Brief Comment on US Fed’s approval on ICBC’s acquisition application

Q1: How do you think of Chinese banks’ expansion in U.S. market?

A: TheUShas a huge and highly developed financial market, offering enormous opportunities. It is no wonder that Chinese bankers would like to have a fair presence here in the States. Chinese banks used to offer traditional set of financial products, more focused on Asian ethnicity. So far the story is quite mixed. They have proved their ability to survive, but that is not sufficient. Their market share is still negligent. They should be more competitive, provide more products, and accommodate better to local demands. I am glad that more Chinese banks will be coming, and certainly wish them greater success.

Q2: Are there any barriers for Chinese banks’ entering and expansion in U.S. market? What advantage do Chinese banks have in doing this?

 A: According to some media report, all the three applications had been pending for as long as nearly two years. For Chinese bankers, it is a frustrating experience. However I don’t see major barriers here for Chinese entry intoUSmarket. Perhaps there could have been some misunderstandings. People become very cautious and even suspicious when dealing strangers. This is also the case for Chinese banks.  Ten years ago or even five years ago, Chinese banks were technically broken. With Chinese government’s huge capital injection and support, Chinese banks return to make money almost overnight. When Chinese banks come to the States, they should familiarize themselves with local environment, including regulation and supervision. They also need time to prove their tracking record. One the other hand, US regulators need time to know and build confidence in Chinese banks, including their business models, risk management, corporate governance and internal controls, etc.

US Federal Reserve Board has very clear and transparent guidance of whether or not to grant its approval on applications. For example, the foreign applicant should be subject to comprehensive, consolidated supervision (CCS), largely based on extent of home regulator’s adherence to Basel Core Principles.China’s banking system has made significant improvements in risk measurement and management. The CBRC has adopted “activist, forward-looking” supervision process, supported by requirements for high-quality capital and liquidity. All these progress has been positive factors for Fed’s final decision. Admittedly, the Fed Reserve is also walking under the tight rope under the current economic situation, to be sure.

The Fed’s order could create the opportunity for other leading Chinese banks to acquire US banks. Even though the Fed make it very clear that the CCS determination is specific to ICBC in this application, in practice a CCS determination for one bank in a country is typically precedential for all similarly situated banks in that country. So it is likely that more applications from Chinese side will follow suit in the near future. From the perspective of theUS, regulations are still strict and currently theUScould only allow Chinese banks to take small banks. The aim for Chinese banks entering into the states is mainly to help Chinese multinationals with financing in order to develop the trade and economic ties betweenChinaand US. I believe that more entry of Chinese banks will without doubt facilitate those efforts.

Q3: How do Chinese banks improve their operations in global stage?

A: The Chinese people are very smart, and they learn things very fast. In order to be global players, Chinese banks should learn mistakes committed by others. I offer two suggestions here. One is to build up business capacity. Even though largely Chinese banks escaped from the global financial crisis, which does not necessarily mean Chinese banks are superior to other banks. To sustain the successful story, Chinese bankers should continually consolidate their risk management, fine tune their business strategy and monitor their risk profile, amongst others. The other thing is to proceed with a proper expansion plan. Chinese banks should avoid head-on competition with global giants at least for now. It is better for Chinese banks to focus China-related business first, and then gradually expand to other business line. Be wary of big acquisitions.

Q4How will U.S. and China strengthen their financial cooperation?

A: American banks used to be strategic investors for Chinese banks during their restructuring and listing process. Because of recent financial turmoil, American banks pulled their investment out of Chinese market. Now it might be going the other direction. The American banks are subject to tremendous regulatory uncertainties and in the process of deleveraging, it might be the proper time for Chinese banks to buy some assets at pretty prices.

Other potential fields of cooperation could be risk management, risk IT and professional training. Many entities on both sides, including the IIF, have been working to promote those efforts. The IIF, as the global association of financial institutions, has been aiming at strengthening understanding and cooperation betweenUSAandChina. Every year, the Institute will host its annual and spring membership meetings, which provide opportunity for bankers globally to exchange ideas and views. Also, the Institute holds regional fora and PDF program, which offer good chances to foster sound industry practice and risk management.

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2007年至2009年这场金融危机过后,各国学者、监管者和金融从业者都在思索危机爆发的根源和避免危机再度发生和减轻危机损害程度的措施。现在的国际共识是需要进一步提升金融机构的风险抵御能力(loss absorbency)、增强金融系统的稳定性、改进金融机构的监管模式、强化宏观审慎性监管。
从目前提及的建议措施来看,可大体分为两类:一方面从增强金融机构体质着手,降低企业倒闭机率。这些措施注重于提升金融机构的持续经营能力(Going Concern),通过提高资本要求(如强化资本质量、提高资本充足要求)、约束经营行为(如限制自营行为)、加强风险管控能力、改善公司治理机制等措施,强化企业运营能力。另一方面则是从处置(Resolution)角度出发,减轻金融机构倒闭的负面影响。这些措施尚存在一些争议,还没有取得广泛共识。这些措施主要探讨金融机构出现非持续经营(Gone Concern)时的处置方法,主要目的是降低对金融系统的冲击,提高金融系统的整体稳定性,主要原则是股权债权投资人要共担风险,避免政府注资挽救以避免道德风险,同时加快金融机构的处置效率。
目前,在处置系统重要性银行(Globally Systemically Important Banks, G-SIBs)、解决金融机构大而不倒问题(Too Big To Fail, TBTF)上,贝林机制(Bail-in Mechanism)提供了新的思路,与或有资本安排(Convertible Contingent Capital, CoCo)在国际上引起了广泛关注。
一、 贝林机制的概念和其作用
理论上讲,当企业破产时,债权人和股东应共同承担损失。但是金融危机的破产清算,其复杂程度远高于一般工商业企业,需要给予特别的关注。金融企业,特别是大型银行,在国民经济中发挥了重要作用。银行资产规模大负债率高,资金主要来源于储户存款和客户资金,而其资产价值波动性很大,处置不当会引起连锁反应,导致系统性危机,这就要求在处置银行必须给予特别关注,需要兼顾公平效率。在本次金融危机中,欧美各国政府为防止经营不善的金融机构破产而引发系统性风险,不得不注入巨额资金予以救助(Bail out)。这些救助行为,虽然维护了市场稳定,避免了危机的蔓延,但是违反了发达国家普遍公认的市场规则。有人认为,政府救助行为是以纳税人资金去拯救金融机构债权人,有失市场公平,而且政府救助只针对大银行,有严重的道德风险。贝林机制的这一概念的提出,通过法律授权和政府主导金融机构的处置,实现债权人和股东共担损失,在相当程度上可以解决金融机构大而不倒问题。
所谓贝林机制,到目前为止国际上还没有统一定义。一般理解,贝林机制是指金融机构在面临法定破产或者无力偿还时将债权转化为股本而进行资本重组的制度安排(Bail-in refers to a mechanism whereby at a point in time in advance of the legal bankruptcy or insolvency of a financial firm a power is exercised to convert part of the firm’s debt into capital to bring about a recapitalization) 。贝林机制作为银行资本重组的方案设计,可增强银行的信任度;由于没有增量现金的进入,为保障中央银行和市场参与者的信任度,贝林机制尚需要有明确的法律依据和监管支撑。需要强调的是,贝林机制的出发点在于减少金融机构处置过程的不确定性、维持公众对相关金融机构的信心、保障金融机构处置的有序并减缓对金融系统的冲击,而不是着眼于挽救问题金融机构 。
贝林机制的出发点在于通过股权核销和债权转股权,债权人和股权所有人共同承担损失并实现资本重组,提升市场对问题银行的信心,隔绝风险传播。贝林机制成功的重要前提是降低金融机构的相互关联性(Interconnectedness)和债务工具的互持。如果在资本市场上银行互持各自发行的债务工具,这是一家银行出现经营困难需要实施贝林机制,风险依然会通过债务转换和消减来进行传播,从而降低系统安全。因此,为提高系统稳定性,有必要降低金融机构的关联性。这也完全符合目前国际监管机构的思路(如在2010年底颁布的第三版巴塞尔协议 (Basel III)流动性覆盖率 规定,银行间资金的流失率为25%,远高于零售存款的5%,也是不鼓励银行间的资金流动)。
二、 贝林机制实施途径和效果
需要指出的是,贝林机制的实施范围只是银行部分债务而不是全部债务。一般认为,一年期以上的高级债权(Senior Debt)可以实施贝林机制,银行吸收的个人存款和交易发生的短期债权债务不在贝林机制的实施范围。目前,对于贝林机制的实施范围还有争论,有人主张不限定债务范围,避免出现逆向选择。
资产 负债和所有者权益
现金 200 零售存款 5000
证券投资 1500 合格高级债务* 2000
按揭贷款 3500 其他高级债务 2300
公司贷款 1000 次级债务 200
其他资产 3800 股本 500
资产合计 10000 负债及所有者权益合计 10000
* 满足实施贝林机制实施条件的高级债务
因银行经营不善,M银行的按揭贷款出现大量不良贷款,年度经营亏损800亿美元。如果银行清盘,假定债务偿还顺序相同(rank pari passu) 、债权回收率为70%,则银行清盘损失共计3490亿美元(包括股本500亿美元、次级债务200亿元和其它债务2790亿美元)。因此,合格高级债务持有人损失600亿美元(损失率为30%),股本和次级债务持有人损失700亿美元(损失率为100%),资产负债表参见例2。

资产 负债和所有者权益
现金 200 零售存款 3500
证券投资 1400 合格高级债务* 1400
按揭贷款 1000 其他高级债务 1610
公司贷款 610 次级债务 0
其他资产 3300 股本 0
资产合计 6510 负债及所有者权益合计 6510
资产 负债和所有者权益
现金 200 零售存款 5000
证券投资 1500 合格高级债务* 1200
按揭贷款 2700 其他高级债务 2300
公司贷款 1000 次级债务 0
其他资产 3800 股本 700
资产合计 9200 负债及所有者权益合计 9200
根据上例,破产清算和实施贝林机制下金融机构的资产价值有很大区别。其中,主要原因是破产清算下金融机构的商业价值(Business Value)遭到很大破坏,商业价值包括连锁经营价值(Franchise Value)、客户价值(Customer Value)和员工价值(Workforce in Place),在清算中基本不复存在。另外,清算费用和资产甩卖(Fire Sale Effect)也是资产损失的重要原因。
根据美国联邦存款保险公司(Federal Deposit Insurance Corporation, FDIC)2011年4月份发表的一份报告 ,在2008年9月雷曼兄弟申请破产保护前,资产合计2100亿美元;股东权益200亿美元,次级债务150亿美元,各项短期和长期债务850亿美元,其它债务900亿美元。根据2011年1月25日清算评估结果,高级无担保债权持有人的资产回收率为21.4%,其他无担保债权人在11.2%至16.6%之间。美国联邦存款保险估计,如实施贝林机制,雷曼兄弟不良资产约500至700亿美元,按照400亿美元损失计算(相应损失率为60%至80%),扣除350亿美元股本及次级债务,债权人承担的损失为50亿元,平均资产回收率将达到97%。
三、 贝林机制与或有资本安排的区别
2010年10月20日,金融稳定理事会(Financial Stability Board, FSB)发表了《降低系统重要性金融机构道德风险:金融稳定理事会的政策建议及时间表》 ,强调系统重要性金融机构应具备较高的风险损失能力,应要求金融机构采取一系列手段包括附加资本或或有资本或贝林机制来提升风险抵御能力。
1、 两者的出发点不同。贝林机制主要立足于金融机构的非持续经营,即在面临破产的威胁下如何保存企业价值从而降低系统风险;或有资本主要是进一步提高金融机构的资本实力,更好的满足监管要求。
2、 两者的操作形式也有差异。贝林机制非常灵活,既可以是法律安排,也可以法律安排与合同约定的组合;或有资本只能是合同式安排。
3、 两者的适用工具也不一样。贝林机制适用的债务工具比较广泛,在理论上讲可以包括清偿权优于次级债务的一般债务;或有资本一般只能是次级债务,适用债务工具比较窄。
四、 贝林机制的最新进展
自从2010年初贝林机制的概念 提出之后,就得到了国际上的广泛关注。2010年6月27日发表的20国集团首脑峰会宣言 提出,“…要求金融稳定理事会就首尔峰会提出的有关有效处理系统重要性金融机构相关问题研究相关政策建议。除金融工具和鼓励市场纪律相关机制外,这还应包括或有资本、贝林措施、资本附加、征税、结构约束和扣减无抵押债权人等措施…”(Called upon the FSB to consider and develop concrete policy recommendations to effectively address problems associated with and resolve systemically important financial institutions by the Seoul Summit. This should include more intensive supervision along with consideration of financial instruments and mechanisms to encourage market discipline, including contingent capital, bail-in options, surcharge, levies, structural constraints, and methods to haircut unsecured creditors…..)。这说明贝林机制已纳入政策研究层面,不再仅仅是学术讨论课题。
2011年1月6日欧盟理事会 (the European Commission) 发表题为《欧盟有关银行恢复和处置可能框架的相关技术细节》 (Technical Details of a Possible EU Framework for Bank Recovery and Resolution) 的工作文件 (Working Document) ,在附件中专题研究债务消减作为银行处置的工具之一,对贝林机制的具体实施细节(包括实施范围、市场和定价机制、集团处理、维护债权人信心和保持流动性)进行了深入讨论。2011年7月巴塞尔委员会发表报告,对银行处置(含贝林机制)的进展情况予以说明。2011年7月19日金融稳定理事会发表征求文件,征求各国对系统重要性银行处置措施的建议,其中明确包括贝林机制。因此有理由相信,贝林机制将在不久的将来为各国所认可,并成为处置系统性银行、维护金融系统稳定性的有力工具,当然具体立法过程仍将由各国立法机构通过国内立法手续完成。


1. Basel Committee on Banking Supervision: Resolution policies and frameworks- progress so far, July 2011
2. Clifford Chance: Legal Aspects of Bank Bail-ins, May 2011,
3. FDIC Quarterly: the Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd-Frank Act
4. European Commission: Technical Details of a Possible EU Framework for Bank Recovery and Resolution, working document, January 6th 2011,
5. IIF: Addressing Priority Issues in Cross-Border Resolution, IIF Report, May 2011
6. IIF: Macroprudential Oversight: An Industry Perspective, Submission to the International Authorities, IIF Report, July 2011
7. Financial Stability Board (FSB): Effective Resolution of Systemically Important Financial Institutions, consultation paper, July 19th 2011
8. 中国金融:《自救安排及其在我国的应用》,李文泓、吴祖泓,2011年第6期

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The Offshore Renminbi Market in Hong Kong

1. The Offshore Renminbi Market in Hong Kong

The RMB has traditionally been a non-deliverable currency, convertible on the current account but considerably limited on the capital account. Cross-border capital account flows are limited to FDI, QFII, and QDII as well as through informal channels. Hong Kong is the first jurisdiction to allow accumulation of RMB outside China mainland. The RMB became officially deliverable in Hong Kong on July19, 2010 when the PBOC and HKMA issued a joint announcement clearing policy obstacles.

Hong Kong is a special administrative region of China, and maintains separate legal and financial systems. Given its close link with China mainland and its open economy, Hong Kong is considered an ideal testing ground for assessing the impact of capital account liberalization and RMB convertibility. Even though RMB can be accumulated in other jurisdictions (such as Singapore or London), Hong Kong is the only jurisdiction to date where RMB is officially sanctioned and regulated, and where there is also a RMB clearing bank. Combined with the fact that Hong Kong has been the traditional center of offshore RMB deposits and liquidity, Hong Kong has become the de factor CNH market. Generally speaking, CNY is referred to the currency within China mainland traded in the onshore market, while CNH is referred to offshore RMB market, traded primarily in Hong Kong.

The offshore RMB market in Hong Kong started in 2004, after the PBOC and HKMA agreed that Hong Kong banks could conduct personal RMB business on a trial basis and BOC (HK) was designated as the RMB clearing bank. Under the arrangement, the Hong Kong resident is allowed to convert up to RMB 20000 daily in Hong Kong. On July 19th, 2010, the PBOC signed with HKMA the “Memorandum of Cooperation on RMB Business”, which substantially expands Hong Kong’s capacity to conduct RMB transactions. It allows a rich menu of RMB trading activities, including spot and forward RMB trading. Under the Memorandum, financial institutions could offer deliverable forward, in addition to non-deliverable forward (NDF) that already traded in market. The offshore market experiment started mainly with a RMB retail deposit market, followed by institutional bond issuance, RMB trade settlement and RMB (sport and forward) trading. The current and planned cross-border channels include:

 Cross-border trade RMB settlement, now fully rolled out to all domestic and international jurisdictions.

 Interbank bond market investment scheme, allowing the clearing bank, trade settlement banks, and central banks to invest RMB accumulated offshore into the onshore interbank bond market.

 RMB FDI, a program allowing ODI (outward direct investment) and inward FDI. Currently the ODI is working on a pilot scheme and inward FDI is still waiting for the green light from Chinese central government.

 RMB QFII was rolled out last year, allowing Hong Kong fund managers to invest offshore RMB into onshore market under a QFII scheme. Earlier this year, the quota has bee expanded to RMB 70bn from RMB 20bn initially allowed.

The CNH has obvious advantage in that investor can access a rapidly growing universe of real underlying assts and derivative products. Beyond access to RMB denominated assets offshore, CNH will increasingly be vehicles to access RMB assets onshore as the authorities continue gradually opening up cross-border capital flow channels.

2. Governmental Objectives, Policies, and Timeline

China has traditionally instituted a stable foreign exchange policy by maintaining substantial controls on its currency Renminbi (RMB) and restricting the use of RMB overseas. The Chinese government used to maintain that convertibility of RMB will be the ultimate goal and it will take a gradual process. However the stand has changed markedly with China’s quick rise in the global GDP ranks. Based on the measures introduced in the last few years, it is reasonable to conclude that China is keen to press ahead with the development of an offshore RMB market, which will facilitate the internationalization of the RMB. This is generally seen as a precursor to the eventual launch of the RMB as a fully convertible global currency.

China has repeatedly affirmed that liberalizing its capital account is its ongoing official policy. The general sequencing policy appears to be strengthening domestic financial institutions, opening capital accounts, and managing the currency. When in 2009 Dr. Zhou Xiaochuan, the Governor of PBOC commented on the super-sovereign reserve currency and implicitly challenged the dominance of the US dollar, he implicitly suggested that RMB should join the elite club of reserve currencies. As the first step, expanding use of the Special Drawing Right should be a priority. The inclusion in the SDR basket is an official recognition of a currency’s status in the global economy. In the 2012 Joint Spring Conference of IMF and World Bank in Washington, Mr. Yi Gang the Deputy Governor of the PBOC and Administrator of SAFE, stated that RMB should be one basket currency of SDR and even indicated the proper weight of RMB should be 10%. All the statements indicated the Chinese government is very positive about RMB’s convertibility.

It is widely believed in China that eventual convertibility of RMB will offer enormous benefits, including efficiency gains from use of RMB in international transactions, removal of currency mismatch on balance sheet, and less reliance on US dollar, etc. Chinese scholars believes that the international role a currency depends on the following attributes of its issuing country, namely, the size of the economy and the trade sector, the size of the financial market, capital account openness, and the stability of the economic and political conditions. These attributes are necessary but no sufficient conditions for an international currency. The biggest challenge is lying with capital account openness.

In 2009, the State Council decided to build Shanghai into one of global financial centers by 2020. Recently Shanghai aspired to become one international RMB clearing center by 2015. RMB convertibility should be a prerequisite to achieve those goals. Based on that, many scholars have argued that RMB should be convertible by 2015. However the Chinese government has never endorsed this claim. Dr. Zhou Xiaochuan has refused to give a clear timeline of RMB convertibility, only stating that it is up to the market. However, in February 2012, a taskforce led by Mr. Sheng Songcheng, Director General of PBOC’s Statistics and Analysis Department released a report, claiming that the situation now is ripe for opening China’s open account. Many government officials and scholars believe that RMB could be fully convertible with 5 years. At present the official standing is that China will promote RMB convertibility and take positive measures to facilitate the process, but the Chinese government will not commit a timeline.

So far, the Chinese government has adopted a multi-pronged platform to attain the goal of RMB’s convertibility, using RMB as the invoicing and settlement currency for cross-boarder trade, bilateral currency swap agreement with other central government, expansion of Dim-Sum products and encouragement of high capital inflows of portfolio investment. Those policies are largely carried out in Hong Kong. Policy is now focused on building the offshore market’s size, setting up the infrastructure for scalability, and broadening the scope of those who can take part. To further develop CNH market in Hong Kong, more policy initiatives are on the horizon, including offshore RMB loans, RMB-denominated ETF, and RMB-denominated stocks, among others.

In 2004 China started its experiment with convertibility and financial liberalization by establishing an offshore RMB market in Hong Kong. In July 2009, China initiated a pilot scheme to settle cross-border trade in RMB. The State Council approved Shanghai and 4 cities within Guangdong Province for the experimental RMB settlement of cross-border trade with Hong Kong and Macau. On August 23rd, 2011 the program has been expanded to cover the entire nation for trade with corporation globally. RMB-settled trade accounted for 10% by 2011, compared to only 2% in 2010, although the figure is still far below the one-third marline expected by Chinese scholars. China’s total CNY trade settlement volume recorded strongly in the first quarter of 2012, coming in at CNY 580bn, 10.7% of China’s total trade, according to the PBOC data.

RMB deposit in Hong Kong has been increasing dramatically since the start of 2010. By January, 2012, the total deposit reached RMB 576 billion, standing at 9.2% of the territory’s total deposit (lower than a peak of 10.4% in September 2011).

So far, China has signed bilateral currency swap agreement with over 18 economies with a combined value of RMB 1600 billion. These arrangements have a three-year duration and are renewable. They allow the economies to offer RMB trade financing to the local importer to buy Chinese goods.
The RMB has made marked progress in global foreign exchange market. According to BIS 2010 triennial central bank survey, RMB’s share of trading increased to 0.9% in 2010 from 0.5% in 2007 and 0.1% in 2004. The average daily surged to 29.2 billion in 2010 from 14.6 billion in 2007 and from 1.7 billion in 2004. However, RMB trading volume still lagged far behind other currencies. According to a BIS estimate, daily CNY spot market turnover is just USD 8 billion, compared to USD 1.2 trillion in the US dollar. With 2.4% market share, even HKD is much more prominent than RMB.

The Dim Sum Market also develops very quickly. The market so far is dominated by Chinese entities including Ministry of Finance, Bank of China, and China Development Bank. In 2011, the market size is about RMB 30bn.

3. The Latest Developments

The PBOC announced in mid-April that a new CNY clearing and settlement platform, named as the China International Payment System (CIPS), would be set up. It appears that CIPS will be similar to the US Fed’s CHIPS, allowing international banks to connect directly with appointed participating banks onshore. CIPS is a key part of Shanghai’s aspiration to become an international CNY clearing centre by 2015. When it is up and running, it should provide an alternative channel for CNY to enter and exit mainland China, complementing the existing channels (the clearing bank in Hong Kong and onshore agent banks). The result will be a larger global RMB pie.

The Renminbi is heading overseas it is going worldwide. CNY-denominated trade flows between China and the rest of Asia are increasing, CNH trading is picking up in London, and China has announced the creation of a new international CNY payment system. It is now easier for corporates to invoice in CNY, and keyholes in China’s capital account such as the R-QFII scheme, which allows offshore holders of CNY to invest in equities, are being carefully expanded. CNH trading volumes are up to USD 2bn a day in Hong Kong.

The new CNY trading band of +/-1% and the removal of short-dollar limits for banks herald a new phase of CNY market development. The PBOC is expected to reduce its FX intervention and allow market forces to drive increased CNY movement. Implied volatility in the options space has fallen, creating a good opportunity for corporates to buy protection.

CNH bond issuance has had a great start to the year, and liquidity has improved. Upward pressure on yields will remain.

4. Liquidity

One feature of CNH system is the clearing bank, Bank of China (Hong Kong). BOCHK is one of two offshore banks designated by the mainland authorities to settle and clear cross-border RMB FX transactions for various authorized activities. Equally important is the ability of clearing banks to take CNH deposits on custody for other Hong Kong banks and place them with the PBOC to earn a benchmark deposit rate. In this way, the RMB clearing bank plays some central bank functions, i.e., to offer a window for CNH liquidity and to set benchmark rate on CNH deposits.

According to HSBC’s research, by September 2011, the total market liquidity in CNH spot has grown to USD 1.5bn per day, while liquidity in the CNH forward and swaps market is now at USD 2.7bn. Adding up, the total CNH liquidity stood at USD 4.2bn, much large than the figure of USD 0.5bn at the start of 2010. It is expected that the CNH market liquidity will continue to rise as participants globally gain familiarity and access to the CNH market.

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Asset Securitization, Regulation and Its Practice in China

Part I What Is Securitization

1. Definition of Securitization

Asset securitization is a structured finance technique that allows for credit to be provided directly to market investors rather than through financial intermediaries. The term securitization[1] refers to the process of converting assets with predictable cashflows into securities that can be bought and sold in financial markets, a course of refinancing a diversified pool of illiquid present or future receivables financial and/or non-financial receivables through the issue of structured claims into negotiable capital market paper issued to capital market investors.

According to Dodd Frank Act[2], the term asset-backed security (in a broad sense) means a fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset. The act explicitly excludes any security issued by a finance subsidiary held by the parent company or a company controlled by the parent company, if none of the securities issued by the finance subsidiary are held by an entity that is not controlled by the parent company.

Comparison definitions between DFA and SIFMA will lead us to a clear observation of three key components of asset securitization: a pool of non-liquid assets, securities issued by a specially created investment vehicle (Special Purpose Vehicle, SPV) backed by the assets, and investors who purchase such securities. In principal, securitization serves as a refinancing mechanism to diversify external sources of funding and to transfer risks. Conceptually, asset securitization converts regular and classifiable cash flows from a diversified portfolio of illiquid present or future receivables of varying maturity and quality into negotiable capital market instruments issued by a single-asset SPV. So securities are contingent claims on a designated portfolio of securitised assets, which can be divided into different slices of risk to appeal to different investors.

Asset securitization come in two broad classes of securities: debt-like (secured) instruments and equity. Whilst the holders of debt-like notes establish prior claim to the underlying reference portfolio of loans in order of agreed seniority, issuers and/or asset originators frequently retain a residual equity-like class as illiquid first loss position, required by rating agencies as bad debt provision for expected loss.

Securities created by securitizing mortgage loans are known as mortgage-backed securities (MBS), and those collateralized by other types of assets, such as student loans, small business loans, or credit cards, are generally referred to as asset-backed securities (ABS). In theUS, MBS may be further divided into two general categories: agency MBS, which is issued by Government-Sponsored Enterprises (GSEs), like Fannie Mae and Freddie Mac; and private MBS, which is issued by private financial institutions.

Securitization could be categorized into a traditional securitization or a synthetic one. A traditional securitization[3] is a structure where the cash flow from an underlying pool of exposures is used to service at least two different stratified risk positions or tranches reflecting different degrees of credit risk. Payments to the investors depend upon the performance of the specified underlying exposures, as opposed to being derived from an obligation of the entity originating those exposures. The stratified structures that characterize securitizations differ from ordinary senior/subordinated debt instruments in that junior securitization tranches can absorb losses without interrupting contractual payments to more senior tranches, whereas subordination in a senior/subordinated debt structure is a matter of priority of rights to the proceeds of liquidation.

A synthetic securitization[4] is a structure with at least two different stratified risk positions that reflect different degrees of credit risk where credit risk of an underlying pool of exposures is transferred, in whole or in part, through the use of funded (e.g. credit-linked notes) or unfunded (e.g. credit default swaps) credit derivatives or guarantees that serve to hedge the credit risk of the portfolio. Accordingly, the investors’ potential risk is dependent upon the performance of the underlying pool.

Sometimes people are confused between covered bonds and securitization. It is important to distinguish between these two. A covered bond is a corporate bond with one important enhancement: recourse to a pool of assets that secures or covers the bond if the originator becomes insolvent. Liquidity is the only reason to securitize through covered bonds, since the risk or the capital requirements do not change with the issue, and the assets backing the covered bond remain in the balance sheet. However, in the case of the securitization, banks might also securitize so as to transfer risk and/or arbitrage capital requirements.

For investors, one major advantage to a covered bond is that the debt and the underlying asset pool remain on the issuer’s balance sheet, and issuers must ensure that the pool consistently backs the covered bond. In the event of default, the investor has recourse to both the pool and the issuer.

2.  A Brief History of Asset Securitization[5]

In February 1970, the U.S. Department of Housing and Urban Development created the first transaction using a mortgage-backed security. Under the deal, the Government National Mortgage Association (GNMA or Ginnie Mae), acting as the originator, sold securities backed by a portfolio of mortgage loans.

Year 1985 saw for the first appearance of ABS, where a class of automobile loans was securitized. Marine Midland Bank originated this first auto loan deal worth $60 million which was securitized by the Certificate for Automobile Receivables Trust (CARS, 1985-1).

The first bank credit card sale came to market in 1986 with a private placement of $50 million. This transaction demonstrated to investors that, if the yields were high enough, loan pools could support asset sales with higher expected losses and administrative costs could also enter market. Starting in the 1990s, securitization was applied to sectors of the reinsurance and insurance markets including. The first public Securitization of Community Reinvestment Act (CRA) loans started in 1997. CRA loans are loans targeted to low and moderate income borrowers and neighborhoods.

Europe is a late comer in securitization, and the first securitizations of mortgages appeared in theUKin the late 1980s. The European market took off since early 2000s, thanks to the innovative structures implemented across the asset classes, such as UK Mortgage Master Trusts.

As a result of the subprime crisis from 2007-09, the bond market backed by securitized loans has become very weak, and investors are reluctant to participate in this market unless the bonds are guaranteed by a credit-worthy third party. That in turn leads heightened interest rates for loans that were previously securitized such as home mortgages, student loans, auto loans and commercial mortgages. Many industry bodies, like the IIF and SIFMA, call for to revive the market.

3. Structure, Pooling and Transfer

It is without doubt that securitization structure is very complex. Each securitization transaction will be specially tailor- made to suit for its particular needs. However the basic structure remains more or less the same, as shown in Chart 1 below.

Chart 1: Securitization Structure

The originator initially owns the assets engaged in the deal. This is typically a bank looking to seek funding. According to traditional corporate finance concepts, such a company would usually have three options available: a loan, bond issue, or issuance of stock. However, stock offerings dilute the ownership and control of the company, while loan or bond financing is often prohibitively expensive. The consistently cash-generating asset part of a company could have a much higher credit rating than the company itself. Where the originator is a bank that must meet capital adequacy requirements, the structure is usually more complex because a separate company is to be established to buy the assets.

A suitably large portfolio of assets is pooled and transferred to an SPV (the issuer), a tax-exempt company or trust formed for the specific purpose of funding the assets. Once the assets are transferred to the issuer, there is normally no recourse to the originator (bank remoteness). The true sale effectively ring fences the pooled assets, separating securitized assets from other assets of the originator. The true sale works both ways, protecting investors as well as the originator. If the asset transfer is not a true sale, investors are vulnerable to claims against the originator, including the claims of a bankruptcy trustee that might be appointed if the originator were to file bankruptcy. A true sale also protects the originator from claims by investors. If the pooled assets are sold into an SPV, the investor can only seek payment from that entity, not from the general revenues of the originator. In order to achieve this, the governing documents of the issuer restrict its activities to only those necessary to complete the issuance of securities.

In order to purchase the assets from the originator, the issuer SPV issues tradable securities which will be sold to investors through a private placement or in the open market. The performance of the securities is then directly linked to the assets. To facilitate the sales, the securities will be rated by a credit rating agency to help investors make a more informed decision (in theory at least).

Unlike conventional corporate bonds, securities under a securitization deal are credit enhanced, meaning their credit quality is increased over that of the originator’s unsecured debt or underlying asset pool. This increases the likelihood that the investors will receive cash flows to which they are entitled, and thus causes the securities to have a higher credit rating than the originator. Credit enhance is achieved through external enhancement (such as a third-party guarantee, or surety bonds) or with internal enhancement (security tranches, over collateralization, or excessive interest spread accounts).

Individual securities are often split into tranches, and each tranche has a different level of credit protection or risk exposure from another: There exist at least two layers of securities. A senior class of securities have first claim on the cash that the SPV receives and one or more junior subordinated classes function as protective layers for the senior class. The more junior classes only start receiving repayment after the more senior classes receive repayment. The most junior class (often called the equity class) is the most exposed to payment risk, which is usually retained by originators to offer extra protections. In some cases the equity class receives no coupon (either fixed or floating), but only the residual cash flow (if any) after all the other classes have been paid.

In addition to subordination, credit may be enhanced by a reserve or spread account or over-collateralization. A reserve or spread account is kept after expenses such as principal and interest payments, charge-offs and other fees have been paid-off are accumulated, and can be used when SPV expenses are greater than its income. This residual amount normally reverts to the seller as additional profit[6]. However, it is also commonly available to the trust to cover unexpected losses.

A servicer collects payments and monitors the assets that are the crux of the structured financial deal. The servicer can often be the originator, because the servicer needs very similar expertise to the originator and would want to ensure that loan repayments are paid to SPV. The servicer can significantly affect the cash flows to the investors because it controls the collection policy, which influences the proceeds collected, the charge-offs and the recoveries on the loans. Any income remaining after payments and expenses is usually accumulated to some extent in a reserve or spread account, and any further excess is returned to the seller. Bond rating agencies publish ratings of asset-backed securities based on the performance of the collateral pool, the credit enhancements and the probability of default.

Part II             Benefits and Risks of Securitization

1. Benefits of Securitization

Funding costs and asset-liability management might be the top concern for asset securitization. Because of the credit enhancements, the rating of asset-backed securities is often higher than that of the originator. For example, a small bank may be considered more risky than the mortgage loans it makes to its customers; were the mortgage loans to remain with the bank, the borrowers may effectively be paying higher interest. This might be the number one reason to securitize a cash flow and can have tremendous impacts on borrowing costs. The difference between BB debt and AAA debt can be multiple hundreds of basis points. Essentially, in most banks and finance companies, the liability book or the funding is from deposits. Their maturity is often short-lived, more likely shorter than one year. On the asset side, most assets (loans) will be more than one years. Securitization allows such banks and finance companies to create a self-funded asset book, thus great alleviate the asset liability mismanagement.

Securitization might ease capital requirements and lock in profits. The main benefit from asset securitization is that it enables banks to pass the risks of lending on to other parties and remove assets from their balance sheets, thus freeing capital resources to back new lending which would otherwise be beyond their capacity. The funding and liquidity benefits of the securitization process derive from the conversion of illiquid assets into liquid funds available for additional lending. Some firms, especially banks, are subject to capital adequacy requirement and have a limit or range that their leverage is allowed to be. By securitizing some of their assets, which qualify as a sale for accounting purposes, these firms will be able to remove assets from their balance sheets while maintaining the earning power of the assets. Securitization makes it possible to transfer risks from an entity that does not want to bear it, to one that does. Interest rate risk can be reduced by passing it on to the investors. A bank wishing to extend its lending but not having funds of adequate maturity can avoid a maturity mismatch by securitizing the new loans. On the other hand, for a certain line of business, the total profits have not yet emerged and thus remain uncertain. Once the assets under line have been securitized, the level of profits has now been locked in for that company.

In addition, securitization may transfer risks. A bank, which is heavily exposed to a particular region or economic sector, could transfer part of its loan portfolio and also could purchase with the proceeds other types of securitizations, thus achieving a more diversified loan portfolio.

Advantages to investors: highly rated entities have always been the rarity in the financial world. Securitizations, however, allow for the creation of large quantities of AAA, AA or A rated bonds, therefor provide good investment opportunities for risk-averse institutional investors, or investors required to invest in only highly-rated assets. Hedge funds as well as other institutional investors tend to like investing in bonds created through securitizations because they may be uncorrelated to their other bonds and securities, therefore achieve a diversified portfolio. Critics have suggested that the complexity inherent in securitization can limit investors’ ability to monitor risk, and that competitive securitization markets with multiple securitizers may be particularly prone to sharp declines in underwriting standards. Private, competitive mortgage securitization is believed to have played an important role in theU.S.subprime mortgage crisis.

There are a few disadvantages to issuer. Even though it lacks empirical evidence, securitization may reduce portfolio quality. One could argue that, if the AAA risks are being securitized out, this would leave a materially worse quality of residual risk. Securitizations are expensive due to management and system costs, legal fees, underwriting fees, rating fees and ongoing administration. Securitizations often require large scale structuring, and thus may not be cost-efficient for small and medium transactions.

2. A Case Study

In this section we examine the leverage effect of securitization on the return on equity for a true sale structure, which by definition changes the balance sheet composition of the asset originator. For the purpose of simplicity, let us assume that the issuer holds 8% equity[7] and shareholder require 15% return on equity at a debt-to-equity ratio of 0.08/ 0.92 ≈ 8.7%。By accepting a first loss position (equity portion) of 5%, the issuer now holds 5% instead of 8% equity after completion of the securitization transaction.

In the calculation, we further suppose the rating for the issuer is “A”, while the securities under the securitization with proper credit enhancement get a rating of “AAA”. The company may finance its assets either through conventional corporate bond or through securitization. We assume that for an A-rated company, market will demand an interest spread of 80 bps, while 50 bps is needed for an AAA- rated security. The default rate for the pooled assets is 1% under both conditions.

We calculate the net return before cost of equity (COE) by subtracting the total direct cost (5.42% /5.78% respectively) from return of underlying assets (7%). In the case, the net return under conventional funding is 1.58%, much higher than 1.23% under securitization. Dividing this result by total equity capital yields the return on equity (ROE), which clearly indicates a higher figure of securitization (24.50%) compared to conventional on-balance sheet funding (19.80%).

            Table 1: Securitization Impact on Performance

  Conventional Funding Securitization
Debt capital



Equity Capital



Total Capital



Return of underlying assets



Risk-free rate



Expected Return of Equity



Interest Rate spread



Weighted cost of equity (CoE)



Weighted cost of debt (CoD)



Weighted Average Cost of Capital (WACC)



Expected Credit loss (EL)



Fees of Securitization



Total Direct cost (CoD + EL+Fees)



Net return    
    before CoE



    after CoE



Return on Equity (RoE)



3. Risks Associated with Securitization

Credit/default Risk. Default risk is generally defined as a borrower’s inability to meet interest payment obligations on time. For securitization, default may occur when cash inflow from the underlying assets are not sufficient to met the obligation in its prospectus. A key indicator of a particular security’s default risk is its credit rating. Different tranches within the securitization are rated differently, with senior classes of most issues receiving the highest rating, and subordinated classes receiving correspondingly lower credit ratings. The granularity of pools of securitized assets is a mitigant to the credit risk of individual borrowers. Unlike general corporate debt, the credit quality of securitized debt is non-stationary due to changes in volatility that are time-dependent and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves.

In addition, off-balance sheet treatment for securitizations coupled with guarantees from the issuer can hide the extent of leverage of the securitizing firm, thereby facilitating risky capital structures and leading to an under-pricing of credit risk. Off balance sheet securitizations are believed to have played a large role in the high leverage level institutions before the financial crisis, and the need for bailouts.

However, the credit crisis of 2007–2009 has exposed a potential flaw in the securitization process. Loan originators retain no residual risk for the loans they undertake, but collect substantial fees on loan issuance and securitization, which doesn’t encourage stringent undertaking criteria or any further improvement.

Prepayment risk. The majority of revolving securitization is subject to some degree of early amortization risk. The risk stems from specific early amortization events or payout events that cause the security to be paid off prematurely. Typically, payout events include insufficient payments from the underlying borrowers, insufficient excess.

Currency interest rate fluctuations: Like all fixed income securities, the prices of fixed rate securitization move in response to changes in interest rates. Fluctuations in interest rates affect floating rate ABS prices less than fixed rate securities, as the index against which the ABS rate adjusts will reflect interest rate changes in the economy. Furthermore, interest rate changes may affect the prepayment rates on underlying loans that back some types of ABS, which can affect yields. Home equity loans tend to be the most sensitive to changes in interest rates, while auto loans, student loans, and credit cards are generally less sensitive to interest rates.

Moral hazard: Investors usually rely on the deal manager to price the securitizations’ underlying assets. If the manager earns fees based on performance, there may be a temptation to mark up the prices of the portfolio assets. Conflicts of interest can also arise with senior note holders when the manager has a claim on the deal’s excess spread.

Servicer risk: The transfer or collection of payments may be delayed or reduced if the servicer becomes insolvent. This risk is mitigated by having a backup servicer involved in the transaction.

Part III           Systemic Implications and Regulatory Development

1. Implications for financial systems

Securitization allows banks to transform into liquidity assets that otherwise would be stuck on the balance sheet until their maturity. With new funds raised, they can increase lending. At the same time, risk transfer has increased significantly thanks to securitization. In fact, some banks are becoming more and more mere originators of loans and distributors of their risk: soon after the loan has been granted, it is packaged into a bundle of other mortgages, given a risk assessment by a rating agency and sold out through securitization. Securitization is, thus, shaping a new type of banking, one where relationship with the costumer is fading in favor of a transaction-based bank where its main proceeds come from the fees they earn originating and packaging loans.

This “originate to distribute” model is not free of risks as the recent turmoil in financial markets has shown. There are two main problems. The first one is the incentives that the lender has to properly screen and monitor borrowers, since it is going to get rid off the credit risk quickly. A bank selling loans must continue to convince loan buyers of its commitment to evaluate the credit quality of borrowers by maintaining a portion of the loan’s risk. That makes asset securitization incentive compatible. The fact that some loan originators might have shed off all the credit risk in a loan securitization made the lack of confidence from investors in those asset securitization an accident to happen. The second problem is an excessive reliance on the wholesale market to fund lending growth (as in Northern Rock). The fact that the alternative “originate to maturity” model (i.e. the bank loan is kept in the balance sheet until maturity) has been eroded during the last years makes even more compelling to understand why banks securitize.

Moreover, the securitization process might lead to some pressure on the profitability of banks if non-bank financial institutions exempt from capital requirements were to gain a competitive advantage in investment in securitised assets. Although securitization can have the advantage of enabling lending to take place beyond the constraints of the capital base of the banking system, the process could lead to a decline in the total capital employed in the banking system, thereby increasing the financial fragility of the financial system as a whole, both nationally and internationally. With a substantial capital base, credit losses can be absorbed by the banking system. But the smaller that capital base is, the more the losses must be shared by others. This concern applies, not necessarily in all countries, but especially in those countries where banks have traditionally been the dominant financial intermediaries.

While asset transfers and securitization can improve the efficiency of the financial system and increase credit availability by offering borrowers direct access to end-investors, the process may on the other hand lead to some diminution in the importance of banks in the financial intermediation process. In the sense that securitization could reduce the proportion of financial assets and liabilities held by banks, this could render more difficult the execution of monetary policy in countries where central banks operate through variable minimum reserve requirements. A decline in the importance of banks could also weaken the relationship between lenders and borrowers, particularly in countries where banks are predominant in the economy.

2. Regulation Development of Securitization

Banks need to hold a minimum level of regulatory capital against risks. UnderBaselI framework, capital is a very rough function of the level of riskiness in their assets. For instance, a loan to a firm need 8% of capital no matters how risky the firm is. Risk insensitivity might be the main thrust for great efforts undertaken by the Basel Committee on Banking Supervision (BCBS) to overhaul the capital regulatory framework. That process ended up in the Basel II framework in 2004, in which the capital requirements of banks will be better aligned with the risk profile of their portfolios. In this way, they will be obliged to hold a higher level of capital for loans granted to high-risk borrowers. However, thanks to securitization it is possible that banks sell a part of those loans (in particular that of better quality) and with the proceeds, lend to riskier borrowers so as to increase the expected returns of their portfolio with no change in capital requirements. Table 2 summarizes the regulatory developments in the field of securitization.

Table 2:  BCBS Regulations on Assets Securitization


Issue Date Document
September 1992 Asset Transfers and Securitization
June 1999 The new Basel Capital Accord First Consultative Paper
January 2001 The NewBaselCapital Accord Second Consultative Paper and Asset Securitization: Supporting Document to the NewBaselCapital Accord
October 2001 Working Paper on the Treatment of Asset Securitizations
October 2002 Second Working Paper on Securitization
April 2003 The NewBaselCapital Accord Third Consultative Paper
January 2004 Changes to the Securitization Framework
June 2004 International Convergence of Capital Measurement and Capital Standards: a Revised Framework
June 2006 International Convergence of Capital Measurement and Capital Standards, a Revised Framework Comprehensive Version
July 2009 Enhancements to the Basel II framework
December 2010 A global regulatory framework for more resilient banks and banking systems
June 2011 A global regulatory framework for more resilient banks and banking systems (revised version)

The subprime crisis exposed inherent deficiency within the Basel II. The international community took step to correct those weaknesses. Mainly the goals are achieved through strengthening the treatment for certain securitizations in Pillar 1 (minimum capital requirements), and introducing higher risk weights for resecuritizations exposures (so-called CDOs of ABS) to better reflect the risk inherent in these products, as well as raising the credit conversion factor for short-term liquidity facilities to off-balance sheet conduits. The BCBS also require that banks conduct more rigorous credit analyses of externally rated securitization exposures.

It is generally expected that tougher treatment of securitization exposures under Basel II.5 (effective December 2010) and Basel III will raise the costs of securitization.  These include changes to both capital and liquidity requirements.

2.1 Capital

In July 2009, the BIS announced new capital requirements for banks in relation to market risk as part of Basel II.5.  The specific changes to banks’ treatment of securitization exposures include:

  • More conservative collateral haircuts for securitization collateral with respect to counter party exposure.  Basel II did not require explicit haircuts for securitization exposures.  Under Basel III haircuts for securitization exposures will be higher than for other types of collateral in the same rating category and with similar maturity profiles e.g. haircuts are two times that of corporate bonds.  In addition, resecuritizations, irrespective of credit ratings, are not eligible collateral.
  • Specific risk haircuts for securitization exposures when calculating capital treatment related market risk.  Basel III will require that banks treat securitization exposures the same when calculating market risk whether they are held in the trading or banking book.  Previously, Basel II allowed for lower capital charges for securitizations in the trading book than those in the banking book giving raise to capital arbitrage opportunities. Moreover, only the standardized approach may be applied when calculating specific risk capital charges.  Specific risk capital changes under the standardized approach will be higher for securitization exposures than for similarly rated government and corporate securities.  However, there will be an exemption for correlation trading books from the full treatment for securitization positions.  They would qualify either for a revised standardized charge or a capital charge based on a comprehensive risk measure.

In September 2010, the BIS announced further new and stricter capital requirements for banks. The change in treatment of securitization exposures when calculating capital requirements is:

The application of a 1250% risk weight to lower rated (BB+ or below) and unrated securitization exposures.  Basel II required banks to deduct certain unrated or non-investment grade securitization exposures from regulatory capital (50% from Tier 1 capital and 50% from Tier 2 capital).  The overall increase in the bank’s overall risk-weighted assets affects several capital ratios.  The addition of some bank securitization exposures with a 1250% risk-weight may well force banks to raise additional common equity to maintain the increased common equity requirement under Basel III.

2.2 Liquidity

In December 2010, the BIS published its final reforms to strengthen liquidity risk management.  The liquidity framework sets out two minimum standards for funding liquidity:

Securitized assets are generally not considered liquid assets under either of those ratios.  The LCR is defined as the ratio of the bank’s stock of high-quality liquid assets divided by its total cash outflows over the next calendar days.  The LCR must be at least 100%.  Apart from market securities issued by public sector entities (PSEs) e.g. Fannie Mae and Freddie Mac which may (under supervisory approval) be considered Level 2 assets (subject to a 15% haircut and are limited to 40% of the total stock of liquid assets after haircuts), all other asset backed securities are not considered liquid assets.  In addition, with respect to the cash outflows component of the LCR, asset backed securities are considered a 100% cash outflow as it is assumed the re-financing market will not exist.

The NSFR is defined as the ratio of the bank’s available amount of stable funding (ASF) divided by its required amount of stable funding (RSF).  Encumbered assets including those backing ABS on the balance sheet receive a 100% RSF unless there is less than a year remaining in the encumbrance period.

Basel III liquidity requirements can be considered rather punitive for securitization.  Although covered bonds are also considered 100% cash outflows for purposes of the LCR and assets backing covered bonds are generally considered encumbered assets for purposes of the NSFR, unlike ABS, qualifying covered bonds  rated AA- or higher are included as Level 2 liquid assets for the LCR requirement.  This begs the question of why the liquidity requirements do not distinguish between securitizations with high credit ratings with below investment grade securitization.  Some note that traditional high quality lines of business e.g. vanilla senior securitization performed well throughout the crisis.  It should also be noted that for purposes for capital i.e. application of risk weights, the BIS does distinguish between above and below investment grade (and unrated) securitization exposures.

ForU.S.banks implementing Basel II, such changes give subordinate tranches of securitizations—and all resecuritizations— significantly higher capital weightings. However, investment-grade tranches receive more favorable treatment, particularly those classified as “granular,” or well diversified. These changes will lower charges for most securitizations (e.g. Chart 9), but discourage securitization of lower-quality loans and re-securitizations. For example, an originating bank owing $100 million of loans would face a capital change of $8 million (or 8%). If the loans were securitized, with the AAA tranches receiving 90% subordination, the capital charge to a bank holding such securitized products would be only $0.73 million. Hence the changes to capital weightings under Basel II in and of themselves

should not present an obstacle to reviving securitization markets; however, their impact when combined with that of the accounting changes of SFAS 166/167 and the risk retention measures noted below could be considerable, particularly for U.S. issuers (SFAS 166/167 will bring U.S. accounting standards closer to IFRS, which already requires far more extensive consolidation of securitization transactions).

Many market participants estimate that the aggregate impact of these three sets of changes could drive up capital requirements forU.S.issuers dramatically—making other means of bank funding such as traditional customer deposits markedly more attractive. However, it is not clear if these traditional sources could satisfy the current funding gap.

2.3 Accounting

In order for an originating bank to remove a pool of securitised assets from its balance sheet for purposes of calculating risk-based capital, the bank must transfer the assets legally or economically via a true sale[8], e.g. novation, assignment, declaration of trust, or subparticipation. More specifically, a clean break has occurred only if:

(a) The transferred assets have been legally isolated from the transferor; that is, the assets are put beyond the reach of the transferor and its creditors, even in bankruptcy or receivership. This must be supported by a legal opinion;

(b) The transferee is a qualifying SPV and the holders of the beneficial interests in that entity have the right to pledge or exchange those interests; and

(c) The transferor does not maintain effective or indirect control over the transferred assets.

Clean-up calls should represent a relatively small percentage of the overall issuance of securities backed by the securitised assets. If such call arrangements are not a relatively small percentage of the total security issuance or if the sponsoring bank wishes to exercise the clean-up call at a level greater than the pre-established level, then the bank should consult with its national supervisor prior to exercising the call.

If the minimum requirements described above are not met, then the securitised assets must remain in the originating bank’s risk-weighted assets for purposes of calculating its risk-based capital ratios – even if the transaction otherwise would be treated as a “true sale” under the home country’s accounting or legal systems.

Accounting standards govern when such a transfer is a sale, a financing, a partial sale, or a part-sale and part-financing. In a sale, the originator may offload the transferred assets from its balance sheet; in a financing, the assets should remain the property of the originator (as the case for covered bonds). Under US accounting standards, the originator achieves a sale by being at arm’s length from the issuer, in which case the issuer is classified as a qualifying special purpose entity or “qSPE”. Because of the complexity of securitization, the originator typically needs the help of an investment bank (the arranger) for proper structuring the transaction.

The accounting changes of SFAS 166/167 For U.S. banks, SFAS 166 and 167 have raised the bar for de-recognition and consolidation of assets, which is at the heart of securitization. This could in some cases trigger consolidation of underlying loans on balance sheet. The criteria for determining whether consolidation is required are based on two key questions: first, whether an institution has or could have the power to significantly impact the economic performance (i.e., of underlying loans) of a securitization, and second, whether it has the right to receive benefits or absorb losses. If the answer to both these questions is yes, then the institution must consolidate the underlying loans of the securitization on its balance sheet. Firms that must consolidate will need to retain capital against these assets on their balance sheets.

Part IV            Securitization in China

1. Summary of Securitization in Chinese market

As early as in the early 1990s,Chinabegan the exploration of asset securitization. In 1992 Hainan Development Construction Corporation issued RMB200 million in real estate investment bonds. In April 2004, it was the first time that asset securitization was utilized to dispose non performing loans (NPLs) when ICBC Ningbo Branch disposed assets worth of RMB2.602 billion. Strictly All those securities are not securitization, but they help to foster further market development (please refer to Table 3 for relevant developments).

Table 3: Milestones forChina’s Securitization Development



1992 Hainan Development Construction Corporation issued RMB 200 million investment bond,  using capital from sale of land and interests of depots as future ash flow from 800 acre land
1994 The People’s Republic ofChina’s Company Law was promulgated
1996 Guangdong Zhuhai Highway Ltd. Issued $200 million securitization in US
1999 The People’s Republic ofChina’s Contract Law was promulgated
2000 China Development Bank (CDB) and Industrial and Commercial Bank of China (ICBC) were designated as pilot banks to issue securitization
2000 Four Asset Management Corporations (AMCs) were established to purchase NPLs from the big four Chinese banks
2001 The People’s Republic ofChina’s Trust Law was promulgated
2002 PBOC issued Provisional Rules on Entrusted Funds Management of Trust and Investment Companies
2003 China Cinda AMC sold NPLs to Deutsche Bank
2003 China Security Regulatory Commission (CSRC) issued Interim Rules on  Asset Management Business for Securities Companies Clients
2004 Huarong AMC and ICBC utilized trust-based structure in quasi-securitization transactions to dispose of NPLs
2005 PBOC and CBRC jointly released the Administrative Rules of Pilot Projects of Credit Assets Securitization
2005 CBRC released the Interim Regulatory and Supervisory Rules on Pilot Projects of Credit Assets Securitization for Financial Institutions
2005 CDB and CCB were designated as first batch of pilot banks to conduct asset securitization, with total quota of RMB10 billion
2005 China Unicom issued short-term securitization backed by CDMA rental and raised RMB 9.5 billion
2005 CDB issued short-term industrial loan securitization of RMB 5.73 billion
2005 China Construction Bank (CCB) issued long-term mortgage loan securitization of RMB 3.04 billion
2007 The People’s Republic ofChina’s Property Law was promulgated
2007 China Merchant Bank, Industrial Bank and Shanghai Pudong Development Bank were designated as the second batch of pilot banks to conduct asset securitization, with total quota of RMB60 billion.
2010 CSRC issued the Interim Guideline on Pilot Business of Asset securitization Business for Securities Companies
2010 CBRC issued the Guideline of Capital Calculation for Asset Securitization Exposure for Commercial Banks

There are two separate securities markets inChina, the National Inter-Bank Bond Market (NIBBM) which is supervised by the PBOC, and the two local stock exchanges, which are supervised by the CSRC. Asset securitizations of banks and non-bank financial institutions are issued and traded in the interbank market, and their activities are regulated and supervised by the PBOC and the CBRC. On the other hand, corporate securitization, which is regulated under the CSRC as Special Assets Management Plan (SAMP), is issued and traded in stock exchanges. Such a segmented market severely affects the pace of development of securitization. Since most institutional investors are NIBBM participants and NIBBM dominatesChina’s bond market, PBOC’s interbank market appears to be the ideal place for securitization.

Year 2005 witnessed a comparatively rapid development in securitization market. The most important effort has been the joint administrative decree in April 2005 by the PBOC and the CBRC on the Administrative Rules of Pilot Projects of Credit Assets Securitization (the Rules). In the absence of other matching laws, this decree sets out a relatively complete framework for the securitization process. Prior to the Rules, the Chinese legal system could not accommodate securitization projects because it was unlawful for SPVs to hold assets and issue securities according toChina’s Company Law. However, the Rules do not carry the same authoritative weight as laws. In times of conflict, laws will prevail over the Rules.

As a result, the scale of security issuance in 2005 exceeded total volume of the previous 10 years. In March 2005, the CDB and the CCB were allowed to carry out the pilot securitization of corporate loans and mortgage. Combined, two pilot bank issues, one MBS and one CLO, raised nearly USD 1 billion. Such securities are now trading in the NIBBM. Another issues by a non-bank corporate originators raised more than $1 billion, though a bank guarantee was used for credit enhancement. The non-bank deal took place entirely outside the PBOC/CBRC framework mentioned above, with the securities traded on theShanghaistock exchange (please refer to Case Studies below for details).

The global financial crisis caused by the subprime turmoil in theUSled to a reasonable argument that securitization did not function as well as it should have, instead, it encouraged high risk lending and distributed risks globally, with the help of derivative products. With such a mentality, the Chinese securitization market was practically suspended in 2008.

In order to counter negative impacts from global financial crisis, Chinese banks grants huge amounts of loans to local governments financial vehicles (LGFVs), the amount of which could reach RMB 8 trillion. It is of no question that part of those LGFVs will become bad debts, and there are a lot of suggestions that securitization could be tapped to offload these burden from banks. On the other hand, Basel III has tightened the capital requirements for banks, and banks are eager to find way to raise money or streamline its balance sheets. Securitization has major benefits for financial institutions inChina: capital releases, new tool for asset-liability management, alternative source of funding, and disposal of NPLs. So that is very natural to see many calls recently from private sectors as well as regulators to reopen the securitization market. It is expected that local securitization market will be reopened shortly.

2. Case Studies

2.1 ChinaUnicom[9]

The China Unicom’s securitization is the first proper ABS after the Rules were issued. China Unicom was successfully raised RMB9.5 billion through five separate transactions which listed in the Shanghai Stock Exchange for qualified institutional investors, as table 4 shows.

Table 4: Securitization ofChinaUnicom (RMB)

  01 02 03 04 05
Issuance Date 09/06/2005 06/06/2005 12/28/2005 02/06/2006 02/06/2006
Amount (BN) 1.6 1.6 2.1 2.1 2.1
Interest (%) 2.55 2.8 3.1 2.55 3
Maturity Date 02/16/2006 08/14/2006 02/14/2007 05/22/2006 11/14/2006

All five issuances of securitization were backed by the revenues gained from leasing CDMA network capacity by CNHL[10] to CUCL[11], and the raised capital through issuances would be used to purchase the income rights of specified seasonal revenues from CNHL, and to pay the interests and nominal amounts to the investors on a pro-rata basis, which would be completed through periodical dates or at maturity.. The securitization was listed in Shanghai Stock Exchange.

Chart 2: ChinaUnicom’s Securitization Structure[12]

Arranger: CICC







Institutional Investors

Trustee Bank: BOC

Rating Agency:


Credit Enhancer:



Income Rights


Income Rights


Third Party Guarantee




Since the introduction of CDMA network by China Unicom, the CUCL leased the CDMA network lessee, paying increasing leasing fees to the CNHL in returns of CDMA network capacity. After the leasing fees were paid quarterly which constituted into a pool of asset, the CNHL could undertake CDMA securitization and the capital received by the CNHL would be used to repay the loans for constructing CDMA hardware. The five issuances use the same structure as chart 2 shows.

2.2 China Development Bank

The CDB’s securitization can be seen as a typical CLO, which is the first credit securitization inChina. In addition, the CDB’s securitization was issued in China National Intra-Bank Bond Market, rather than in a stock exchange. The total amount of issuance is RMB 5.72 billion and raised RMB 5.74 billion in total, as Table 5 shows.

Table 5: Securitization Issuance of CDB (RMB)

  Tranch A Tranch B Tranch C
Issuance Date 04/25/2006 04/25/2006 04/25/2006
Method of Issuance Public Offering Public Offering Private Placement
Amount (Bn) 4.3 1 0.44
Interest (%) 2.98 3.46 N/A
  Basis Interest (%) 2.25 2.25 N/A
  Interest Gap (%) 0.73 1.21 N/A
Maturity Date 06/30/2009 12/31/2009 12/31/2009
Credit Rating AAA A N/A

Chart 3:  Securitization Structure of CDB[13]


Arranger: CDB



Institutional Investors




Trust Bank:


Clearing Institution

Credit Rating:





Issuance Agreement






Capital Raised


Payment of


& Principal



In this particular deal, the CDB did not use any external credit enhancers, instead the Bank enhanced the pool of assets through subordination of assets (three tranches), and therefore the domestic rating agency the CCXI was able to grant credit rating accordingly. On top of that, the CBD played multi roles here. Apart from being an arranger and originator, CDB also plays the role of servicer after the securitization was issued.

2.3 China Construction Bank

The securitization issued by the CCB can be seen as a typical MBS, which primarily due to the increase of personal mortgages caused by the rising housing market. In addition, the issuance of CCB’s securitization is the first CMBS inChina, although many aspects of CCB’s securitization are similar with CDB, such as both of them were issued in the National Intra-Bank Bond Market, and CCB’s securitization was also divided into different tranches, as Table 6 shows.

Table 6: Securitization Issuance of CCB (RMB)

  Tranch A Tranch B Tranch C Tranch D (equity)
Issuance Date 12/15/2005 12/15/2005 12/15/2005 12/15/2005
Amount (Bn) 2.7 0.2 0.05 0.09
Interest (%) Floating Floating Floating N/A
  Basis Interest 7-day Repo Rate 7-day Repo Rate 7-day Repo Rate N/A
  Interest Gap 1.10 1.70 2.80 N/A
Maturity Date 11/26/2037 11/26/2037 11/26/3027 11/26/2037
Credit Rating AAA A BBB N/A

Chart 4: CCB’s Securitization Structure


Arranger: HSBC




 & Other Investors





Trust Bank:

Clearing Institution

Credit Rating:





Issuance Agreement






Capital Raised


Payment of


& Principal



The CCB deal shares many common features with the CDB deal with two prominent exceptions. First, the CCB case structured more aligned with international practice. Second, the CCB played multi functional roles here, acting as servicer, originator and investors in the same time.

The use of SPV inChinais generally classified as two types. One is ruled by the banking regulators, as in the cases of the CCB and CBD; the other one is governed by the CSRC to use SAMP in securitization, witnessed by China Unicom. The distinction of Chinese deals structure is that SPV is established and operated by a third party, not by originators, and the later is popular in the West. This could restrain the extent of adverse selection and moral hazards for the originator, which are one the fundamental causes of the recent subprime credit crises. In addition, the creation of SPV in China can be viewed as government initiative, since all the securitizations need to be approved by a regulatory body, but the role of government is only limited to assessment rather than establishment by itself. Since securitization inChinais still in the experiment stage and Chinese government remain cautious about full impacts from securitization. So the Chinese government is willing to adopt both approaches to see which one works better and more suitable to the Chinese financial market. In the long run, those two sets of rules will combine into one integrative framework to suit all Chinese market participants.

3. Informal Securitization

When we talk about the securitization inChina, we could not let go the informal securitization principally undertaken by Chinese banks. According to a recent report, in 2011 alone, the Chinese banks issued wealth management products (WMPs) with a total value of RMB16.99 trillion, an increase of over 100% over 2010. We don’t know the exact percentage yet, but we are pretty sure that credit-backed wealth management products (CWMPs) will make up a large part. We refer CWMPs to informal securitization, as they share similar features as asset securitization (please refer to Chart 5 below). Chinese will pack some loans into CWMPs and promote them as good investment opportunities to Chinese investors.

Chart 5: Structure of Informal Securitization inChina







Principal before


Principal after

Loan Transferred

Sales Proceeds




Sales Proceeds

As said above, informal securitization has exponential growth, however this is still a grey area for Chinese supervisors and so far no comprehensive legal framework is in place. Regulators have focused most of their attention on directing specific aspects of transactions. Credit-backed investment products are frequently marketed as substitutes for bank deposits, and investors commonly believe there is an implicit commitment from banks to repay investors upon the products’ maturity.

The principal drivers behind are banks’ need to free space on banks’ balance sheets and retain customers’ loyalty. InChina, banks commonly use CWMPs to deal with regulation on loan quotas and regulations on capital, liquidity, concentration and sectoral exposures. In the past, the primary driver was to seek a loophole to deal with loan quotas. After 2010, banks are more focused on alluring customers to keep money with them. This convergence of interests between banks eager to adjust loan balances and investors keen on higher-yielding investments has fuelled the rapid rise in volume recently.

WithChina’s equity and property markets languishing and real savings rates now in negative territory, investors are avid for alternative, higher-yielding investments. Although broadly similar, informal securitization inChinadiffers considerably from traditional securitizations in some critical aspects: asset pools are usually very heavily concentrated; no tranching structure exists based on credit risk; and the roles of loan originator, product distributor, custodian, and loan manager are frequently commingled, and in practice sometimes all played by a single bank.

4. Perspectives

InChina, there are huge amounts of corporate assets that generate stable streams of cash flows, such as toll roads, power plants and water disposal systems. Since the owners of these assets are normally actively seeking low-cost funding for expansion, corporate ABS backed by such assets is thought to be the most promising sector for securitization inChina.

However, before reaping the fruits, clearly there are still obstacles involved in the Chinese securitization, such as less understanding of securitization products by the investors, or regulation limitations. On top of that, other issues should be tacked likewise, including the following:

· It is not clear whether the current accounting and tax measures will still apply to future transactions after the pilot projects.

· Regulators expect to release certain credit risk from the banking system through securitization. However, in practice, most securitization products originated by banks were bought by other banks. As a result, the risk is still left within the banking system.

· It is questionable whether products supplied by a limited number of financial institutions would support the securitization market effectively, even if PBOC opened up securitization issuances in the interbank market.

With those issues in mind, we could remain cautious optimistic aboutChina’s securitization market.


  1. BCBS (December 2010): Basel III: International framework for liquidity risk measurement, standards and monitoring
  2. Alfredo Martin-Oliver, Jesús Saurina (November 2007): Why do banks securitize assets?
  3. Michael Simkovic:  Competition and Crisis in Mortgage Securitization
  4. Michael Simkovic, Secret Liens and the Financial Crisis of 2008, American Bankruptcy Law Journal, Vol. 83, p. 253, 2009
  5. OCC (November 1997): Asset Securitization Comptroller’s Handbook.
  6. Tarun Sabarwal (December 29, 2005): Common Structures of Asset-Backed Securities and Their Risks
  7. IIF ( June 2010): Reviving Securitization Safely: A Staff Discussion Note
  8. Fitch Rating (July 14, 2010):ChinaSpecial Report, Chinese Banks Informal Securitisation Increasingly Distorting Credit Data
  9. Fitch RatingsChinaSpecial Report (July 2010): Chinese Banks Informal Securitization Increasingly Distorting Credit Data
  10. Hong Yanrong: Restarting Securitization Markets and theDevelopment WayofChina
  11. IMF (October 2009), Global Financial Stability Report: Navigating the Financial Challenges Ahead
  12. BIS (2005): Securitization inAsiaand the Pacific: implications for liquidity and credit risks
  13. Amato, J D andE Remolona(December, 2003): The credit spread puzzle, BIS Quarterly Review
  14. Mimi HU (2008): Developing Securitization Laws inChina
  15. Paul Browne and Jane Newman: Securitization in the People’s Republic ofChina, moving forward, but challenges still remain
  16. BIS Quarterly Review (December 2003) The credit spread puzzle

[1] The Securities Industry and Financial Markets Association (SIFMA):

[2] Dodd Frank Act: Subtitle D—Improvements to the Asset-Backed Securitization Process, Sec 941 regulation of credit risk retention.

[3] Basel Committee of Banking Supervision (June 2006): International Convergence of Capital Measurement and Capital Standards: a Revised Framework – Comprehensive Version, para 539, page 120.

[4] Id, para 540, page 120.

[6] Asset Securitization Comptroller’s Handbook: page 22, para 1.

[7] Basel III requires that banks should hold at least 10.5% capital for 100% risk-weighted assets after 2019, however bear in mind that banks possess large portion of low risk assets, so the equity percentage is significantly lower than 10.5%.

[8] Basel Committee of Banking Supervision: Consultative Document Assets Securitization, January 2001, para 12-13, page 3.

[9] China United Telecommunications Group (China Unicom) is aChina state-owned telecommunication operator, which established in 1994 by the Ministries of Electronic Industry, of Electric Power and of Railways.

[10] China New Horizon Limited (CNHL) is a subsidiary of China Unicom.

[11] China Unicom Corporation Limited (CUCL) is also a subsidiary of China Unicom.

[12] In this securitization structure, CICC refers to China International Capital Corporation, SAMP refers to Special Asset Management Plan, BOC refers to Bank of China, and CCXI refers to China ChengXin International Corporation. The threshold for investment is RMB1 million.

[13] In this transaction, CCTIC refers to China Credit Trust Co. Ltd, borrowers are a pool of assets of  51 loans  worth RMB4.17bn, most of which were performing.

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The Global Reach of IFRS

Globalization is the dominant driving force of world economy. With growing numbers of economies are joining the parade, the finance markets are becoming more global. It is increasingly evident that a combined world financial market should speak a unified language when talking about financial positions, performance or liquidity situation, so that people could compare different companies with an identical scale and make their decisions accordingly.

A single set of high-quality international standards will enhance comparability of financial information and should make the allocation of capital across borders more efficient. The development and acceptance of international standards should also reduce compliance costs for corporations and improve consistency in audit quality. This unified language, through recent development within the past decade, is more likely to be the International Financial Reporting Standards (IFRS) . The article will discuss about the IFRS and their publishing body, global adoption and usage of the IFRS, and some outstanding issues.

Part I. Introduction of IFRS and IASB

IFRS refer to a set of principles-based standards, interpretations and the framework, adopted by the International Accounting Standards Board (IASB). They comprise:

• International Financial Reporting Standards (IFRS)—standards issued after 2001 by the IASB, currently 9 standards;
• International Accounting Standards (IAS)—standards issued before 2001 by the IASC, 29 standard remain valid;
• International Financial Reporting Interpretations Committee (IFRIC) —issued after 2001, 15 interpretations so far;
• Standing Interpretations Committee (SIC)—issued before 2001, at present 10 interpretations still effective;
• Conceptual Framework for the Preparation and Presentation of Financial Statements (September, 2010).

As shown above, many of the standards forming part of IFRS are known by the older name of IAS, which were issued between 1973 and 2001 by the International Accounting Standards Committee (IASC). The IASC was founded in June 1973 in London and later on 1 April 2001 was restructured into the IASB. The IASB took over the responsibility for setting international accounting standards. During its first meeting, the IASB adopted existing IAS and SICs. The IASB continues to develop standards calling the new standards IFRS.

The IASB is the independent standard-setting body of the IFRS Foundation, responsible for the development and publication of IFRS, including the IFRS for SMEs and for approving Interpretations of IFRSs as developed by the IFRS Interpretations Committee (formerly called the IFRIC). The IASB has no authority to require compliance with its accounting standards; however, many countries require that the financial statements of listed companies be prepared in accordance with IFRS.

The IFRS Foundation is an independent, not-for-profit private sector organisation working in the public interest. Its principal objectives, along with the IASB, are to develop a single set of high quality globally accepted IFRS and to promote the use and rigorous application of those standards.

Part II. Organization of IFRS Foundation and IFRS Due Process

1. The Three-tier Organization Structure of IFRS Foundation

The IFRS Foundation now has a three-tier system of governance: the Monitoring Board acting on behalf of public authorities, the Trustees of the IFRS Foundation as overseers, and the IASB as the standard-setting body. The current structure is, to a large extent, modeled after the US accounting practice. In the US, the Financial Accounting Foundation (FAF), the parent of the FASB, is overseen by the US Security and Exchange Commission (SEC). The IFRS Foundation has not historically had a similar link with any national securities regulators. With the idea to enhance public accountability of the IFRS Foundation, its Trustees decided to amend its Constitution to establish a connection between the IFRS Foundation and a Monitoring Group composed of securities authorities charged with the adoption or recognition of accounting standards used in their respective jurisdictions.

Diagram: Organization Structure of the IFRS Foundation

As shown in the diagram above, the governance and oversight of the activities undertaken by the IFRS Foundation and its standard-setting body rests with its Trustees, who are also responsible for safeguarding the independence of the IASB and ensuring the financing of the organisation. The Trustees are publicly accountable to a Monitoring Board of public authorities.

The Monitoring Board’s main responsibilities are to ensure that the Trustees continue to discharge their duties as defined by the IFRS Foundation Constitution, as well as appointing Trustees. Through the Monitoring Board, capital markets authorities will be able to more effectively carry out their mandates regarding investor protection, market integrity, and capital formation. The decision to establish a Monitoring Board was made in January 2009 to enhance the organization’s public accountability by establishing a link to a Monitoring Board of public authorities. The members of the Monitoring Board are, at this moment, the International Organization of Securities Commissions (IOSCO), the European Commission, Financial Services Agency of Japan (JFSA), and the SEC. The Basel Committee on Banking Supervision (BCBS) participates in the Monitoring Board as an observer.

The IASB, comprised by experts with an appropriate mix of recent practical experience, is an independent group responsible for setting accounting standards. The IFRS Interpretations Committee is the interpretative body of the IASB, with a mandate to review on a timely basis widespread accounting issues that have arisen within the context of current IFRSs and to provide authoritative guidance (IFRICs) on those issues. The IFRS Advisory Council provides strategic advices to the IASB, and offers important channels for the IASB to receive valuable input and to consult interested parties.

The organizational structure of the IRFS Foundation is under constant evolving state. The IASB was founded in 1973 by professional accountancy bodies in Australia, Canada, France, Germany, Japan, Mexico, Netherlands, United Kingdom and Ireland, and the United States. Since then, there has been a drift towards international representation. Currently, the International Accounting Standards Committee Foundation has six trustees from the Asia/Oceania region, six from Europe, six from North America and four from any region of the world. In spite of this drift, IFRS currently reflect a strong common-law philosophy. On top of that, the current membership representation and philosophy of the IASB seem likely to face challenges in the longer term. Over time, each of the 100-plus IFRS-adopting jurisdictions will have a politically-legitimate argument that they deserve some sort of representation in the standard-setting process. They seem to have a very convincing argument that the standards that are chose by the IASB affect their economies.

To date, there are some concerns about institutional arrangement, in particular about the status, roles and functions about the Monitoring Board, its relationship with the Trustees, and as well as the composition of the Board itself. Some people argue for an expanded Monitoring Board in order to better represent and serve the global investment community.

The Monitoring Board, which oversees the Foundation, began in April 2010 a review of the governance structure and processes underpinning IFRS standard setting. The aim is to establish whether the governance structure effectively promotes the standard setter’s primary mission of setting high quality globally accepted standards and whether the standard-setter is appropriately independent yet accountable. In February 2011, the Monitoring Board published a Consultative Report t setting out proposals for governance reform.

2. Standard Setting Process

The IFRS Foundation is a unique example of international co-operation in the financial arena. Unlike other bodies that establish international rules, the IASB is composed of full-time professionals, not serving as representatives of particular jurisdictions and interests. The IFRS Foundation’s Constitution establishes an independent standard-setting process, subject to extensive due process requirements, but protected from special and parochial interests. This independence has been a fundamental strength of the IFRS Foundation and the IASB, giving credibility to the standards.

A thorough and transparent due process is essential to developing high quality, globally accepted accounting standards, which involves interested individuals and organizations from around the world. The due process comprises six stages, with the Trustees having the opportunity to ensure compliance at various points throughout:

• Setting the agenda;
• Planning the project;
• Developing and publishing the discussion paper;
• Developing and publishing the exposure draft;
• Developing and publishing the standard, and
• After the standard is issued.

The IASB’s due process is reviewed and further enhanced regularly, benefiting from regular benchmarking against other organizations and from stakeholder advice. The Trustees’ Due Process Oversight Committee reviews and discusses due process compliance regularly throughout the standard-setting process and at the end of the process before a standard is finalized.

In addition, all meetings of the IASB are held in public and through webcast. In fulfilling its standard-setting duties the IASB follows a thorough, open and transparent due process of which the publication of consultative documents, such as discussion papers and exposure drafts, for public comment is an important component. Besides, Interpretation Committee meetings are also open to the public and webcast. In developing interpretations, the Interpretations Committee works closely with similar national committees and follows a transparent, thorough and open due process.

The IFRS Foundation and the IASB keep close links with of a network of national and other accounting standard-setting bodies as an integral part of the global standard-setting process. In addition to performing functions within their mandates, national and other accounting standard-setting bodies are encouraged to undertake research, provide guidance on the IASB’s priorities, encourage stakeholder input from their own jurisdiction into the IASB’s due process and identify emerging issues.

The IASB engages closely with stakeholders around the world, including investors, analysts, regulators, business leaders, industry associations, accounting standard-setters and the accountancy profession . In addition to the existing enhanced technical dialogue, the IASB meets these groups regularly, most often on a bilateral basis.

3. Maintaining Transparency, Public Accountability and Independence

In carrying out the IFRS Foundation’s mission as the standard-setting body, the IASB should develop financial reporting standards that provide a faithful presentation of an entity’s financial position and performance, as well as give information relevant to economic and resource allocation decisions for investors and other market participants. The confidence of all users of financial statements in the transparency and integrity of financial reporting is critically important to the effective functioning of capital markets, efficient capital allocation, global financial stability and sound economic growth.

Independence is a prized asset for the IFRS Foundation. The IFRS Foundation has financed IASB operations largely through voluntary contributions from a wide range of market participants from across the world’s capital markets, including from a number of firms in the accounting profession, companies, international organizations, central banks and governments. In June 2006, the IFRS Foundation Trustees agreed on four elements that should govern the establishment of a funding approach designed to enable the IFRS Foundation to remain a private-sector organization with the necessary resources to conduct its work in a timely fashion. Those four elements should be broad-based, compelling, open-ended and country-specific. The funding system should maintain the independence of the standard-setting process, while providing organizational accountability. The existing base of financing should be expanded to enable the IFRS Foundation to serve the global community better and to fulfill the strategy described above.

However independence comes with the requirement of public accountability. A form of public accountability was provided from the outset insofar as the binding character of IFRS depended on their validation by local authorities. Subsequently, following two formal reviews of the Constitution, the Trustees have enhanced their oversight function, increased the transparency of their operations and made a number of institutional reforms to expand representation. In 2009 a Monitoring Board was created and a Memorandum of Understanding linking it to the Trustees provided a formal public component to the governance structure for the first time. The creation of the Monitoring Board and the emergence of publicly sanctioned financing regimes for the IFRS Foundation anchored the organisation more formally with those responsible for serving the public interest.

Part III. IFRS Is Becoming More Global

The increasing acceptance and use of IFRS in major capital markets throughout the world over the past several years, and its anticipated use in other countries in the near future, indicate that IFRS will become the set of accounting standards that best provide a common platform on which companies can report and investors can compare financial information. According to Deloitte , at the moment, there are over 120 jurisdictions that permit or require IFRSs for domestic listed companies. The IASB has marked solid progress in reaching its goal to deliver a set of high quality globally acceptable accounting standards, but the goal is not a reality yet.

Different jurisdictions often have internal processes through which they incorporate IFRS into their national accounting standards. Decisions made during those processes may result in discrepancies from IFRS as issued by the IASB.

1. Approaches to Incorporating IFRS

In some jurisdictions, local accounting principles are applied for regular companies but listed or large companies must conform to IFRS, so statutory reporting is comparable internationally. Many jurisdictions that maintain their own local principles claim that their local standards are “based on” or “similar to” or “converged with” IFRSs. Sometimes, the local principles are not in English. Often, not all IFRS have been adopted locally. Often there is a time lag in adopting an IFRS as local Standards. Generally, jurisdictions have incorporated IFRS by the following ways:

• Full adoption approach, use of IFRS as issued by the IASB without a national incorporation process,
• Endorsement approach, IFRS incorporated into local accounting standards with a firm commitment to adopt fully IFRS as issued by the IASB,
• Convergence approach, converging local standards with IFRS without a firm commitment, or
• Hybrid of above.

The first category could be viewed as representing the purest form of incorporating IFRS. Under this approach, jurisdictions make no changes to the standards issued by the IASB, and the standards are applicable once issued without approval by any local body. While this approach, if adopted by all jurisdictions, would seem to result in the most consistent application of IFRS, it also results in a much greater degree of relegation of the local regulator’s authority and responsibility for investor protection to a global private sector and independent standard-setting body with a multinational constituent base. Understandably the IASB is firmly behind this approach and strongly support the need to maintain the long-term goal of full adoption of IFRS. However no major jurisdiction currently follows this approach.

The second category consists of economies (national or regional) that use IFRS after some form of a national incorporation process with a commitment of full future IFRS adoption. A good example is the European Union. The European Parliament in March 2002 passed the resolution with a wide margin requiring all firms listed on stock exchanges in the EU to apply IFRS by 2005. However, the EU endorsed all extant IFRS then except IAS 39. Instead of adopting IAS 39 as issued by the IASB, a carve-out version of IAS 39 was adopted, sometimes this practice is referred to as the IASB by the EU, and the practice caused much controversy. Endorsing IAS 39 with this carve-out would mean that IFRS as applied in Europe would differ from IFRS applied elsewhere in the world, thereby thwarting the goal of global convergence.

Convergence refers to the process of narrowing differences between IFRS and the accounting standards of countries that retain their own standards. Depending on local political and economic factors, these countries could require financial reporting to comply with their own standards without formally recognizing IFRS, they could explicitly prohibit reporting under IFRS, they could permit all companies to report under either IFRS or domestic standards, or they could require domestic companies to comply with domestic standards and permit only cross-listed foreign companies to comply with either. Convergence can offer advantages, whatever the reason for retaining domestic standards. It is a modified version of adoption.

Convergence by definition will not lead to a common set of global standards. Convergence may narrow differences, but will not produce identical results because each set of standards has a different starting point and convergence will not address all of the details. Having once converged, standards could well diverge again. Furthermore, in a world of standards that have converged, issues of mutual recognition are raised. Countries will seek acceptance of their ‘equivalent’ but different standards for access to capital markets. The benefits of IFRS adoption, particularly in relation to comparability for investors, are partially lost in favoring convergence rather than adoption. Therefore the IASB changed its previous position and now states that convergence is not an objective in itself but is a means to achieve the adoption of IFRS .

2. Critical Success Factors and Challenge Ahead

Nowadays, more firms seeking to be listed in an offshore exchange will choose to prepare their financial statements in line with the IFRS. The IFRS has replaced the US GAAP as the prevalent international accounting standards for cross-border listing and capital-raising. It is expected that more companies will be likely to follow suit. All those changes take place with the past 10 years.

Much of the success of IFRSs to date is a result of following factors:

• The IASB’s strength as an organisation and the quality of IFRSs;
• IOSCO recognition and decision to recommend IFRS for cross-border listing;
• The European Union’s decision to elect the IASB as its standard-setting body, which served as a catalyst for the adoption of IFRSs elsewhere internationally; and
• The willingness of the United States to engage in convergence, accept IFRSs for non-US companies and consider possible adoption for US companies.

In 1973, the IASC (the predecessor body to the IASB) was established by the AICPA and its counterparts in 8 other countries. Its mission was to formulate and publish, in the public interest, basic standards to be observed in the presentation of audited accounts and financial statements and to promote their worldwide acceptance. Prior to the inception of the 21st century, this effort didn’t bear much fruit. Until 2002, only a few economies decided to use IASC standards. Many of those lacked their own standard-setting infrastructure.

On July 11th 1995, the IASC and the IOSCO agreed on what constitutes a comprehensive set of core standards, and upon successful completion, the IOSCO agreed that if it found those core standards acceptable, it would recommend endorsement of IASC standards for cross-border capital and listing purposes in all capital markets. The IASC undertook a project to complete those core standards by 1999.

In May 2000, the IOSCO President’s Committee passed a resolution on the IASC standards, stating: “…the IASC’s work to date has succeeded in effecting significant improvements in the quality of the IASC standards. Accordingly, the Presidents’ Committee recommends that IOSCO members permit incoming multinational issuers to use the 30 IASC 2000 standards to prepare their financial statements for cross-border offerings and listings, as supplemented in the manner described below where necessary to address outstanding substantive issues at a national or regional level…”. The endorsement from the IOSCO greatly facilitated wide international use of IFRS.

The European Union soon became the catalyst for IFRS adoption worldwide, making IFRSs an alternative to US GAAP for international capital-raising. In 2002 the European Union decided to adopt IFRSs for its publicly traded companies as part of the effort to create a common European capital market. Due to the well-publicized “carve-outs” it legislated, however, this did not result in full IFRS adoption. Apart from a limited waiver granted by the SEC, this means that foreign private issuers using “EU-endorsed IFRS” will not be granted exemption from the SEC’s reconciliation requirements, a fact that may cause the European Union to reconsider the wisdom of the carve-out strategy. Since 2005, the European decision has spurred the advancement of IFRSs across Asia-Oceania, Africa and the Americas.

After the Enron scandal, the US reconsidered its stance on adopting the IFRS and began to take concrete measure to promote adoption process. Beginning with the 2002 Norwalk agreement, an intensive and joint convergence programme has been a dominant feature of the US Financial Accounting Standards Board (FASB) and the IASB’s agenda. Importantly, the convergence process has led to improvements of the inherited standards, reduced differences with US GAAP, and the removal of the reconciliation requirement by the SEC. At the same time, the United States has yet to make a final decision on adopting IFRSs. A recent SEC staff work plan indicates that the SEC expects to make a determination in 2011 on the use of IFRSs. This determination will have an impact on the consideration of IFRSs by other major economies (e.g. China, India and Japan) and the growing number of emerging markets that are implementing IFRSs as their chosen accounting standards.

While these factors have spurred the organization’s success, a number of challenges remain for the organisation:

• Convergence and adoption: In an effort to facilitate adoption of its standards, the IASB has devoted considerable energy to convergence. But convergence alone will not produce a single set of global standards. A number of countries still need to make decisions to adopt IFRSs for domestic use.

• Quality and implementation of the standards: Two tensions have arisen in this area. First, the IASB must continue to demonstrate the quality and relevance of its standards to ensure global acceptance, including a need to reflect the lessons learned from the financial crisis. Second, even as the standards are adopted universally, there is a risk that practices related to implementation and adoption will diverge.

• Governance and accountability: As adoption of IFRSs has extended to more and more countries, public authorities around the world have paid increasing attention to the accountability and governance of the institution. While the IASB’s independence has been a source of strength, it is widely understood that those arrangements may need to evolve further, in order to enhance the IFRS Foundation’s public accountability.

3. Case Study of Chinese Accounting Convergence

One example of a country using the convergence approach is the China, which is moving its standards closer to IFRS without incorporating IFRS fully into its national financial reporting framework.

Since its economic reform programme, China has sought to transition its accounting system from one based on the needs of a planned economy towards international accounting standards based on market economic principles. The new Chinese Accounting Standards for Business Enterprises (CAS) were published by the Ministry of Finance (MoF) in 2006 and became effective on January 1, 2007. These standards are substantially converged with IFRSs, except for certain modifications (e.g. disallow the reversal of impairment loss on long term assets) which reflect China’s unique circumstances and environment.

In April 2010, the MoF released the roadmap for continuing convergence of CAS with IFRSs. China has made a commitment to convergence with IFRSs. Standard convergence is an ongoing process and the MoF is continuing to spend significant effort on the ongoing convergence between CASs and IFRSs.

The CASs are now mandatory for entities including PRC-listed companies, financial institutions (including entities engaging in securities business permitted by China Securities Regulatory Commission), certain state-owned enterprises, private companies in certain provinces. In the roadmap, the MoF has indicated its intention to have all large and medium-sized enterprises (regardless whether they are listed companies or private companies) adopt the new CAS by 2012.

The CAS has won equivalent recognition from other jurisdictions. In December 2007, the HKICPA recognized CAS equivalence to HKFRS, which are identical to IFRSs, including all recognition and measurement options, but have in some cases different effective dates and transition requirements. From then the CASC and HKICPA together with IASB created an ongoing mechanism to reinforce continuously such equivalence. In December 2010, the Hong Kong Stock Exchange decided to allow mainland-incorporated companies listed in Hong Kong to have an option to present financial statements using CASs and audited by an approved mainland audit firm. A number of such companies have chosen to present financial statements using CASs for annual reporting. The EU Commission permits Chinese issuers to use CAS when they enter the EU market without adjusting financial statement in accordance with IFRS endorsed by EU.

In September 2009, the World Bank released an assessment report of “Report on the observance of Standard and code (ROSC)- accounting and auditing: People’s Republic of China”. According to this report , the CAS and IFRS are basically comparable. The memorandum signed between CASC and IASB in 2005 identified two major differences between the two sets of standards. These are (a) reversal of impairment losses and (b) disclosure of related party relationships and transactions. In January 2008, CASC and IASB established a continuing convergence mechanism. Meetings between the two parties in April and October 2009 helped to identify and eliminate some differences between CAS and IFRS. In August 2009, the IASB decided to exempt from the disclosure requirements for transactions between a government-controlled reporting entity and that government or other entities controlled by that government. This exemption would ensure CAS convergence with IFRS in respect of related party relationships and transactions.

In July 2011, the new chairman of IASB, Mr. Hans Hoogervost paid a brief visit to Beijing and exchanged view with the MOF. He acknowledged that China has made tremendous progress by building an accounting profession and setting in place a process of continuous convergence with IFRS, and he also admitted that for companies with dual listings in Shanghai (using Chinese GAAP) and Hong Kong (using IFRSs) the average difference in reported profit is 0.6%, thee difference in term of net assets is even as smaller as around 0.2%. In his view, this closeness is not from perfect. The term “principally in line with IFRS” does China no favors. There is a lingering suspicion among the broader international financial reporting community about closeness between IFRSs and Chinese accounting standards. He suggested that Chinese should move a step forward for a full adoption of the IFRS.

4. Convergence between IRFS and US GAAP

In October 2002, the FASB and the IASB announced the issuance of a memorandum of understanding, called the Norwalk Agreement. The two bodies acknowledged their joint commitment to the development, “as soon as practicable,” of high-quality, compatible accounting standards that could be used for both domestic and cross-border financial reporting. At that time, the FASB and the IASB pledged to use their best efforts to make their existing financial reporting standards fully compatible as soon as is practicable and to co-ordinate their future work programs to ensure that once achieved, compatibility is maintained.

In a 2006 Memorandum of Understanding, the FASB and the IASB indicated that a common set of high-quality global standards remains the long-term strategic priority of both the FASB and the IASB. As part of this commitment, the IASB and the FASB set out a work plan covering several projects and coordinated agendas so that major projects that one board takes up may also be taken up by the other board. That plan covered specific long- and short-term projects for work into 2008.

In November 2007, the Trustees of the IASC Foundation reiterated their support for continuing the work program described in these memoranda, noting that future work is largely focused on areas in which the objective is to develop new world-class international standards. The FASB and the IASB have updated the timetable for their joint work under the 2006 Memorandum of Understanding. The next phase of the joint work plan goes through 2011.

The full adoption of the IFRS will face strong political pressures. Some people have objected that the incorporation of IFRS for U.S. issuers means the United States would cede its sovereignty to the IASB. Any incorporation approach will not affect the SEC’s responsibility to protect investors, maintain fair orderly and efficient markets, and facilitate capital formation through its regulation, and it will not alter the SEC’s ultimate authority under the federal securities laws to prescribe accounting principles and standards to be followed by U.S. issuers and other entities that provide financial information to the SEC and investors. The SEC will always be the decision-maker over financial reporting standards in the United States.

Most significantly, the FASB would participate in the process for developing IFRS, rather than serving as the principal body responsible for developing new accounting standards or modifying existing standards under U.S. GAAP. The FASB would play an instrumental role in global standard setting by providing input and support to the IASB in developing and promoting high-quality, globally accepted standards; by advancing the consideration of U.S. perspectives in those standards; and by incorporating those standards, by way of an endorsement process, into U.S. GAAP. Additionally, the FASB would become an educational resource for U.S. constituents to facilitate the understanding and proper application of IFRS and promote ongoing improvement in the quality of financial reporting in the United States.

The FASB would continue to promulgate U.S. GAAP primarily through its endorsement of standards promulgated by the IASB. Under the framework, due to the FASB’s participation in the IASB’s standard setting process, the FASB should be in a position to readily endorse (i.e., incorporate directly into U.S. GAAP) the vast majority of the IASB’s modifications to IFRS. However, the FASB would retain the authority to modify or add to the requirements of the IFRSs incorporated into U.S. GAAP, similar to other jurisdictions, and such U.S.-specific modifications would be subject to an established incorporation protocol. Such a protocol could entail the FASB determining whether the IASB’s modification to IFRS (either by means of issuance of a new standard or amendment of an existing standard) met a pre-established threshold—for example, a threshold that incorporates the consideration of the public interest and the protection of investors.

Part IV. Outstanding IFRS Issues

As an organisation that serves the public interest and promotes economic progress, the IASB must deliver its main output, financial reporting standards, with the highest quality. They must be developed following a robust process that takes into consideration the requirements of those who use them, and must be recognised, understood and accepted internationally. However, many standards are not free of controversies. For example, netting/offsetting is a big issue that still results in the largest balance sheet difference between IFRS and US GAAP banks. The IASB and FASB tried to converge on this topic earlier in recent years but are unable to reach a joint conclusion. The following is just a few examples open for debate.

1. Insurance Contracts

Insurance contracts often expose entities to long term and uncertain obligations. However, current insurance accounting does not provide investors, analysts and others with the information they need to understand an insurer’s financial position and performance and to make meaningful comparisons between insurers. Many users describe insurance accounting today as a ‘black box’, especially in life insurance.

In July 2010 the IASB published an exposure draft (ED) containing proposals on the recognition, measurement, presentation and disclosure of insurance contracts. The exposure draft is part of the IASB’s project on insurance contracts, which intends to replace IFRS 4 Insurance Contracts issued in 2004.

Although IFRS 4 addressed some of the more urgent issues in insurance contract accounting, it was only a temporary solution. It permits a wide variety of existing accounting practices to continue, hindering comparability for users. In 2004 the IASB established a working group of senior financial executives to help it analyze accounting issues related to insurance contracts. Users find it difficult to understand insurers’ financial statements. Accounting methods are complex and vary by product and country.

Proposed change includes:
 The measurement model focuses on the key drivers of insurance contract profitability, and would provide users with a clearer insight than they gain from today’s patchwork of different models for different types of contract.
 The same model would apply to all insurance contracts.
 A modified version would apply to most short duration insurance contracts.
 Insurers would present information in the financial statements that focuses on the drivers of performance, i.e.:
o release from risk, as the risk adjustment decreases
o what insurers expect to earn from providing insurance services
o investment returns on invested premiums, and the investment returns provided to policyholders (either implicitly through pricing or explicitly)
o differences between expected and actual cash flows and
o changes in estimates and the discount rate.
 This information would be supplemented by disclosures of important headline indicators, such as premiums, claims and expenses.

The exposure draft has been developed following a rigorous and comprehensive due process.
The exposure draft builds on proposals contained in the IASB’s discussion paper. The proposed standard would apply to all insurance contracts (i.e. both life and non-life) that meet the existing definition in IFRS 4, which is based on the transfer of significant insurance risk. The proposals would improve financial reporting by providing more understandable and relevant information for users as well as eliminating accounting mismatches.

The exposure draft proposes to replace IFRS 4 with a high quality standard that better meets the needs of users. Building on the proposals in the discussion paper that arise today because assets reflect current market rates, while liabilities often reflect ‘locked-in’ rates

In addition, the ED proposes a modified measurement approach for short duration contracts. The modified model combines the advantages of the proposed model with the benefits of existing practice. A principle-based standard reflects the economics of insurance contracts. The exposure draft proposes:

 a measurement model that focuses on the drivers of insurance contract profitability and uses current estimates of cash flows
 presentation of information about insurance contracts that reflects changes in those drivers
 consistent accounting for embedded options and guarantees in insurance contracts
 consistency with market prices for financial market inputs, such as interest rates
 a coherent framework for dealing with more complex insurance contracts, including those that might be developed in the future.

2. Fair Value Accounting to Financial Instruments

The past financial crisis has reinvigorated a debate on the effectiveness of the existing accounting and regulatory frameworks for banks. In particular, the focal point of the debate centers around the pros and cons of fair value accounting, where fair value is meant to value amount for which an asset could be exchanged, or a liability settled, between knowledgeable willing parties in an arm’s length transaction, other than in a liquidation. IAS 39 Financial Instruments: Recognition and Measurement is the clear target for banks, and many people argued for the standard’ suspension during the crisis.

Accounting standards stipulate that as a guiding principle, the quoted market price in an active market should be used as the basis for the measurement of the fair value of an asset. The problem is that such a price is not always available, for example, in illiquid markets. In such cases, fair values need to be estimated based on available information. A related concern is the potential procyclical nature of fair value accounting, which could magnify fluctuations in bank lending and economic activity. A broader concern is that the current “mixed attribute” model of accounting, in which some financial instruments are measured at historical cost and some at fair value, together with discretion over how financial instruments are measured, gives rise to accounting arbitrage.

Despite difficulties of determining fair values in illiquid markets, advocates of fair value accounting maintain that fair value is the most relevant measure for financial instruments. They argue that financial assets, even complex instruments, tend to trade continuously in markets and it should therefore be possible to use information embedded in market prices to compute fair values of financial assets.

Some large US securities firms (mainly broker dealers, which manages their portfolio on fair-value basis) is supportive to that fair value accounting. This view is based on the belief that fair valuation is significantly more relevant than historical cost for financial instruments and is sufficiently reliable if appropriate policies, governance, controls and disclosure are in place. Further and importantly, fair value has been standard practice among US securities firms for many years, without adverse consequences, and those firms believe that its use has encouraged a disciplined approach to risk management that, if more broadly applied, could engender greater market discipline and greater financial stability.

However some bankers disagree. They still maintain a tradition commercial banking model, focused on lending and depositing services. They claim that most of their assets are currently not impaired, that they intend to hold them to maturity anyway, and that market prices reflect distressed sales into an illiquid market. On top of that, some financial instruments, particularly the book of loans carried by banks (especially loans to consumers and small businesses) are not suited to fair valuation and the traditional approach, historical cost less provision for incurred impairment, should be maintained. In their views, the relevance of historical cost valuations to the lend-and-hold-to-maturity philosophy still holds that has characterized bank lending for decades.

The Basel Committee and the US Federal Reserve Board have cautioned against a move to comprehensive fair valuation without resolving significant implementation issues or providing rigorous guidance on valuation of such financial instruments. They are concerned about the practical difficulty of valuing loans or some other financial instruments when most do not have readily observable prices.

3. Impairment

IFRS and US GAAP provide similar guidance related to the recognition of impairment losses on originated loans and receivables. For other financial assets, the timing of impairment loss recognition and the measurement of that loss may differ under the two sets of standards.

Under IAS 39 “Financial Instruments: Recognition and Measurement”, a financial asset is deemed impaired, requiring recognition of an impairment loss, if its carrying amount is greater than its estimated recoverable amount, and evidence must be evaluated at each balance sheet date to determine whether financial assets are impaired. In contrast, for investment securities classified as HTM or AFS under US GAAP, an impairment exists when fair value has declined below amortized cost basis, but an impairment is only recognized when it is deemed to be “other than temporary.” For example, an other-than-temporary impairment shall be considered to have occurred if it is probable that the investor will be unable to collect all amounts due according to the contractual terms of a debt security not impaired at acquisition. The differing standards for recognition of an impairment loss for investment securities under IAS and US GAAP could cause differences in the timing of recognition of an impairment loss.

In terms of measurement, IAS and US GAAP differ a bit. IFRS requires that an impairment of an HTM investment be measured based upon the difference between the asset’s carrying amount and the present value of expected future cash flows, discounted at the instrument’s original effective interest rate. Under US GAAP, an impairment of a security (including an HTM security) is measured based on the difference between the security’s amortized cost basis and its fair value, where a fair value calculation would be based on current market interest rates, as opposed to the security’s original effective interest rate.

4. Derivatives and Hedging

Derivatives are financial instruments that derive their cash flows, and hence their value, by incorporating in their terms references to other financial instruments or financial or non-financial indexes (e.g., spot oil prices). Accounting for derivatives is among the most difficult areas in financial reporting.

When a contract is a derivative, it must be recorded on the balance sheet as an asset or a liability at its current fair value. Changes in fair value are recorded in income unless the derivative is designated and effective as a hedge in cash flow hedge strategies. In these instances changes in the value of the derivative are excluded from income until the hedged transaction occurs or affects income. The objective of hedge accounting can be summarized as neutralizing the impact on income, to the extent that the hedge is effective, of the consequences of the hedged risk.

Derivatives in a hedging relationship are used to offset the risk profile of designated assets, liabilities, firm commitments or probable forecasted, although not committed, transactions. The common risks in financial instruments are interest rate, credit, market and foreign currency. The accounting standards are largely designed to closely link the derivative to the position being hedged (via specific documentation requirements) and to ensure that the derivative is expected to be, and has achieved, high effectiveness in altering the risk profile of the hedged item. Note that neither IAS nor US GAAP requires that a derivative reduce the hedger’s exposure to the risk, only that it effectively offset changes in the fair value or cash flows of the hedged item. It is possible that a hedger would utilize derivatives to alter risk profiles but not to account for the derivative as a hedge either because (1) the derivative was not sufficiently effective in altering the risk profile or (2) the hedger did not document the derivative as a hedge.

There are a number of differences in the detailed rules on hedge accounting between IAS and US GAAP, which may increase as a result of the IASB’s recent tentative decisions in its IAS 32 and IAS 39 improvements project. These differences can result in hedge accounting being achieved under one regime but denied under the other. In the new IFRS 9 that replaces IAS 39, there is no bifurcation of embedded derivatives for financial assets. For liabilities the treatment is similar to current IAS 39.


On Nov 4th 2011, the leaders of G20 convened in Cannes France, and in the Cannes Summit Final Declaration, there are the following observations in relation to accounting standards:

“…We reaffirm our objective to achieve a single set of high quality global accounting standards and meet the objectives set at the London summit in April 2009, notably as regards the improvement of standards for the valuation of financial instruments. We call on the IASB and the FASB to complete their convergence project and look forward to a progress report at the Finance Ministers and Central Bank governors meeting in April 2012. We look forward to the completion of proposals to reform the IASB governance framework…..”

It is not easy to have genuine cross-border comparability of financial statements. It is not an easy task that IASB or IFRS Foundation is trying to promote global accounting standards. With the strong commitment from G20 for a single set of global financial reporting standards, the IASB should seek the momentum to push forward and complete the remaining convergence projects with the US standard-setter to the highest possible standard, and to do so in a way that benefits from the input that we receive from the entire global financial reporting community. These remaining convergence projects address some of the most difficult and important areas of financial reporting. Without any coherent global representation of investors, the dream could never come true. This challenge could be ameliorated through further structure within IFRS Foundation and better cooperating efforts with national policy bodies as well as international entities.

However, we do believe that with the future efforts from the IASB, FASB and support from world investment community, the goal of achieving a single set of high-quality globally accepted international financial reporting standard will be within reach for a foreseeable future; however the path will not be easy or short.


4. G20: Cannes Summit Final Declaration, Nov 4, 2011
5. Hans Hoogervost, new IASB Chairman speech in Beijing, July 2011,…32B5…/HansHoogervorstBeijingJuly2011.pdf
6. Basel Committee on Banking Supervision: “Supervisory guidance for assessing banks’ financial instrument fair value practices”, April 2009
7. Harry Huizinga and Luc Laeven, “Accounting discretion of banks during a financial crisis”, IMF Working Paper, WP/09/207, September 2009
8. SEC Commissioner Kathleen L. Casey, “Keynote Address at the Society of Corporate Secretaries and Governance Professionals 65th Annual Conference”, June 29, 2011
9. US SEC Staff Paper, “Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for U.S. Issuers: Exploring a Possible Method of Incorporation”, May 26, 2011
10. US SEC, “Work Plan for the Consideration of Incorporating International Financial Reporting Standards into the Financial Reporting System for US Issuers Progress Report”, division of corporation finance, office of the chief accountant, October 29, 2010
11. US SEC: “Roadmap for the potential use of financial statements prepared in accordance with international financial reporting standards by US issuers”, Release Nos. 33-8982; 34-58960; File No. S7-27-08, 2008
12. World Bank: “Report on the Observance of Standards and Codes (ROSC)- Accounting and Auditing: People’s Republic of China”, October 2009
13. IFRS Foundation: “Report of the Trustees’ Strategy Review IFRSs as the Global Standard: Setting a Strategy for the Foundation’s Second Decade”, April 2011
14. IFRS Monitor Board: “Consultative Report on the Review of the IFRS Foundation’s Governance”, February 7, 2011
15. IOSCO: “A Resolution on IASC Standards Passed by the Presidents’ Committee”, May 2000
16. Group of 30, “Enhancing Public Confidence in Financial Reporting”, 2003
17. Nicolas Véron, “Suggestions for Reforming the Governance of Global Accounting Standards”, Bruegel Policy Contribution, issue2011/04, May 2011

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Recent Developments of Asian Bonds

Recent Developments of Asian Bonds
By Wilbert OUYANG, August 12th 2011

The Need for a Balanced Asia Financial Market after 1997 crisis
The idea to develop a deep and liquid Asia Bond market gained prominence after the l997 Southeast Asian financial crisis. Analysts generally agreed that the local business was too dependent on indirect financing of banking credit. The “double mismatch” problem, namely currency and maturity risk, was one important factor behind the crisis.
Even though one basic function of banks is maturity transformation, the maturity management remains one big headache for bankers. Ideally, commercial banks should primarily be making short-term loans, as their liabilities are largely demandable short-term deposits (especially true for Asian banks). Banks are not well suited to finance long-term investments on a large scale, although maturity mismatches could be ameliorated by artful asset-liability management and prudential regulation. The maturity mismatch makes banks more vulnerable to crisis, which often tend to be systemic. The 1997 Asia crisis is a good illustration. By then, Asian corporates borrowed heavily short-term funds from commercial banks in foreign currency for long-term domestic investments. When the crisis knocked, these corporate borrowers were unable to borrow fresh capital for their outstanding investments. As default cases increased, the investors were panic to get their money out, naturally local currencies depreciated and the credit quickly dried up. So the corporate sector went busted.
Those countries including Thailand, Indonesia and Malaysia were hit the hardest, which generally lacked well-developed capital markets, and their corporate external financing were mainly bank loans. Therefore financial risk was concentrated in the banking system. The double mismatch risk could be reduced if more corporate borrowers financed their needs through well-diversified portfolios, particularly through bonds. This called for the development of sound and sustainable bond markets in Asia. The corporate sector can borrow for longer maturity periods in local currency, which matches their investment needs and thus enables them to avoid balance sheet mismatches. This also reduces the currency mismatch, another source of vulnerability of a financial system. Therefore, there was a growing consensus in Asia after 1997 crisis to build greater balance in the financial sector through the development of robust local bond markets.

Additional Impetus for Asian Bond Market
The global financial crisis further stressed the importance of developing a full-fledged local bond market to provide funding. Investor uncertainty caused capital outflow from most Asian economies. As the crisis deepened, foreign banks found it necessary to withdraw investments from Asia, thus Asian corporates was facing severe constraints in securing foreign and local currency financing.
Furthermore, Asia needs to mobilize a large amount of capital to finance its huge infrastructure need. The financing need for Asia’s infrastructure was estimated at around US$750 billion per year during 2010–2020. Infrastructure projects are usually long-term in nature. The funding thirsty used to be satisfied through credits through private loans as well as foreign governments and international institutions such as World Bank and Asia Development Bank. With the further development of Asian economies, there could be others financing resources. In 2009, the total annual savings of the 11 major Asian economies was approximately US$3,390 billion, while the stock of total foreign exchange reserves reached US$4,686 billion . At present, a large portion of these savings is invested in markets of developed economies at a low return. Given this huge requirement, one solution could be Asia’s large savings and international reserves. This huge financial resource can be channeled towards long-term infrastructure projects and other productive investments through bond markets.
Strengthening, integrating, and deepening local bond markets, particularly in local currencies, can play a significant role in mobilizing the required funds for enhancing regional demand. Output correlation among Asian economies, for example, has turned from being negative in the early 1990s to average 0.5–0.75 since 1997 (which is now comparable to that of European Union economies). Those investments will not only stimulate domestic economies but also enhance regional connectivity and integration, thereby rebalancing Asia’s growth away from high dependence on exports to advanced economies, such as the United States and the European Union.
Both the crisis experience and the new reality require the development of local currency bond markets in Asia. Asian bond markets can provide alternative sources of financing for public and private investment and alternative modes of wealth holdings for Asian households. This is very important for Asian economies which are gravely in need of both viable funding schemes for infrastructure and capital investment and attractive options for retirement financial arrangements and pensions in a rapidly ageing society.
Besides, Asian bond markets can make the local financial system more resilient. Rather than relying solely on international capital markets, Asian bond markets can facilitate direct mobilization of Asian savings for Asian long-term investment in local currencies. Asian bond market development can reduce currency and maturity mismatches. With the development of local bond markets, the healthy competition between banking sector and bond market will achieve greater diversification of financial risks and make the whole system more sustainable.
Finally, mobilization of Asian savings for Asian investment can contribute to the reduction of global payments imbalances. Well-developed, liquid, transparent local currency bond markets can help mitigate the “information asymmetry” that exists between investors and borrowers by identifying bankable projects and right investment opportunities in the region for potential investors. This would require the creation of a more robust financial system that facilitates information transparency, price efficiency, and legal certainty.

What is Asia Bond?
The term bond in this note refers to bonds and notes with a maturity greater than one year. Bond markets can be classified according to maturity, interest payment schedule, types of issuers, or other details. For instance, the Bank for International Settlements (BIS) categorizes bonds by residence of issuer, targeted investors and currency of denomination by (cf. Table 1).
Table 1: Classification of BIS Securities Statistics
Currency Targets Issuers
Residents Non-residents
Domestic currency Resident investors Domestic Foreign
Non-resident investors Offshore Offshore
Foreign currency Any investor International International

Domestic bonds cover issues by residents targeted at resident investors denominated in domestic currency. Issues by non-residents targeted at resident investors and denominated in domestic currency are part of the foreign bond markets, which go by various colorful names (Yankee for United States, Samurai for Japan, Bulldog for the United Kingdom, Panda for China and Kangaroo for Australia). Offshore (or “euro” in the old sense) markets involve targeting investors with bonds not denominated in their domestic currency. The combined foreign bonds and offshore bonds could be grouped under the title of International bonds.
We will define Asian bonds by residence of issuer. They are interest bearing obligations of Asian governments, financial institutions or corporations, wherever marketed and in whatever currency of denomination. In this connect, Asia bond is determined by the value of Asian currencies and issued and traded in the Asian region’s debts markets. Most of the supply side of Asia bond from Asian economies, and its demand side from the Asian economies as well as global investors. Asia bond market refers to the Asia bond issuance, trading and distribution market. As a regional bond market for some time, the Asia bond market has increasingly become one of the ideal platforms for Asian economies, especially East Asian economies to strengthen regional financial cooperation.

Initiatives for Developing Asian Bond Markets
Ever since the 1997 financial crisis, Asian economies have taken various initiatives for developing bond markets in Asia. The major regional initiatives are highlighted below.
I. Asia Bond Market Initiative (ABMI)
In June 2002, Thailand proposed the conception of the Asian Cooperation Dialogue (ACD), a mechanisms to focus on regional economic cooperation. In June 2003 the second ACD Foreign Ministers’ informal meeting adopted Chiang Mai Initiative, the initiative to develop the Asia bond market, including joint issuance of bonds by Asian countries, measures to promote bonds dominated by national currencies or a basket of Asian currencies, establishment of regional credit guarantee mechanisms, and setting up foreign exchange reserves of Asian countries dedicated to investing in Asia bonds and other recommendations.
Under this mechanism, Thai Government is encouraging all ACD members to issue local currency-denominated Asia Bond to promote the Asia bond market development. In 2004, Thailand’s Ministry of Finance issued in batches some 30 billion U.S. dollars of Baht-denominated sovereign debts, and urged transnational corporations and international agencies to issue Thai Baht-denominated bonds through tax concessions and other preferential treatment to expand the Asia bond circulation. China has been the Asia bond Market Development Initiative active advocate. In 2005, China allowed eligible international development organizations to issue RMB Bonds (Panda bonds) in domestic market.
II. The Development of Asset Securitization and Credit Guarantee Markets Initiative
The initiative was raised by Hong Kong, China in September 2002. It aims to enhance the development of the regional asset securitization and credit guarantee markets through the establishment of expert groups to carry out policy dialogue and discussions and other activities. South Korea, Thailand and the World Bank have joined as co-leaders.
Under the initiative, three working groups have been established in China, Thailand and Mexico, and two policy dialogue seminars have been held. There were six field research investigations to the three participating countries. Suggestions for improvement of the development of asset securitization and credit guarantee mechanism has been forward to the relevant countries for, and related research was submitted in September 2004 to Asia-Pacific Economic Cooperation (APEC) Finance Ministers’ Meeting in Chile.
III. Asia Bond Fund (ABF)
The Executives’ Meeting of East Asia-Pacific Central Bank (EMEAP) is a regional international financial organization with 11 members (including China, Hong Kong, Indonesia, the Republic of Korea, Malaysia, Philippines, Singapore, Thailand, Australia, Japan and New Zealand). With the objective of facilitating bond issuance, EMEAP is working to stimulate from the demand side of this market mainly through the establishment of Asia Bond Fund.
In June 2, 2003, EMEAP announced the establishment of the Asia Bond Fun-1 (ABF-1) with the total amount of l billion USD under the management the Bank for International Settlements (BIS) and the proceeds was now fully invested in investment-grade US dollar-denominated bonds issued by sovereign and quasi-sovereign issuers in EMEAP economies.
Starting from April 2004, EMEAP worked to launch the Asia bond Fund-2 (ABF-2) to be invested in local currency denominated bonds in the Asian region. In December 16, 2004, EMEAP announced the launch of Asia Bond Fund II. ABF-2 was mainly funded by reserves from member states and its size was about 2 billion U.S. dollars, including two parallel funds, namely the Pan-Asian Bond Index Fund and the Fund of Bond Funds. Pan-Asian Bond Index fund was a single bond fund index investing in local currency bonds issued in eight Asian economies, while the Fund of Bond funds was a parent fund investing in eight sub-funds.
Compared with ABFl, ABF2 made significant progress, its sized increased from one billion US dollars to 2 billion US dollars; investment targets expanded from in US dollar-denominated sovereign and quasi-sovereign bond issuers in eight economies to local currency bonds issued by sovereign and quasi-sovereign issuers; the principle of opening to the private sector has been confirmed.
The establishment of a unified bond funds can gradually boost the reputation of the Asia bond market as well as the investment attractiveness of the entire region. This process of continuous improvement in national bond markets along with enhancing participations of regional member states, can promote the formation of an effective credit system in Asia.
IV. The Asia Bond Market Development Initiative (ABMI)
Since 2003, ASEAN, China, Japan and the Republic of Korea (10+3) member states decided to integrate those initiatives and put forward a unified “to promote the Asia bond Market Development Initiative” (ABMI), which will cover the above-mentioned initiatives. ABMI aims to develop efficient and liquid local currency denominated bonds markets in Asia as well as to enable better utilization of Asian savings for Asian investments. It would also contribute to the mitigation of currency and maturity mismatches in financing. Activities of ABMI focus on the following two areas:
1. Facilitating access to the market through a wider variety of issues;
2. Enhancing market infrastructure to foster bond markets in Asia
In August 2003 in Manila, the sixth “10+ 3″ meeting of finance ministers formally decided, under ABMI, to establish six working groups from different areas to promote the Asia bond market development. The six initially created working groups later reorganized these into 4 working groups and 2 support teams. Currently the 4 working groups are focusing on:
• Issuance of new securitized debt instruments;
• Establishment of a regional credit guarantee agency;
• Exploration of possible establishment of a regional settlement and clearance system;
• Strengthening of regional rating agencies.
Under the wave of the economic globalization, it remain a topic of common concern for Asian economies to maintain the region’s financial stability and economic security, which also lays a solid foundation for the development of Asia bond markets. From an economic point of view, Asian economies have been forging an ever closer economic entity, which has laid a good foundation for the Asia bond market development. At present, many Asian economies have made substantial progress in the Asia bond market development. From the second half of 2004, Malaysia, Thailand and other countries have allowed issuance and transactions of cross-border bonds in the domestic markets. Thus, the Asia bond market has good prospects for development.

Current Status of Asian Bonds Markets
As shown in table 2, the developing Asian financial market also remains financially underdeveloped relative to the advanced economies . The figure compares financial development, as measured by total liquid liabilities, bank credit, stock market capitalization, and bond market capitalization—of some major developing Asian countries with that of high-income OECD countries. In particular, the region’s bond markets are the least developed. However, the situation is under significant improvement with exponential volume increase in local bond market (cf. table 3). During the period from 1997 to 2010, the total volume of local bond market has risen from US$405.31 billion to US$5210 billion, an increase of 12 folds. The size of government bond market has been grown even faster, up 2,256%. By end of 2010, the Asian bond market was dominated by Government debts, comprising 68.91%. The fast expanse of Asian bond market stems from official measures to develop local currency bond markets, including regional efforts such as the ABMI and the Asian Bond Funds.
Table 2: Financial depth, selected Asian and OECD countries, 2008
(% of GDP)
Economy Overall financial markets and banks Capital markets
Liquid liabilities bank credit Stock market Bond market
China 150.0 104.2 80.6 48.7
Bangladesh 57.5 35.9 11.1
India 73.2 47.8 173.2 34.3
Indonesia 38.0 22.8 55.3 19.9
Pakistan 46.9 27.5 45.1 26.9
Philippines 53.2 22.1 76.3 32.3
Thailand 91.5 78.1 73.3 56.7
OECD 113.3 127.8 119.2 108.1

East Asia’s capital controls and regulations have been relaxed gradually but they remain a major obstacle impeding capital movement within the region. Capital controls and regulations create distortions in international capital flows. They often take the form of restrictions on foreign financial institutions entering the domestic financial market or a cap on foreign equity ownership in domestic financial institutions. Such restrictions have long since been removed in more mature economies such as Japan, Korea, Hong Kong and Singapore, but many East Asian countries still control capital flows in many ways.
Table 3: Size and Composition of Local Bond Markets in Asia
Unit: USD billion
1997 2004 2005 2006 2007 2008 2009 2010
China 116.40 527.70 899.24 1,184.12 1,689.83 2,213.00 2,567.00 3,052.00
Government 67.40 331.80 835.18 1,078.57 1,533.12 1,957.00 2,113.00 2,408.00
Corporate 49.00 195.90 64.07 105.55 156.71 256.00 454.00 644.00
Hong Kong 45.78 78.24 85.59 96.19 97.98 88.00 144.00 164.00
Government 13.12 15.78 16.34 16.94 17.52 20.00 70.00 87.00
Corporate 32.66 62.46 69.25 79.25 80.46 68.00 74.00 77.00
Indonesia 4.60 57.70 54.15 76.72 87.55 68.00 99.00 106.00
Government 0.90 50.80 48.27 69.88 79.14 61.00 89.00 94.00
Corporate 3.70 6.90 5.88 6.84 8.41 6.00 9.00 13.00
South Korea 130.37 567.70 983.53 1,192.72 1,313.81 817.00 1,016.00 1,149.00
Government 21.60 170.50 583.07 702.88 722.11 368.00 444.00 492.00
Corporate 108.77 397.20 400.45 489.84 591.69 448.00 572.00 657.00
Malaysia 57.00 110.70 106.70 121.38 164.16 163.00 185.00 247.00
Government 19.40 47.30 52.25 61.00 88.61 89.00 101.00 145.00
Corporate 37.60 63.40 54.45 60.37 75.55 74.00 84.00 101.00
Philippines 16.92 35.30 41.66 46.36 58.02 59.00 63.00 73.00
Government 16.60 35.00 40.20 43.50 52.84 53.00 55.00 64.00
Corporate 0.32 0.30 1.46 2.86 5.18 6.00 8.00 8.00
Singapore 23.77 79.39 83.10 99.39 118.11 129.00 141.00 179.00
Government 13.05 44.02 46.90 55.92 68.13 73.00 88.00 103.00
Corporate 10.73 35.37 36.20 43.47 49.98 56.00 53.00 76.00
Thailand 10.47 68.00 78.84 112.01 153.93 143.00 177.00 225.00
Government 0.30 36.20 54.29 74.58 107.47 114.00 141.00 183.00
Corporate 10.17 31.80 24.55 37.44 46.45 28.00 36.00 42.00
Viet Nam 0.00 3.78 4.30 4.93 9.79 129.00 12.00 15.00
Government 0.00 3.78 4.20 4.50 8.28 124.00 11.00 14.00
Corporate 0.00 0.00 0.11 0.43 1.51 5.00 1.00 2.00
Emerging East Asia 405.31 1,528.51 2,337.11 2,933.82 3,693.18 3,809.00 4,404.00 5,210.00
Government 152.37 735.18 1,680.70 2,107.77 2,677.22 2,859.00 3,112.00 3,590.00
Corporate 252.95 793.33 656.42 826.05 1,015.94 947.00 1,291.00 1,620.00

The credit rating might also be a contributing inhindrance for the full development of local bond market. As shown in Table 4, up to now, the sovereigns rating for some Asian economies are still below investment grade (below BBB-). For instance, Indonesia gets BB+; Viet Nam gets BB-, while Philippines manages to get BB. Lower sovereign ratings will to some extent deter investors’ enthusiasm in local market. In addition, there are only a limited number of large, reputable firms which can issue high-rated bonds. Corporate governance of family-controlled companies and the emphasis on the expansion of capital through business profits or bank loans tend to discourage raising through direct financing. That helps to explain the faster growth of government bonds in recent years.
Table 4: Standard& Poor’s Sovereign Ratings List for Asia Economies
As of August 11th 2011
Economy Foreign Rating Economy Foreign Rating Economy Foreign Rating
China AA- Singapore AAA Viet Nam BB-
Korea A Indonesia BB+ India BBB-
Hong Kong AAA Thailand BBB+ Japan AA-
Malaysia A- Philippines BB Pakistan B-
Another factor could play in some role, that is, institutional investors in East Asia are largely underdeveloped. Most of the pension funds, mutual funds and insurance companies are small and incapable of expanding their cross-border portfolios. Institutional investors are in their early stage of development in most East Asian countries. Some Asian countries have established sovereign wealth fund (SWF). For example, Singapore has a well established Temasek, and China set up the China Investment Corporation (CIC). Those SWFs could be potential investors into local bond markets. To further boost the development of bond market, further policy initiatives, such as Asian Funds Passport, should be established.
Last, risk-averse behavior by regional investors is another factor limiting capital movement within East Asia. The increase in accumulated foreign exchange reserves is creating a situation that structurally forces East Asian countries to manage their assets safely. East Asia’s relatively weaker capability to evaluate and manage risks also discourages East Asian investors from taking risks.

Concluding remarks
Asia delivered a strong performance during the global financial crisis, however decades of bank-dominated financial intermediation has left local financial systems still underdeveloped. Complex institutional and regulatory frameworks have limited the scope further for expanding growth continually. A more balanced and modern financial systems would facilitate developing Asian economies to go farther in their quest for a higher-growth path.
Initiatives to develop Asia bond markets could include: sustaining a stable macroeconomic environment with low inflation and stable interest rates, developing a healthy government bond market that would serve as a benchmark for the corporate bond market, promoting the growth of regional bond market centers, improving corporate governance, strengthening the regulatory framework for bond market, and broadening the investor base. A regional credit guarantee scheme could further boost the overall appeals of Asian bond market, which should give a serious consideration. Since at present there is a great diversity in the levels of bond market development across countries, significant country-specific deciphering of these requirements will be needed for developing country strategies for bond market development.

Asia Development Bank: Asian Development Outlook 2010 Update
Asia Development Bank: bond market development in East Asia: issues and challenges
Asia Development Bank: Asia Bond Monitor March 2011
Bank for International Settlements: Local Currency Bond Market and the Asian Bond Fund 2 Initiatives, 14 July 2011
Bank for International Settlements: Asian Bond Market: Issues and Prospects, Nov 2006
Masahiro Kawai: Asian Bond Market Development: Progress, Prospects and Challenges, Keynote Address at High Yield Debt Summit Asia 2007, 16-17 May 2007
Committee on the Global Financial System: Financial stability and local currency bond markets, CGFS Papers No 28, June 2007
Asian Development Bank Institute, Bond Market Development in Asia: An Empirical Analysis of Major Determinants, ADBI Working Paper Series, July 2011

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Implications of Basel Framework on Trade Finance

No one can ever underestimate the importance of trade finance, especially under current severe economic situation. The success of a nation’s export program and even economic recovery, to some significant extent, relies upon the availability of trade finance, which facilitates the transfer of commodities and manufactured good between countries.

Trade finance covers a spectrum of payments arrangements between importers and exporters. While a seller (the exporter) would like to ask the purchaser (the importer) to prepay for goods to be shipped, the purchaser (importer) may wish to reduce risk by requiring the seller to document the goods that have been shipped. Banks may assist by providing support in various forms. According to IMF estimate, by 2008 the global merchandise trade reached some 16 trillion USD. International Chamber of Commerce (ICC) banking commission believes that almost 90% of the world merchandise trade is supported by trade finance.

The Basel Committee on Banking Supervision (BCBS, or Basel Committee) is an institution created by the central bank Governors of the Group of Ten nations in 1974, and now comprise of 27 members from both developed and emerging economies. The BCBS is mandated with issuing supervisory standards and guidelines and recommending statements of best practice in banking supervision, with the aim to encourage global convergence toward common approaches and standards. The Basel Committee along with its sister organizations, the International Organization of Securities Commissions (IOSCO) and International Association of Insurance Supervisors (IAIS) together make up the joint fora of international financial regulators.

The most influential publications by the BCBS are Basel Accords (the initial version was issued in 1988, undated in 2004 and 2010 respectively). The key part of Basel Accords, or Basel framework as commonly referred to, guides banking industry how to calculate risk-weighted assets (RWA) and capital requirements, and the Basel Committee has just finished the final text of details of updated global regulatory standards on bank capital adequacy and liquidity, which was agreed by the Governors and Heads of Supervision, and endorsed by the G20 Leaders at their November 2010 Seoul summit. As requested by the G20 Leaders, the Basel Committee, in a press release issued on Dec 1st 2010, will evaluate the impact of the regulatory regime on trade finance in the context of low income countries.

The focus of this paper is on short-term trade finance arrangements in which the banking system provides lending, insurance against nonpayment, or other support to help international trade. For example, the importer’s bank may provide a letter of credit to the exporter (or the exporter’s bank) providing for payment upon presentation of certain documents, such as a bill of lading. Or the exporter’s bank may make a pre-shipment loan (by advancing funds) to the exporter on the basis of the export contract or the letter of credit, etc.

Part I. Definition and functions

There is no universal definition about trade finance, and people may use the same term for different things. According to LEE Yow Jinn from International Trade Institute of Singapore, trade finance refers to the institutions, laws, regulations and other systems related to the following three activities: 1. provision of capital to firms that are engaging in international trade transactions, 2. provision of support services to manage the risk involved in these transactions, and 3. provision of international payment mechanisms.

The Basel Committee does not define trade finance itself. However in June 2004 when the BCBS issued International Convergence of Capital Measurement and Capital Standards: a Revised Framework (Basel II), it defines commodities finance as one of the five-subclass specialized lending. According to Basel II paragraph 223, commodities finance refers to structured short-term lending to finance reserves, inventories, or receivables of exchange-traded commodities (e.g. crude oil, metals, or crops), where the exposure will be repaid from the proceeds of the sale of the commodity and the borrower has no independent capacity to repay the exposure. It is believed that commodity finance covers on-balance-sheet part of trade finance.

Basel II also stipulates the way to handle with off-balance-sheet (OBS) items. OBS items under the standardized approach as well as in foundational internal ratings- based (FIRB) approach will be converted into credit exposure equivalents through the use of credit conversion factors (CCF).  A 50% CCF will be used for certain transaction-related contingencies (e.g. performance bonds, bid bonds, warranties and standby letters of credit related to particular transactions), and a 20% CCF will be used for  short-term, self-liquidating trade-related contingent liabilities arising from the movement of goods (e.g. documentary credits collateralized by the underlying shipments). Under the advanced internal ratings- based approach (AIRB), banks will be allowed to use their own internal estimates of CCFs across different product types, provided they meet the minimum requirements.

With trade finance, exporters and importers can achieve four broad functions, i.e., arrange for payment, raising fund, mitigating risks and costs, and access of credit information. Trade finance transactions can be structured in a number of ways. The structure used in a specific transaction reflects the relationship between participants, countries involved, and competition in the market.  So far, letter of credit (L/C) transactions are the norm in sales associated with emerging market countries. Collections, especially documentary collections are also important in bank trade finance.

Letters of credit allow the issuing banks to substitute their creditworthiness for that of their customers. At an importer’s request, the issuing bank pays stated sums of money to sellers of goods against stipulated documents transferring ownership of the goods. Through L/Cs, exporters can be assured about the payment from the importer and mitigate commercial risks by gaining assurance from the importer’s bank.

Under a pre-shipping financing, a bank may grant short-term loans, discount L/Cs or provide advance payment bonds for the exporter, to ensure that the company has sufficient working capital for the period before shipment of the goods. An exporting company can get post-shipping financing to bridge the period between shipping the goods and receiving payment from the importer.  

Collection is a very important form of trade finance to facilitate the payment. Basically, there are two types of collections: clean (financial document alone) and documentary (commercial documents with or without a financial document). A financial document is a check or a draft; a commercial document is a bill of lading or other shipping document. A clean collection involves drafts and checks presented for collection to banks by their foreign correspondents. In a documentary collection, the exporter draws a draft or bill of exchange directly on the importer and presents this draft, with shipping documents attached, to the bank for collection. In collection and letter of credit transactions, the bank takes a very active role in the exchange of documents between buyer and seller.

With further development of trade, there come into existence new forms of trade finance. For example, factoring gains momentum in emerging markets recently. This involves the sale at a discount of accounts receivable or other debt assets on a daily, weekly or monthly basis in exchange for immediate cash. The debt assets are sold by the exporter at a discount to a factoring house, which will assume all commercial and political risks of the account receivable. In the absence of private sector players, governments can facilitate the establishment of a state-owned factor or a joint venture set-up with several banks and trading enterprises.

Part II. Roles in promoting economic recovery


It is recognized that world trade is essential to the economic recovery and that the availability of trade finance is key to the smooth functioning of trade flows. Any disruption in the ability of the financial sector to provide working capital, export finance, issue or endorse letters of credit or deliver export credit insurance, is likely to create a contraction in trade and output.  Trade finance is particularly vital to emerging markets and least-developed countries.

More than ever, the level of activity in trade finance markets is crucial to global economic recovery. Limited access to trade finance significantly curbs import/export activity, one of the principal drivers of economic growth. With the global integration of supply chains, trade had become proportionally more responsive to output changes. Historical data shows that the elasticity of global trade volumes to real world GDP has increased gradually from around 2 in the 1960s to above 3 in recent years, driven by production-sharing networks and the proliferation of global supply chains[1]. The higher elasticity means that trade declines faster than in the past as output drops, but it also suggests that a more rapid recovery will take place as the recession ends.

The World Trade Organization (WTO) pointed out that the global trade volume dropped by 12% in 2009, the greatest decrease since World War II[2]. The World Bank estimates that 85-90% of the fall in world trade since the second half of 2008 is due to falling international demand, and 10-15% is attributable to a fall in the supply of trade finance. The potential damage is enormous to the real economy from shrinking trade finance. More important, small and medium-sized enterprises (MSEs) rely on a high level of trust and confidence in global suppliers that they will deliver their share of the value-added, and need financial means to produce and export it in a timely manner.[3]

Responding to ongoing financial crisis, governments and enterprises all over the world, with their deep awareness of the importance of trade finance, have paid more and more attention to the unique role of trade finance. The London G20 Summit held in April 2009 contended that the recovery of international trade and investment was the key to the global economic growth. Thus the summit put forth several important measures such as providing 250 billion US dollars for trade finance through multilateral banking mechanism and export credit agencies to facilitate the resurrection of international trade and bail out the world economy.

Part III. Risks and Features


The risks associated with trade finance are credit, transportation and political risks, amongst others. The credit risk is by far the most severe threat essentially from the inability of one of the parties involved to carry out its obligations. For example, an exporter is not able to secure payment from his merchandise in case of rejection from the importer for improper quality or in case of insolvency or bankruptcy of the importer. Alternatively, the importer may suffer from a delayed or false delivery of goods from the part of the exporter.

However in trade finance, many transactions are short-term credit and self-liquidating, and most credits are supported by L/Cs and letters of guarantee (L/Gs) from banks, some collateralized by the underlying shipments of goods. ICC banking commission claims that default rate of trade finance is very low, and trade finance is a very safe asset on banks’ balance sheets. This is supported by industry data from the International Chamber of Commerce (ICC) – Asian Development Bank (ADB) Trade Finance Default Register study. The study, covering 5.2 million trade finance transactions over a period of 5 years, confirms that trade finance has historically had low default rates, even during the financial crisis. Additionally, in the rare occasions when trade loans default, loss recoveries are high. [4]

Trade finance is a well-established industry practice. With regard to trade finance and guarantee conducted against the real trading background, there are international standardized and mature rules and practice as business guidelines recognized within the industry and as authoritative evidence to resolve disputes and conflicts in a just and reasonable manner.

According to OCC handbook, upon reviewing the history and performance of trade finance credit, the Interagency Country Exposure Review Committee (ICERC) usually concludes that trade finance credits granted by US banks to entities in foreign countries have a low risk of default. The low default risk is due, in part, to the importance that countries assign to maintaining access to trade credits. In a currency crisis, central banks may require all foreign currency inflows to be turned over to the central bank. The central bank would then prioritize foreign currency payments. Trade liabilities would be more likely to be designated for repayment than most other types of credits. For this reason, trade finance is viewed as having less transfer risk than other types of debt.[5]

One more factor helps to account for low credit risk for trade finance. Even in times of severe difficulty, companies will generally try to avoid defaulting on trade obligations, as continuing access to trade finance is a lifeline for most firms. In a similar vein, it should also be noted that trade-related instruments are generally the last forms of credit to be cut, and the first to be established, in debt-distressed economies.

That safe nature of trade finance is well recognized by the BCBS. When the committee published (and later updated) International Convergence of Capital Measurement and Capital Standards (Basel I), a preferential 20% CCF was assigned to short-term, self-liquidating trade-related contingent liabilities arising from the movement of goods (e.g. documentary credits collateralized by the underlying shipments).

Part IV. Basel Regulations’ Likely Impact


As said above, trade finance received a favorable regulatory treatment under Basel I (20% CCF value). The basic text and CCF value for trade finance is largely unchanged under Basel II, however, as the banking and regulatory communities are moving toward internal ratings-based (IRB) methodology, a number of concerns emerged with respect to the treatment of trade assets, particularly in periods of economic crisis. As the official sector has just published the final text of Basel III[6] by imposing more stringent capital requirement, tougher liquidity ratios as well as an un-weighted leverage ratio, people are more and more concerned that the Basel III proposals might have adverse consequences on trade finance, particularly for SMEs and counterparties in emerging markets.

1. Basel II framework is biased against banks in emerging markets.

The minimum standards set for the IRB approach even at the foundational level are complex and beyond the reach of many banks. Emerging markets would face serious implementation challenges with their low technical skills, structural rigidities and less robust legal system, and shortage of experienced talents, etc. The complexity and sophistication of the proposals makes its application in emerging markets highly unlikely, where the banks continue to be the major segment in financial intermediation and would be facing considerable challenges in adopting all the proposals.

Financial Stability Institute (FSI) in last August published 2010 Survey on the Implementation of the New Capital Adequacy Framework: Summary of Responses to the Basel II Implementation Survey.[7] According to this survey, more than one third of respondent banks would prefer to use standardized approach to implement Basel II. Considering those respondents are more likely international active banks, the percentage of banking employing standardized approach, particularly from emerging markets, will be much higher.

Under Basel II, for banks with good quality assets, the risk weighted assets (RWA) under IRB approach will be significantly lower than under standardized approach, and that is what exactly what the Basel Committee intends to encourage banks to migrate from standardized approach. It is felt that the proposals will disadvantage banks in emerging markets. Those banks plays pivotal roles in extending trade finance to local traders. With those banks’ cutting finance support, the trade development for emerging market will be adversely impacted. [8]

2. One year maturity floor should be waived for trade finance

Basel II paragraph 320 prescribes one-year maturity floor to the maturity of lending facilities despite of the fact that the maturity of trade finance products is usually shorter than 180 days. Since capital requirements (naturally) increase with maturity length, the capital costs of trade finance are artificially inflated as a result. Such measurement does not precisely reflect the short-term and low-risk nature of trade finance and expands the occupation of risk capital of banks, which is not conducive to the development of trade finance business.

Basel II paragraph 321 stipulates that the one-year floor does not apply to certain short-term exposures, as defined by each supervisor on a national basis. In other words, the Basel Committee permits that all national regulators have the discretion to waive this floor,  however many regulatory authorities are still reluctant to exercise this discretion, even after UK FSA waived the one-year maturity floor at the end of 2008. 

3. Lack of Specific Data Puts Trade Finance in an Unfavorable Situation

Banks are allowed to use either the standardized approach or the IRB approach to measure RWA in terms of credit risk. The fundamental difference between IRB and standardized approach lies in that banks would adopt their own models to estimate parameters required for calculating RWA. The low-risk nature of trade-related OBS items should lead to low values when calculating risk parameters and demonstrate the advantage of saving risk capital compared with other lending facilities. Nevertheless, IRB requires that banks accumulate relevant historical data for at least 5 years when calculating probability of default (PD) and the calculation of loss given default (LGD) and exposure at default (EAD) be based on data even longer.

The majority of banks in the world do not have sufficient historical performance data for trade-related OBS items. The factors causing this are wide and varied, but particular problems include: (a) migration of facilities (i.e. when a trade loss results in an exposure on another facility, such as an overdraft); (b) customer-centric data collection practices; and (c) inherent biases in the data collected. Due to the common shortage of relevant record of historical performance data of trade-related OBS items, the low-risk nature is not given a full play from the values of risk components devised by Basel II. When calculating the occupation of risk capital, banks have to adopt 20% or 50% CCF made by the regulatory rules and it gives rise to the excessive occupation of risk capital as far as trade-related OBS items are concerned.

The ICC, with Asia Development Bank (ADB), decided to establish a pooled performance database for trade finance products, which is called Register on Trade & Finance (the Register). By September 2010, altogether nine banks provided portfolio-level data comprising 5,223,357 transactions worth of USD2.5 trillion, with a total throughput between 2005 and 2009. The initial finding is encouraging. Only 1,140 defaults have been reported within the full data set of 5,223,357 transactions.[9].More important, reported default rates for off-balance sheet trade products are especially low. The Basel RWA methodology are more concerned with issues of counterparty instead of facility issues, therefore it is somewhat difficult to build that some type of facility is low in credit default. However, the ICC is determined to further their efforts to meet regulatory requirements for data collection, and the ICC will work to enhance and expand the data collected

4. Basel III 100% CCF for Leverage Ratio Proposal Poses Threat to Trade Finance

Basel III capital standards paragraph 163 provides that the Basel Committee recognizes that OBS items are a source of potentially significant leverage; therefore banks should calculate the above OBS items for the purposes of the leverage ratio by applying a uniform 100% credit conversion factor (CCF). Increasing the CCF to 100% for trade-related contingencies for the purposes of calculating a leverage ratio could significantly disadvantage trade finance-focused banks.

When the leverage ratio becomes compulsory, a bank may choose to increase the cost of providing trade products or selectively offer these products to customers, which will undoubtedly impact the perspectives of trade finance. It is not appropriate to apply 100% CCF to trade-related OBS items such as L/Cs and L/Gs in calculation of leverage ratio under Basel III. This calculating method fails to differentiate trade finance products from other OBS fictitious financial instruments. Trade finance products are often of the short-term and self-liquidating nature and closely related to the activities of real economy with actual trade background of goods and services. In other words, this sort of transaction is based on the real-economy need of customers and totally satisfies the demand of customers for credit enhancing, settlement and financing in the trade of goods and services. Compared with OBS synthetic financial instruments, it cannot increase market risk. Consequently, it is not justified to treat trade-related OBS items as the significant source of excessive leverage and to adopt 100% CCF to restrain them.

If the risk difference of distinct OBS assets is ignored, it might encourage banks to retain high-risk and high-profit asset businesses like derivatives driven by the motive to gain more profits when stepping into the precautionary area of leverage ratio supervision, thus deviating from the original intention of leverage ratio supervision.     

5. Asset Value Correlation should not Cover Trade Finance


Basel III capital standards paragraph 102 prescribes that a multiplier of 1.25 is applied to the correlation parameter of all exposures to those financial institutions with assets of $100 billion or unregulated financial institutions. Under the rule, asset value correlation (AVC) of financial institutions employs a multiplier of 1.25 in the framework of IRB. Although it will definitely strengthen the capability of financial institutions to prevent systematic risk, the proposed AVC is nearly two times that of the present one in Basel II.

The rule will increase the cost of the providing credit to trade finance, thus potentially inhibiting the flow of trade. The implementation of this rule may incentivize banks to lend more to financial institutions which are some (less than $100 billion in assets) and thereby taking risks which they would have otherwise not taken. In addition, the rule will also potentially impact the AVC for risk participations, which could limit a bank’s ability to use risk participation, thus increasing a bank’s exposure to underlying risk in a transaction. Therefore trade assets should not be included in the financial institutions assets calculation when determining the AVC should be applied.

6. Likely Implementation Issue under Basel Liquidity Standards

On top of the aforementioned capital standards in the new Basel III regime, there are new liquidity ratios that firms are forced to adhere to.  Both the short-term Liquidity Coverage Ratio and long-term Net Stable Funding Ratio allow national discretion on all other contingent funding liabilities such as trade finance and L/Cs when calculating the amount of liquid assets and stable funding required to match the potential liabilities. As with the one- year floor issue above, it is likely that some national supervisors will use this discretion to implement onerous liquidity requirements, which, when added on to other aspects of Basel III, will restrict the availability of trade credit even further.  These rules should be harmonized to avoid having irregular national rules for global business.

Part V    Recommended Solutions

The implementation of Basel framework will undoubted strengthen the resilience of international banking industry, however the official sector as well as the private should work closely to avoid any potential unintended consequences.  Given the importance of trade finance to economy recovery and its primary characteristic of low default risk, some corrective proposals should be raised to facilitate its smooth development.

1. Adjust Default Data Calculation Requirements. Most financial institutions lack historical performance data of trade finance (usually with short term in tenor). Current Basel default data calculation requirements may disadvantage trade finance focused banks. Banks should be allowed to enhance their current default data calculations using available industry data, such as the ICC Trade Finance Default once it improves its data quality.

2. Leverage ratio should give preferential treatment to trade finance. Trade-related OBS item business is generally considered a routine operation, providing liquidity and security to the movement of goods and services, but it is regulated by leverage ratio in the Basel III this time. It is inappropriate for the Basel Committee to give the equal treatment to trade-related OBS item as derivatives which are the real source of excessive leverage in the banking system and the real cause of financial crisis. Historically, a very small portion of letters of credit, trade guarantees, and trade standby letters of credit (SBLC) convert into on-balance sheet exposures. The BCBS should develop a more adequate treatment of trade finance for leverage purposes ,which takes into account the fact that a very small portion of these off-balance sheet exposures convert into on-balance sheet exposures, even in stress scenarios.

3. Create separate AVC for trade finance. Trade exposures which are diverse in nature, smaller in value, shorter in tenor and self-liquidating in nature and which exhibit different behavior and payment patterns from other corporate banking products, may warrant a separate AVC.

4. One-Year maturity floor should be abolished. The Basel Committee allows national regulators to waive the one-year maturity floor for trade finance. However, most of the national regulators have not executed their discretion. Even in countries where this is waived, it is waived only for a limited list of trade finance products. The Basel Committee should move forward to encourage national supervisors to waive one-year maturity floor.

5. Preferential run-off rate should be given to trade-related OBS items. The national discretion of giving preferential run-off rate, such as 5% or 10%, should be pushed, just as the one-year maturity floor above.

6. It might be timely to set up a BCBS Working Group on Trade Finance. The Basel Committee will evaluate the impact of the regulatory regime on trade finance in the context of low income countries, as requested by the G20. Given the broader concerns surrounding the (unintentional) impact of Basel framework on trade finance, it may be timely for the Basel Committee to establish a specialist trade finance working group. Such a group would be well placed to examine the specific characteristics of trade finance products, the issues that arise when applying the existing regulatory framework to trade facilities, as well as the trade related aspects of the Basel Committee’s current proposals.

[1] The Trade Response to Global Downturns: Historical Evidence, abstract, by Caroline Freund, The World Bank Development Research Group Trade and Integration Team, August 2009,WPS5015

[3] Boosting the availability of trade finance in the current crisis: Background analysis for a substantial G20 package, by Marc Auboin, WTO Secretariat, Center of Economic Policy Research, Policy Insight 35, June 2009

[4] ICC: Report on findings of ICC-ADB Register on Trade & Finance Statistical analysis of risk profile of trade finance products, page 6.

[5] OCC: Comptroller’s Handbook: Trade Finance, Page 3, November 1998

[6] There are 2 parts, one is Basel III: A global regulatory framework for more resilient banks and banking system, and the other is Basel III: Basel III: International framework for liquidity risk measurement, standards and monitoring.

[8] One further point. The Basel Committee provides that the counterparty cannot be rated higher than the country risk. This provision does not conform to the basic philosophy that capital adequacy assessment should be aligned more closely with the key elements of risk. The mere location may not necessarily be a good indicator of a bank’s creditworthiness. Besides, any deterioration of the country risk during period of recession will automatically and negatively affect the counterparty risk regardless of the underlying creditworthiness of that counterparty

[9] ICC: Register on Trade & Finance:  Statistical analysis of risk profile of trade finance, Products

Document No. 470/1147 (Rev) – 21 September 2010, page 5/6.

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