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By Stephen M. Harner
September 3, 2004

CBRCfs Grand Strategy for Chinafs Banks

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Stephen M. Harner
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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 ifjB  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 system.  

 

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 World

 

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 banking. 

 

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 borrowers

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 II objectives);

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:

 

I.  Capital Adequacy

 

         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 market risk)

         Core capital adequacy ratio = (core capital – deductions) / (risk-weighted assets + 12.5 * capital charge for market risk)

         Core capital shall consist of paid-up capital/common stocks, reserves, capital surplus, retained earnings and minority interests.

         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 capital.

         Deductions from the total capital base when calculating capital adequacy ratio:

o       Goodwill

o       Equity investments in unconsolidated financial institutions; and

o       Equity investments in commercial real estate (not used by the bank itself) and equity investments in business enterprises.

         Deductions from core capital when calculating the core capital ratio:

o       Goodwill

o       50% of equity investments in unconsolidated financial institutions; and

o       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.

 

II.  Risk Weighting

         Risk weights: 

o       Claims on the Chinese government                      0%

o       Claims on central governments and central

               banks where rating for sovereign is below AA-    100%

o       Claims on public sector entities invested

by central govts were rating is AA- or higher              50%

o       Claims on public sector entities invested

by central govts were rating is below AA-                 100%

o       Claims on domestic public-sector entities

invested by the Chinese central government                 50%

o       Claims on other public sector entities                   100%

o       Claims o domestically incorporated commercial

banks with maturity over 4 months                               20%

o       Claims on residential mortgages                              50%

o       Claims on business enterprises and individuals      100%

 

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.

 

Credit conversion factors for off-balance sheet items

 

  • Direct credit substitutes                                             100%
  • Certain transaction-related contingent items               50%
  • Short term self liquidating trade-related transactions  20%
  • Sale and purchase agreements where the credit

risk remains with the bank                                                100%

 

For Market Risk Capital Charge the Standardized Measurement Method (e.g., Basel methodology) is used

o       Specific risk and general market risk components

o       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 risk.

 

 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s兑汇[)

 

A few examples will serve to illustrate the above points.

 

Risk Asset Category

New Weighting

Old Weighting

I.  Loans to public sector entities

 

 

I.a.Claims on domestic public-sector entities

invested by the Chinese central government                 

50%

20%

I. b.Claims on domestic public-sector entities invested by provincial governments

n/a

50%

I. c. Claims on domestic public-sector entities invested by sub-provincial (city or country) governments

n/a

70%

I. d. Claims on other public sector entities                  

 

100%

 

II.  Loans to business enterprises and individuals (including guaranteed and collateralized loans)

100%

 

II. a. Loans guaranteed by very large SOEs

n/a

50%

II. b. Loans guaranteed by large SOEs

n/a

70%

II. c.  Loans collateralized by land and building transfer right

n/a

50%

II. d. Loans collateralized by residential buildings

n/a

50%

III.  Issuance of bankerfs acceptance drafts

100%

70%

 

 

III.  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:

Loan Asset Classification             Loss Calculation

        Normal                                        1%

        Watch                                          2%

        Substandard                                20%

        Doubtful                                      40%

        Loss                                            100%

Full provisioning to this standard is required by year end 2005.

 

IV.  Disclosure

 

         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

3)      Capital

4)      Capital adequacy ratios

5)      Credit and market risk

 

V. Supervision

 

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:

o       Issuing a supervisory letter of notice, which includes a description of the bankfs capital adequacy, corrective actions to be taken, and timeframe for implementation;

o       Requiring banks to submit and implement an acceptable capital restoration plan within two months after receiving the supervisory letter;

o       Requiring banks to restrict asset growth;

o       Requiring banks to reduce risk assets;

o       Requiring banks to restrict purchase of fixed assets;

o       Requiring banks to restrict dividend payouts or other forms of payment to shareholders; and

o       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:

o       Requiring removal of senior management; and

o       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ss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 (份业银s风险评级 ̌ni暂sj,  promulgated and effective from March 22, 2004.

 

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 Issues, Ahead

 

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 past. 

 

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 raising.

 

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 economy. 

 

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 crisis.

 

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

 

For 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 action plan.  

 

Bocom Recapitalization

 

 

NPL resolution in 2003 and 2004.

 

Bocomfs 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.  

 

The target reduction for 2004 is RMB 60 billion. 

 

Capital Adequacy Compliance Plan and Schedule

 

In 2003 MOF greinvestedh taxes due to be received from Bocom to increase equity from 24% to 29%. 

 

Bocomfs 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 6.36%.

 

2004 Recapitalization Plan 

 

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 Limited. 

 

According 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 billion shares).

 

Other existing shareholders will be issued 1.5 billion new shares (price to be determined). 

 

2)  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. 

 

3)  Issuance of Subordinated debt:  Issuance of RMB 10-20 billion subordinated debt.  Will raise capital adequacy to over 9%. 

. 

4)  Last step IPO:  Planned for 2005 or 2006, at latest.

 

After the 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.

 

Source:  21st Century Herald (June 24, 2004)


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