher 50%
Claims on public sector entities
by central govts
were rating is below AA-
Claims on domestic public-sector
invested by the
Chinese central government
Claims on other public sector entities
Claims o domestically incorporated
maturity over 4 months
Claims on residential mortgages
Claims on business enterprises and
Credit risk calculation for off-balance
sheet items. Off-balance sheet
item credit risk shall be calculated by 1) multiplying the nominal principal
amounts by a credit conversion factor, and 2) calculating risk-weighted assets
according to the risk weight of the counterparty.
conversion factors for off-balance sheet items
- Direct credit substitutes
- Certain transaction-related contingent items
- Short term self liquidating trade-related transactions 20%
- Sale and purchase agreements where the credit
with the bank
For Market Risk Capital Charge the
Standardized Measurement Method (e.g., Basel methodology) is used
Specific risk and general market risk
Foreign exchange risk related to
positions of foreign exchange and foreign exchange derivatives
Removing the privileged position on
local government borrowing
Categories and specific risk weights under
the Regulation Governing Capital Adequacy of Commercial Banks differ markedly
from what Chinese banks had been applying before (and used to calculate capital
adequacy for reporting purposes for year end 2003). Under previous methodologies, there was much
unbundling of risks categories (e.g., separate categories for loans guaranteed
by very large SOEs and loans
guaranteed by large SOEs). The new regulations substantially
reduce the number of categories of risk assets, simplifying and clarifying
In general, risk weightings for all levels of SOEs were
discounted, providing to these entities a privileged position versus non-SOE
borrowers. The new regulations remove
this favoritism for all but Central government invested SOEs.
Previous methodologies provided risk
weighting discounts for collateralized loans and off-balance sheet exposures
such as for issuance of bankerfs acceptance drafts (银s³兑汇[)
A few examples will serve to illustrate the
Loans to public sector entities
I.a.Claims on domestic public-sector
invested by the Chinese central
I. b.Claims on domestic public-sector
entities invested by provincial governments
I. c. Claims on domestic public-sector
entities invested by sub-provincial (city or country) governments
I. d. Claims on other public sector entities
Loans to business enterprises and individuals (including guaranteed
and collateralized loans)
II. a. Loans guaranteed by very large
II. b. Loans guaranteed by large SOEs
II. c. Loans collateralized by land and building transfer right
II. d. Loans collateralized by
III. Issuance of bankerfs acceptance drafts
Loan Loss Reserve Coverage Ratios
In connection with above measures, CBRC
has mandated a provisions coverage ratio of 80% vs. the 5 category
system of measuring risk assets and NPLs, as follows:
Full provisioning to this standard is
required by year end 2005.
The regulations mandate that banks
must begin to publicly disclose capital adequacy. Some banks have begun the disclosure. All will have to comply by 2006.
Disclosure must cover:
1) Objectives and policies of risk management
2) Scope of application
4) Capital adequacy ratios
5) Credit and market risk
The regulation stipulates that CBRC will
closely monitor compliance and will take specific corrective actions against
banks failing to meet capital adequacy requirements.
The Boards of Directors of each bank
shall assume ultimate responsibility for capital adequacy management.
Banks must report capital adequacy to
the CBRC on a quarterly basis.
CBRC will conduct quarterly reviews of
banks non-performing assets, including loan and non-loan non-performing assets.
Banks are being ranked and those
ranked low will be subject to frequent, strict oversight and inspections
For banks that are undercapitalized
(capital adequacy less than 8%, or core capital adequacy ratio less that 4%),
CBRC will take the following corrective actions:
Issuing a supervisory letter of
notice, which includes a description of the bankfs capital adequacy, corrective
actions to be taken, and timeframe for implementation;
Requiring banks to submit and
implement an acceptable capital restoration plan within two months after
receiving the supervisory letter;
Requiring banks to restrict asset
Requiring banks to reduce risk assets;
Requiring banks to restrict purchase
of fixed assets;
Requiring banks to restrict dividend
payouts or other forms of payment to shareholders; and
Restricting banks from setting up new
branches or starting new products and services.
For significantly undercapitalized
banks (though with capital adequacy ratios of less than 4%, or core capital
adequacy ratio less than 2%), the CBRC will take further corrective actions:
Requiring removal of senior
Taking over the banking institution.
More Severe Than Hong Kong?
It is hard to overemphasize the chilling
(and energizing) effect of these regulations, as well as others, such as the
gTemporary Measures on Monitoring and Examining Non-Performing Assets of
Commercial Banksh (¤业银ssĒ资产监测alj暂s办@), promulgated and effective from March 25, 2004 and the
g(Provisional) Risk Rating System for Shareholder Commercial Banksh (Ņ份§¤业银s风险评级 Ģni暂sj, promulgated and effective from March
In industry circles, it is being said that
the new system is more severe and demanding—in the sense of requiring greater
capital--than even that in effect in Hong Kong.
Adjustment Pains, and a Plethora of Bond
What can we expect, and what can we
observe, to be the result of this new regime? First, we can expect a period of adjustment that begins with
banks recalculating capital adequacy using new risk weightings, provisioning,
and capital definition criteria.
This recalculation has already begun. To their great dismay, the banks are
realizing that, despite recent efforts to raise equity through IPOs and/or
private placements, and the an initial confidence that they had achieved or
comfortably exceeded the 8% threshold, they now fall below, often far below,
the minimum level required by January 1, 2007.
This situation is illustrated by one of the
top five city commercial banks. At
year end 2003, following a substantial equity increase that brought in a number
new private corporate investors, the bank was able to assure shareholders that
an it had achieved based on regulatory policies at the time the mandated 8
percent capital adequacy ratio.
However, as the bank faced shareholders in June, it was necessary to
announce that, recalculated according to CBRCfs new regulations, capital
adequacy at yearend 2003 was actually around 6 percent, and the figure had
dropped to under 6 percent as of the first quarter of 2004.
The task of bank boards and managements
during the next two years will be to fill this new, and entirely unwelcome, gap
in capital adequacy.
In many cases, including the one described
above, asking shareholders for additional capital will be the least attractive
plan. In many cases, the
shareholders would have just put in new money. They will be highly disinclined (or simply unable) to give
the bank additional funds, especially when it is expected that a large share of
the funds will simply be used to make provisions are bad debts and other
non-performing asset write-offs.
(The exception might be the prospect of
welcoming a new strategic investor, particular a foreign bank. In this case, the urgency of topping up
capital and the stringent valuation requirements in the regulations could
actually help in overcoming what is normally a great reluctance of existing
shareholders to accept the lower valuation of assets—as effective diminution of
their investments--that inevitable follows due diligence and informs the price
offered by a foreign bank.)
Two alternatives will be more palatable,
but still not easy: reducing risk
weighted assets and issuing subordinated bonds. We have begun in 2004 to see much action aimed at both
these objectives, and we shall certainly see more.
After Adjustment: A New Mode of Banking
What changes can we expect after the transition, and full
implementation of CBRCfs new regime?
Of course we must allow for slippage and some compromise in the early
stages of implementation, but it is likely that the Liu Mingkangfs severe
gcapital constrainedh regulatory paradigm will come to fruition.
Such an eventuality will inevitably create
a much more disciplined and efficient banking system in China. As bank managements and, particularly,
shareholders, focus on returns on scarce capital, greater attention will
certainly be focused on quality and profitability of asset growth.
Capital constrained banks in China will
inevitably place greater demands on borrowers, and will find themselves in a
greatly more advantageous negotiating position than was the case in the
Capital constrained banks will also develop
a changed relationship with shareholders, and seek out different
shareholders. Bank managements and
boards will become more keenly aware of the need to return value to
shareholders, and will be more diligent in trying to understand what (and how
much) return shareholders want.
Understanding that a continuing flow of new capital will be required to
support bank growth, banks will seek shareholders who are ready and able to
make regular investments, and access to public capital markets for regular fund
Hope For Chinafs Declining ICOR?
The impact and implications of the new
capital adequacy regulations go far beyond management of the banks and even of
Chinafs banking system. They
extend to the health of Chinafs economy as a whole, and even to the world
Unconstrained capital from the banking
system has been one of the reasons that the productivity of capital investment
in China has been in a free-fall since the mid-1990s. This issue is frequently raised by Wu Jinglian, one of
Chinafs most thoughtful and influential economists.
Wu points out that Chinafs incremental
capital output ratio (the ratio of GDP growth to increased investment) was at
roughly the level of 2:1 during the period 1991-96 (the level in the West is
general 1:1 – 2:1). Since 1996,
however, the ratio has plummeted to 5-8:1. This is evidence of high inefficiency and waste of
resources. Such a high ICOR level
characterizes highly dysfunctional economic systems, and was typical of the
situations in Southeast Asian economies in the years before the Asian financial
Raising the productivity of investment in
China is inconceivable without reform of bank lending practices. Indeed, such reform would appear to be
a sine qua non for improvement.
The vital issue of productivity of
investment appears to have been noticed by leading officials in Beijing. This is good news, because political
backing for Liu Mingkangfs new paradigm capital adequacy reform will be needed
as the pain of adjustment increases.
A Case of Biting The Bullet: Bank of Communications
evidence that banks have begun to adjust to CBRCfs new regulatory demands, we
can look at the largest of the shareholder banks, Bank of Communications. While it has been studying
and pondering issues of capital adequacy and accepting foreign investment for
several years, entering 2004 the bank has clearly stepped up the tempo of
activity. Indeed, the elements of
Bocomfs recapitalization plan, including a major share sale to a foreign
investor, issuance of subordinated debt, and an IPO, suggest that meeting new
CBRC capital adequacy requirements has been a driving ethos in the bankfs
resolution in 2003 and 2004.
published numbers put yearend 2003 NPLs at RMB 70 billion, 13.3% of loans. Step one of recapitalization was
obtaining government approvals for provisions: Out of pre-provision 2003 operating income of RMB 9.5
billion, MOF approved provisions of RMB 10.1 billion and write-offs of
RMB 8.8 billion.
target reduction for 2004 is RMB 60 billion.
Adequacy Compliance Plan and Schedule
MOF greinvestedh taxes due to be received from Bocom to increase equity from
24% to 29%.
yearend 2003 book net assets were RMB 41 billion (USD 5 billion). Yearend 2003 total capital
adequacy (under previous criteria) was 7.41% and core capital adequacy was
1) Private placement:. Share placement to existing and government shareholders. Reportedly completed in all but
technical details in June. New
(increased) investors Ministry of Finance, State Social Security Insurance
Funds, HSBC, other existing shareholders, and Central Huijin Investment Company
to Bocomfs plan, MOF will put in RMB 3 billion, Hui Jin Company (under State
Council) will invest RMB 5 billion, and the State Social Insurance Funds will
put in RMB 10 billion. MOF and Hui
Jin will be receiving shares for RMB 1 per share (for 3 billion shares and 5
billion shares, respectively). The
State Social Insurance Fund will be paying RMB 1.67 per share (receiving 6
existing shareholders will be issued 1.5 billion new shares (price to be
Foreign strategic investor: HSBC will not make an
investment until the new capital subscription from MOF and Hui Jin is
received. Then HSBC will
take the maximum 20% of shares.
The price is yet to be decided.
Issuance of Subordinated debt:
Issuance of RMB 10-20 billion subordinated debt. Will raise capital adequacy to over
Last step IPO: Planned for 2005 or 2006, at latest.
recapitalization (but before IPO), Bocom will have issued about 41 billion
shares, compared with the pre-increase RMB 17 billion shares.. Total share capital will be about RMB
46 billion, compared with some RMB 17 billion at yearend 2003. The ownership share of the state financial
agencies will remain about 30%, controlling.
Century Herald (June 24, 2004)