China Banking Industry’s Developments
With the robust growth consecutively for past 30 years, China has become an economic powerhouse in the world arena, and its size of economy is forecast to overtake Japan to become the No. 2 by the end of 2010. The same thing can also be said about Chinese Banking Industry. The industry gains global attention by its amazing finance performance, especially with the context of current world financial crisis. Four Chinese banks dominate the top 10 position of world biggest 1000 banks by market capitalization.
This success is beyond anyone’s expectation and imagination, to Chinese or to the Westerns. For an industry, which seven years ago is said to be technically bankrupted, what has happened? How could the Chinese banking industry emerge as a superpower? What is the future of the industry, and how to look at its supervisor?
The article is centered on China banking industry’s developments, from both industry perspectives and regulatory perspectives.
Table of Contents
China Banking Industry’s Developments 1
1. Banking in China. 3
1.1 Brief history of China Banking Industry- 3
1.2 Major participants 4
1.3 Services Rendered- 6
1.3.1 Banking Cards 6
1.3.2 Individual Credit information- 7
1.3.3 China UnionPay- 7
1.3.4 Consumer Loans 8
1.4 Performance as of 2009- 8
1.4.1 Market Share Changes 9
1.5 Legal Framework- 9
1.6 Major Stakeholders 10
1.7 Supervisory Perspective- 11
2. Financial Crisis and Questions Outstanding. 12
2.1 Economic Stimulus Package- 12
2.2 Credit Boom- 12
2.3 Credit Quality- 13
2.4 Profitability revisited- 13
2.5 Foreign banks in China- 14
3. Regulation and Supervision. 16
3.1 Roles of the PBC- 16
3.2 Functions of the CBRC- 16
3.1.1 Prudential Requirements 16
3.1.2 Supervision- 17
3.1.3 Assessment against Large Commercial Banks 18
4. Looking Forward. 20
4.1 Go-out Challenges 20
4.2 Basel Accord Implementation- 21
4.3 International cooperation for banks and supervisors 22
4.4 Likely change from regulators 23
1. Banking in China
China’s banking system is highly regulated and relatively underdeveloped, but has recently gained momentum and prominence as monetary policy and credit are deemed integral to its overall economic developments, by providing finance to enterprises for investment, seeking deposits from the public to tackle excess liquidity, and lending money to the government.
1.1 Brief history of China Banking Industry
Nationalization and consolidation of the country’s banks received the highest priority in the earliest years of the People’s Republic, and banking was the first sector to be completely nationalized. In the period of recovery (1949-52), the People’s Bank of China (PBC), which was established on December 1, 1948, moved very effectively to halt raging inflation and to bring the nation’s finances under central control. Over the course of time, the banking organization was modified repeatedly to suit changing conditions and new policies.
Before the open and reform policy in 1978, virtually only one banking institution existed in China, i.e., the PBC. The bank served both as a central bank and a commercial bank. Under planned economy, people saw no need to differentiate the two functions. The banking system was basically monitored by the Ministry of Finance (MOF), which exercised firm control over all financial services, credit, and the money supply.
During the 1980s, the banking system was expanded and diversified to meet the needs of the reform program, and the scale of banking activity rose sharply. New budgetary procedures required state enterprises to remit to the state only a tax on income and to seek investment funds in the form of bank loans. With the development of so-called Socialist Market Economy, in early 1980s, Industrial and Commercial Bank (ICBC), Agricultural Bank of China (ABC), Bank of China (BOC) and People’s Construction Bank of China (CCB) have been progressively spin off from the PBC, and functioned as independent commercial banks. At the same time, Bank of Communications (BoCom), other joint-stock commercial banks, rural credit cooperatives, and urban credit cooperatives began to emerge.
Although banks had superficial autonomy, the banking industry was effectively regarded as cashiers for various levels of governments. The capital, finance and manager, and etc were also provided by the government. There was no corporate governance, no checks and balances, and no risk culture. By early 2000, Chinese banking industry ran into great difficulties, and technically almost all banks were bankrupted.
The Chinese government realized the serious situation, and undertook major steps to turn it around. The government injected billions of dollars into the industry, to overtake nonperforming loans from banks, and restructure the whole system. A separate banking watchdog was instituted to keep a close eye on banks, and also to keep local government from interfering bank’s daily operations. Institutional investors (foreign and national) were introduced, corporate governance, risk culture and accountability were setup, and they began to do IPOs. Thus, after tremendous hard work, China banking industry achieved initial success.
1.2 Major participants
The Central Bank: The People’s Bank of China, was formally decreed by the State Council (China’s Cabinet) as the central bank in September 1983. This status was legally confirmed by the Law of the People’s Republic of China on the People’s Bank of China, which was passed by the Third Plenum of the Eighth National People’s Congress (NPC, China’s Parliament) on March 18, 1995. In March 2003, the NPC approved the Decision on Reform of the Organizational Structure of the State Council, separating the supervisory responsibilities of the PBC for the banking institutions, asset management companies, trust and investment companies and other depository financial institutions. Instead, the China Banking Regulatory Commission (CBRC) was established to supervise the financial industry. Under the guidance of the State Council, the PBC formulates and implements monetary policy, prevents and resolves financial risks, and safeguards financial stability. The PBC maintains the banking sector’s payment, clearing and settlement systems, and manages official foreign exchange and gold reserves. It oversees the State Administration of Foreign Exchange (SAFE) for setting foreign-exchange policies.
The commercial banking sector includes a variety of institutions, including policy banks, large commercial banks (big 5), jointly-owned stock banks, foreign banks and a network of credit cooperatives in both rural and urban areas. By the end of 2009, China’s commercial banking industry is made up of 3 policy banks, 5 large commercial banks, 12 joint-stock commercial banks, 143 city commercial banks, 43 rural commercial banks, 196 rural cooperative banks, 11 urban credit cooperatives, 3,056 rural credit cooperatives, 1 postal saving bank, and 37 foreign banks. The total number of business outlets is over 190,000, with total working employees over 2.84 million.
Policy banks: Three are three policy banks, namely, the Agricultural Development Bank of China (ADBC), the China Development Bank (CDB), and the Export-Import Bank of China (China Eximbank), were established in 1994 to take over the government-directed spending functions of state-owned commercial banks. These policy banks are responsible for financing economic and trade development and state-invested projects. The ADBC provides funds for agricultural development projects in rural areas; the CDB specializes in infrastructure financing, and China Eximbank specializes in trade financing.
Postal Saving Bank: The Postal Savings Bank of China (PSBC) was split from China Post in 2007, and was established as a state-owned limited company. It continues to provide banking services at post offices. It is the country’s fifth largest bank by assets, with focus on retailing and intermediary businesses and offer basic financial services in both urban and rural areas. The PSBC boasts 36,000 outlets nationwide, the largest banking network in China, almost 60 percent of which are located in rural areas, and the PSBC has 270 million account holders.
Large commercial banks: Despite the large number of financial institutions, five large still dominates the Chinese banking industry, possessing over half of the assets in Chinese banks are in 5 banks whose shares are majority-owned by the central government. Based on size, these include: the Industrial and Commercial Bank of China, the China Construction Bank, the Agricultural Bank of China, the Bank of China, and the Bank of Communications. The size of Big 5 has secured them places on Fortune Magazine’s 2009 list of the top 500 global companies.
Second tier commercial banks: In addition to the big 5 state-owned commercial banks, there are a dozen of jointly-owned stock smaller banks, including: China Merchants Bank, China CITIC Bank, China Minsheng Banking Corporation, Shanghai Pudong Development Bank, China Everbright Bank, Hua Xia Bank, Guangdong Development Bank, Shenzhen Development Bank, China Zheshang Bank, Evergrowing Bank, and Industrial Bank. The second tier banks generally grow faster, and their profitability is more impressive than Big 5.
City commercial banks: The third significant group in Chinese banking market is the city commercial banks. Most of them are transformed from urban credit cooperatives. The first one was Shenzhen City Commercial Bank in 1995. In 1998, the PBC announced that all urban cooperative banks should change their name to city commercial bank. Altogether 69 city commercial banks were set up from 1995 to 1998. In 2005 additional 112 city commercial banks were formed, and the total number has increased to 143 in 2009. Most city commercial banks have strong ties to their local government and are majority or wholly state owned. Since 2005 some city commercial banks have diversified their shareholders, inviting Chinese and international private companies to take minority shares, merging and cross-shareholding. Some of the banks have listed their shares. The city commercial banks market orientation is towards supporting the regional economy, but also towards financing local infrastructure and other government projects. Since 2008 a strong trend has emerged for city commercial banks to extend business beyond their home regions.
Foreign banks: China’s entry into the WTO is expected to create opportunities for foreign banks. As a milestone move to honor its WTO commitments, the State Council released the Rules for Implementing the Regulations Governing Foreign Financial Institutions in the People’s Republic of China in January 2002. The rules provide detailed regulations for implementing the administration of the establishment, registration, scope of business, qualification, supervision, dissolution and liquidation of foreign financial institutions. Foreign bank branches conducting full aspects of foreign-currency and RMB business to all categories of clients are required to have operating capital of at least 600 million RMB equivalent, of which at least 400 million RMB equivalent must be held in RMB and at least 200 million RMB equivalent in freely convertible currency.
Client restriction and geographic restrictions was lifted immediately after China’s entry into the WTO on December 11, 2001. Since then, foreign financial institutions have been permitted to provide foreign currency services to Chinese enterprises and individuals, and have been permitted to provide local currency business to all Chinese clients by the end of 2006. In 2007 five non-mainland banks were allowed to issue bank cards in China, with Bank of East Asia also allowed to issue UnionPay credit cards in the mainland (United Overseas Bank and Sumitomo Mitsui Financial Group have only issued cards in their home countries; they are not yet allowed to issue cards within the mainland). In May 2009 Woori Bank became the first Korean bank allowed to issue UnionPay debit cards on the mainland (it issues UnionPay credit cards in Korea only).
1.3 Services Rendered
Chinese banks render all major banking functions, including the acceptance of deposits from the general public, the granting of short-term, medium-term and long-term loans, handling domestic and foreign settlements, accepting and discounting of negotiable instruments, acting as an agent for the issue, honoring and underwriting of government bonds, buying and selling foreign exchange and acting as an agent for the purchase and sale of foreign exchange issuing notes, issuing debit and credit cards, and engaging in interbank lending, among other business.
The scope of business shall be specified in the articles of association of individual commercial banks, and submitted to the CBRC for approval. Of those banking products, banking cards and Consumer Loans merit particular mentioning.
1.3.1 Banking Cards
The first bank card in China dates back to June 1985, when Bank of China Zhuhai Branch issued the BOC Credit Card. Since then, bank cards develop very fast.
By the end of the first quarter of 2009, about 1.89 billion bank cards have been issued in China. Of these cards, 1.74 billion or 92% were debit cards, while the rest (150.5 million) were credit cards. At the end of 2008, China had approximately 1.84 million POS machines and 167,500 ATMs. About 1.18 million merchants in China accept banking cards. At the end of 2008, there were 196 issuers in China that issue China UnionPay-branded cards. These issuers include the ‘big 5’, as well as fast-growing second tier banks and city commercial banks. China’s commercial banks in 2003 began to issue a dual-currency card, allowing cardholders to purchase goods within China in RMB and overseas in US dollars.
1.3.2 Individual Credit information
Accurate credit information is a must for sound development of banking cards. However, this information is the biggest obstacle in China. The Chinese, unlike American or Europeans, are more inclined to use. Most of them have no concept of credit. However, with joint efforts from the government and banks, more and more realize the importance of credit and individual credit worthiness.
In order to collect reliable personal credit information, in 2002, the Shanghai Information Office under Shanghai Municipal Government and the PBC Shanghai branch jointed established the first personal credit data organization involving 15 commercial banks. In 2005, the PBC set up a credit reference center, along with a nation-wide personal data system. The system so far contains the data for over 600 million persons, amongst which 100 million persons has bank loan records.
This system is still in its rudimentary stage, and some information is inaccurate or some even missing. Other obstacles include lack of merchant acceptance and a weak infrastructure for card processing. At present, only 2% of merchants in China are equipped to handle card transactions, although in some major cities like Shanghai the percentage is over 30%.
1.3.3 China UnionPay
China UnionPay (CUP) is a bankcard association based in Shanghai. CUP was established in March 2002 and now has about 300 domestic and overseas associate members. CUP is the major defense vehicle of the Chinese government to safeguard its interest in fast-developing banking card business.
In 2009, the national inter-bank bankcard transactions hit RMB 7.7 trillion, 83.7 times that in 2001. The proportion of bankcard consumption in the total volume of retail sales of social consumables increased from 2.7% in 2001 to 32% in 2009.
While keeping tight control of the domestic market, CUP has extended its network to more than 90 countries and regions. Its expansion directly threatens to the interests of Visa, MasterCard and other international players.
On June 3 2010, Visa ordered its banking partners to stop using CUP network for transactions for co-branded banking cards outside China. According to PBC, cards bearing CUP logo accounted for 108.3 billion RMB worth of overseas transaction in 2009, up 62% from a year earlier. The banking bard business is so lucrative that CUP, Visa, MasterCard will continue to fight.
1.3.4 Consumer Loans
Chart 1: China Consumer Loans Developments
Unit: in hundred million RMB
Source: PBC’s statistics.
With the increase of personal income per capita, the consume loans in China has been its fast lane. The outstanding balance increased from 2.47 trillion RMB in Jan 2007 to 6.74 trillion RMB in June 2010, up 172%.
1.4 Performance as of 2009
Despite the negative impact by the ongoing financial crisis, the banking industry performed comparatively satisfactory results by 2009, well in excessive of those of their Western counterparts.
By 2009, the total assets for Chinese commercial banks is 77.2 trillion yuan, an increase of 16trillion yuan over 2008, or 26.2% y-o-y growth rate; the total liabilities is 73.1 trillion yuan, an increase of 15.4 trillion yuan, or 26.7% growth rate; and the total equities stands at 4.1 trillion yuan, an increase of 593.2 billion yuan, or 16.7% y-o-y growth rate.
At the end of 2009, the average CAR (Capital Adequacy Ratio) for Chinese commercial banks is 11.4%. The Chinese banking industry achieves Double Decline in terms of balance and ratio of NPLs. The outstanding balance of NPL in 2009 is 497.3 billion yuan, and NPL ratio is 1.58%. The loan provision ratio (allowance for loan impairment loss against NPLs) reaches 155%, an increase of 38.6 percentage points over 2008.
The annual profit is 638.6 billion yuan, and the ROE is 16.6%.
1.4.1 Market Share Changes
Compared to end of 2003, market shares for commercial banks change a lot (pls refer to Graph 1 below). The biggest losers are large commercial banks. Their combined market share slips from 60.6% to 51.9%, a drop of 8.1 percentage points. The second losers are rural credit cooperatives, and their market share down 2.8 percentage points. The third losers are urban credit cooperatives, and their market share decreases 0.5 percentage point.
The biggest winners are joint-stock commercial banks, gaining a market share of 4.2 percentage points. They are followed by rural commercial banks, city commercial banks, rural cooperative banks, and policy banks, each winning market share by 2.3, 1.9, 1.7 and 1.1 percentage points respectively. The market shares for the PSBC and foreign banks remain stable.
Chart 2: Market Share Changes during 2003-2009
Source: CBRC annual reports.
By the end of 2009, the liquidity ratio is 46.4%, a decrease of 3.6 percentage points over previous year. The loan-to-savings ratio is 71.9%, up 2.7 percentage points. On the whole, commercial banks improve their liquidity management, and their liquidity ratios are over 25% stipulated by the CBRC.
1.5 Legal Framework
In present China exists a hierarchical legal system, which is made up of three tiers of regulations with a decreasing level of legal authority and an increasing level of detail.
The first tier is state laws, promulgated by the NPC, like the Law of People’s Republic of China on Banking Regulation and Supervision, the Law of the People’s Republic of China on Commercial Banks, and other relevant laws.
The second tier is regulations stipulated by the State Council, such as Regulations of the People’s Republic of China on Management to Banks Owned by Foreign Capitalists, Regulations of the People’s Republic of China on Foreign Exchange Administration, and etc.
The third tier consists of rules and procedures of relevant regulators, for example, the CBRC’s Guideline on Liquidity Risk Management of Commercial Banks, the CBRC’s Guidelines for the Supervision of the Internal Rating System for Credit Risk of Commercial Banks, the PBC’s Regulations for Implementing the Administrative Rules on Pilot Program of Renminbi Settlement of Cross-border Trade Transactions, and the SAFE’s Notice of the State Administration of Foreign Exchange on the Examination and Ratification of Short-term External Debt Quotas of Financial Institutions in 2009.
1.6 Major Stakeholders
In line with the CBRC’s Rules on the Implementing Procedure for Administrative Licensing; the Implementing Rules for Administrative Licensing for Chinese-funded Commercial Banks, the Implementing Rules for Administrative Licensing for Foreign-funded Financial Institutions and other relevant rules, strict conditions and restrictions are imposed upon potential institutional investors, which would like to invest to Chinese commercial banks.
Foreign financial institutions may be eligible institutional investors, provided that they have a history of sound operations, with good corporate governance, CAR ratio no less than 8%, and total assets for the year before application no less than 10 billion USD. The upper limit of shareholding by any individual foreign financial institution should be no more than 20%, and maximum shareholding limit is 25% by all foreign financial institutions.
So far, all of the three Chinese policy banks are totally owned by Chinese Central Government, through the arms of MOF and Central Huijin Co. The CDB is in the process of internal restructure, and plans to go public to transform into a fully commercial bank.
The Big 5 are all listed commercial banks, and the Central Government keeps the controlling stakes. The ICBC, the CCB and the BoCom also have foreign stake, and the HSBC Group even holds 20% stake in BoCom.
Most of joint-stock commercial banks are listed banks. Except for China Minsheng Bank, which is publicly held, the rest are controlled by central or local governments through state-owned enterprises (SOEs) and government-sponsored investment vehicles (GSIVs).
City commercial banks, rural commercial bank and rural cooperative banks are controlled by local governments. City credit cooperatives and rural credit cooperatives are collectively owned.
In a word, the shareholder structure for Chinese banking sector is quite complicated. The government is no doubt the pivot player in this sector.
1.7 Supervisory Perspective
China follows a sectoral supervision model for its financial industry, with banking, insurance and securities sectors being under separate supervision by the CBRC, the China Insurance Regulatory Commission (CIRC) and the China Securities Regulatory Commission (CSRC) respectively. On September 18, 2003, the CBRC, the CSRC and the CIRC held the first cross-sector regulatory meeting. All three parties signed an MOU on Functional Division and Cooperation of the CBRC, the CSRC and the CIRC in the Area of Financial Supervision.
The Beijing-based CBRC was officially launched on April 28, 2003, to take over the supervisory role from the PBC. The goal of the landmark reform is to improve the efficiency of bank supervision and to help the PBC to further focus on the macro economy and currency policy. The CBRC is an institution with ministerial rank under the State Council. Its current Chairman is Mr. LIU Mingkang. Its functions are similar to the OCC and OTS combined in the US.
The CBRC is responsible for the regulation and supervision of banks, asset management companies, trust and investment companies as well as other deposit-taking financial institutions. Its mission is to maintain a safe and sound banking system in China.
2. Financial Crisis and Questions Outstanding
Over the past several decades, China has been one of the world’s fastest growing economies, a major contributor to world economic growth. However, the current global financial crisis significantly threatens Chinese economy. Several Chinese industries, particularly the export sector, have been hit hard by the crisis, and millions of workers have been laid off.
2.1 Economic Stimulus Package
This grave situation is of great concern to the Chinese government, which views rapid economic growth as critical to maintaining social stability. “In a developing country like China, with a population of 1.3 billion, maintaining a certain economic growth pace is needed to provide urban and rural jobs, raise income levels, and maintain social stability,” Chinese Premier Wen Jiabao said while delivering a government report to the NPC on March 5 2008.
How to solve this problem? The answer by Chinese government is enormous investment plans. Of the three drivers of national economy, no one expects much hope on the export sector, and it is hard to imagine significant growth in consumption, given average household incomes is limited and Chinese consumers tends to save. That leaves investment as the only potential tool to boost Chinese economy. At the core of Beijing’s investment strategy is a two-year 4 trillion yuan economic stimulus, calling for the central government to put 1.18 trillion yuan into the pot, with local governments and private sources providing the rest.
Much of the money will be borrowed. The MOF plans to enlarge the issuance of government bonds by 570 billion yuan to help narrow a funding gap of 750 billion RMB. The central government estimates that local governments will need 240 billion RMB in loans to meet their total capital requirements in 2009, and another 260 billon in 2010.
2.2 Credit Boom
As part of economic stimulus package, the government plans to remove loan quotas and ceilings for all lenders, and increase bank credit for priority projects, including rural areas, small businesses, technology companies, iron and cement companies. In 2009 alone, Chinese banks granted 9.47 trillion in loan and trade finance, significant part of which went into local government-sponsored finance platforms (LGSFPs).
One obstacle is the uneven repayment abilities of various local governments. China has disparities among costal areas, inland regions and frontiers. Less developed areas may have a more urgent need for infrastructure projects but lack capacity to repay debt. In similar situations in the past, some local governments were buried in debt until the central government stepped in with clean-up projects. Questions about this strategy have now resurfaced.
Beijing’s attitude is to encourage LGSFPs, particularly for roads and power grid renovation projects. Those projects do not generate cash flow, at least not in immediate future. These LGSFPs can borrow from commercial banks, which have plenty of room to expand lending. According to the CBRC, commercial banks will be able to issue credit to raise the capital base for investment projects. Once the project accumulates an adequate capital base, it can seek further loans. Banks have already been heralded to help China boost domestic consumption.
2.3 Credit Quality
A repeat performance is exactly what some fear after the latest binge. Will this recent surge in loans cause a return to the huge level of bad loans that saddled the banking system at the beginning of the new millennium? That future answer will depend on the lending disciplines in making the loans. It will also depend on whether these loans will generate needed capacity in China.
Most worrying are loans to infrastructure projects sponsored by LGSFPs (perhaps a sixth of outstanding loans), and real-estate financing and mortgages (a fifth of the total, with some overlap with infrastructure loans). China’s bankers feel comparatively relaxed but some investors are kept awake by visions of corrupt officials, roads to nowhere and deserted shopping malls.
Although potentially severe, these bad debts will not necessarily be the downfall of the Chinese banks. Even if a chunk of the loans is written off, the system can absorb the hit. That is partly thanks to an impressive regulator, which has prodded banks to raise capital. But it is mainly because of China’s high savings rate. With piles of excess deposits banks do not rely on fickle debt markets for funding. That buys them time to earn their way out of a bad-debt problem, using their high lending profits to replenish capital. As a backstop, China’s government, with little debt and large foreign reserves, has deep pockets.
2.4 Profitability revisited
The reform of the banking system has been accompanied by PBC’s decision to decontrol interest rates. Market-based interest rate reform is intended to establish the pricing mechanism of the deposit and lending rates based on market supply and demand. The central bank would continue to adjust and guide the interest rate development, which allows the market mechanism to play a dominant role in financial resource allocation.
The sequence of the reform is to liberalize the interest rate of foreign currency before that of domestic currency, lending before deposit, large amount and long term before small amount and short term. As a first step, the PBC liberalized the interest rates for foreign currency loans and large deposits (US$3 million and over) in September 2000. Rate for deposits below US$3 million remain subject to PBC control.
The full liberalization of interest rates on other deposit accounts, including checking and saving accounts, is expected to take much longer. On the lending side, market-determined interest rates on loans will first be introduced in rural areas and then followed by rate liberalization in cities.
If China manages to digest its recent lending boom without a slump and then rebalance its economy away from investment and towards consumption (hopefully?), banks will need to free up space on their balance-sheets for lending to individuals and small firms. The heavy lifting of financing infrastructure and state companies will shift to bond markets. As customers have more sources of finance, banks’ lending profits will be squeezed, forcing them to diversify into capital-market activities like underwriting. Banks’ buffers of deposits should also shrink, relative to loans, as the savings rate falls and as people move cash into higher-return shares and bonds (earning banks fees in the process).
China’s banks could then end up looking a lot like banks elsewhere, although the state will still have control. Yet even that could change gradually. At current growth rates China’s banks will need capital injections every few years. The government is reluctant to provide additional capital on regular bases. That will lead to diluted stakes in the long run.
2.5 Foreign banks in China
Foreign bank presence in China remains insignificant, currently constituting just over 2% of the total banking assets. In December 2006, reflecting its commitment to the World Trade Organization, China removed all geographic and most business restrictions on foreign banks. But the authorities set regulatory requirements on retail banking, so effectively most global banks in this area are still restricted. As a result, foreign banks have only set up locations in the largest cities, with Shanghai hosting 30% of foreign bank outlets.
By the end of 2009, 229 representative offices, 33 locally-incorporated foreign banks (with 199 branches under management), 2 jointly-run banks (with 6 branches and 1 local subsidiary), and 95 foreign bank branches have been established. 32 locally-incorporated foreign banks and 49 foreign bank branches have been approved to conduct RMB-denominated business operations.
At the year end of 2009, the total assets for foreign banks reach 1.35 billion RMB, an increase of 0.33% y-o-y, representing 1.71% of total banking assets. Total liabilities stand for 1.18 billion RMB, representing 1.59% of total banking liabilities.
Regulations restrict foreign ownership in a Chinese bank to a 20% or 25% with multiple foreign investors. American Express, Goldman Sachs and Allianz Investments hold stakes in the ICBC. Bank of America is a shareholder in the CCB and Singapore’s Temasek Holdings, the Bank of Tokyo Mitsubishi and the Asian Development Bank are investors in the BOC. Other foreign institutional investors hold various stakes in a few city commercial banks.
3. Regulation and Supervision
Two watchdogs exist for Chinese Banks. One is the PBC, and the other is the CBRC. The PBC is mainly concerned with money supply, and the CBRC focuses on banking supervision and regulation.
3.1 Roles of the PBC
The PBC started functioning as the country’s central bank of China in 1983, its supervisory responsibilities of the banking system was transferred to the CBRC in 2003. The PBC employees the more traditional monetary policy instruments to guide the money markets, including varying required bank reserve levels on loans outstanding, setting base interest rates and performing open market operations in local government bonds and foreign currency. Unlike its US counterpart, the PBC doesn’t independently form monetary policies, and its policies simply reflect the dictates of the State Council.
3.2 Functions of the CBRC
Ever since its establishment, the CBRC has made it clear that conducting consolidated and risk-based supervision, strengthening internal controls of supervised institutions and enhancing transparency are the cornerstones of its supervisory philosophy.
In 2004, the prudential banking regulatory framework took shape. The CBRC formulated rules for capital regulation and risk-based supervision, which specified the regulatory requirement of capital adequacy, asset quality, credit risk and market risk.
In 2006, the risk-based regulatory framework was further improved. The supervisory legal framework was refined with respect to corporate governance, internal controls and compliance management. As the banking reforms progressed, the banking industry moved into a new era of development. The ICBC, the BOC, the BoCom successfully launched their initial public offerings (IPOs) in the domestic and international capital markets.
In addition, China honored its commitments to the WTO in the banking sector. The CBRC also accelerated the construction of financial service system in rural areas by adjusting and relaxing the market entry policy for banking institutions in the rural area under the principle of commercially viable strategy.
3.1.1 Prudential Requirements
The CBRC is responsible for prudential supervision of China’s banking sector. The CBRC has used a set of simple ratios, limits and targets, modeling to supervise Chinese banks. Those ratios, limits and targets will be constantly adjusted to accommodate for the macro economy.
For example, regarding CAR ratio, the required level has been raised from 8% to over 10%. Besides, the CBRC emphasize the quality first and require a simple structure of the capital, with common equity and retained earnings occupying no less than 75% of Tier-1 capital, much higher than the 25% in some developed markets. The provisioning coverage ratio surged from 19.7% in 2003 to 155% at the end of 2009, a strong buffer against expected losses. The loan-to-deposit ratio is 75%, core funding ratio 60%, and liquidity ratio of 25%. The major deposit-taking institutions are also required to have a 16% reserve ratio with the central bank, which automatically gives them access to liquidity facility in case of need. The CBRC also requires a dynamic loan-to-value (LTV) ratio, a debt-to-income (DTI) ratio and at least 40% down payment requirement for second home mortgage loans today, which proves to be quite effective in curbing excessive speculative risks in the property market. For large credit exposures, the maximum limit to a solo corporation that a bank could provide should be no more than 10% of the bank’s capital base, for group client, no more than 15%.
Since its establishment in 2003, the CBRC has introduced a series of counter-cyclical prudential supervision measures. For example, it requires commercial banks to increase counter-cyclical capital buffer and small and medium-sized banks to have a capital adequacy of higher than 10%. As for large commercial banks with systemic importance, it requires the capital adequacy higher than 11%. In addition, it places stringent requirements on the size of banking sub prime debts, and making clear that banks’ cross-holding sub prime debts can not be counted as capital.
These counter-cyclical prudential supervision measures have effectively restrained commercial banks from credit expansion and other short-term acts, thereby enhanced the ability of China’s banking sector to withstand risks. Counter-cyclical supervision policy has become an important part of China’s macro controls.
At the current stage, the CBRC is closely monitoring risks associated with fixed asset loans, especially those placed by LGSFP projects and the real estate sector. The CBRC issues warning timely signals to alert banks of the prominent risks. The CBRC also combined the related information of large exposures of over 190 banking institutions under our radar screen into its database for better examination and scrutiny. Prompt remedial and corrective actions were taken against the excessive concentrated portfolios, irregularities in the credit cards issuance and bill acceptance, disqualified projects with shortfall of equity as well as abuse of the loans for speculation.
Apart from targeted regulations from the micro perspective, the CBRC implements macro-prudential regulatory measures. The CBRC has made two significant decisions. The CBRC prohibits banks from guaranteeing corporate bonds, and forbids banks from cross holding the subordinated debts as Tier-2 capital. Thus, the CBRC ensures that a healthy firewall is in place between credit market and capital market. At the same time, Chinese Banks are required to adjust their business development plans, capital replenish schemes, profit distribution and compensation packages. By such a doing, the CBRC focuses on risk-based supervision with a clear roadmap, and banks will be better to absorb both the expected and unexpected losses. We think we are balancing the two stories, limiting systemic risk by a brand new framework and building a banking system that fulfills its role in the Chinese economy.
3.1.3 Assessment against Large Commercial Banks
The CBRC assesses the shareholding restructuring of large commercial banks against a quantitative benchmark of seven parameters covering three areas, including operational performance, asset quality and prudent operations. Operational performance parameters include net return on total assets, net return on equity, and expense to revenue ratio. Asset quality parameters refer to NPL ratio and prudent operations parameters include capital adequacy ratio, large exposure concentration and coverage ratio of loan loss provisions. Specific requirements are as follows:
- Net return on total assets shall be 0.6 percent in the second year after the completion of financial restructuring and up to good international standard within three years;
- Net return on equity shall achieve 11 percent in the second year after the completion of financial restructuring and increase to over 13 percent gradually in the subsequent years;
- Cost to revenue ratio shall be controlled within 35~45 percent starting from the second year of financial restructuring;
- Reformed banks shall classify credit assets in strict accordance with the five-category loan classification standards and evaluate the quality of credit assets in accordance with the criteria of the 5-category classification. NPL ratio shall be controlled below 5 percent after the financial restructuring;
- Reformed banks shall conduct capital management in strict accordance with the Administrative Rules Governing the Capital Adequacy of Commercial Banks and maintain the capital adequacy ratio above 8 percent continuously after financial restructuring;
- Reformed banks shall strictly control the concentration risk of facilities granted to the same borrower and keep the outstanding loan to the same borrower below 10 percent of total capital of the bank;
- Reformed banks shall maintain the coverage of NPL provision no less than 60 percent when financial restructuring is completed and increase the coverage to 100 percent within five years provided that financial soundness is ensured.
The CBRC shall continuously enhance the process management, by monitoring the operations and progress of reformed banks during restructuring based upon the above benchmark. Reformed banks shall set up their internal corresponding risk monitoring mechanisms and proactively cooperate in the implementation of risk monitoring.
4. Looking Forward
So the Chinese banks make money and have the trappings of public companies, the state owns a majority stake and the Communist Party appoints the top brass, whose pay is a fraction of that of their Western peers. Those bosses, with their dual role as party bigwigs and chief executives, are beholden to a higher authority than the stock market.
And the Chinese banking system is pretty closed. Some foreign banks have minority stakes in Chinese firms. But foreigners’ own operations in China are insignificant, while Chinese banks make less than 4% of their profits abroad. So what will Chinese banks look like? No one is sure about the future, except for one thing, uncertainty.
I would rather suggest the following topics, which are important to my best knowledge.
4.1 Go-out Challenges
Go-out Policy is the Chinese Government’s current strategy to encourage its enterprises to invest overseas. Most nations favor actively attracting inward foreign investment, and would only support outward foreign investment passively. The government of PRC attaches importance to both inward and outward foreign investment, due to huge amounts of foreign reserves, and associated appreciation pressure on RMB. Indeed, the international community is keen on floating RMB. In order to deflate that demand, the Chinese government actively seeks to employ its foreign reserves by acquiring assets overseas.
The Go-out Policy was an effort initiated in 1999 by the Chinese government to promote Chinese investments abroad. The main purpose is to assist domestic companies in developing a global strategy to exploit opportunities in the expanding and international markets. China’s domestic market is becoming ever more competitive as more companies battle fiercely for their slice of the most populous consumer. As multinationals enter China markets, Chinese companies will lose their natural competitiveness. In response, there is an urgent call for Chinese companies to master new skills that traditionally reside with non-Chinese multinationals: in areas like marketing and branding, higher value-added goods and services, advanced technological innovation and management. Another significant driver of China’s globalization strategy is the desire to secure the energy and resources needed to sustain economic growth. More than half of the economy’s overseas investment has been in the resources sector as Chinese companies have taken stakes in oil-production facilities in Algeria and Canada, natural-gas reserves in Iran and Saudi Arabia, and mining projects in Australia, Brazil, Papua New Guinea and Zambia, to name a few.
With the help of state diplomacy and loans in regions like Latin America, energy companies such as Sinopec and CNPC have been able to secure large energy-exploration and development projects as well as joint projects with local energy companies. By associating themselves with a top brand name or product, Chinese companies can quickly raise their international profile as well as gaining instant access to new markets. Lenovo’s purchase of IBM’s personal computer and Geely’s acquisition of are the most often cited example of this strategy.
With the integration of world economy and globalization of finance, the Chinese banking industry will vigorously expand its international profile and upgrade its service capacity, to fully accommodate domestic enterprises’ financial needs. The Chinese banks continue to upscale its presence throughout the world. 2009 saw fruitful results for the Chinese banks. The establishments of ICBC Malaysia and Abu Dhabi Branch have received regulator’s approval.
By the end of 2009, altogether the big 5 banks have established 86 tier-1 operational entities in Asia, Europe, America, Africa and Oceania, also acquired or invested in 5 overseas institutions, with the business operations covering various finance sectors such as commercial banking, investment banking, insurance etc. Five joint-stock commercial banks has also set up branches, representative offices or conducted overseas acquisition.
4.2 Basel Accord Implementation
In July 2009, the BCBS approved a final package of measures to strengthen the 1996 rules governing trading book capital and to enhance the three pillars of the Basel II framework. The package was part of the BCBS’s broader program to strengthen the regulatory capital framework. The program aimed to introduce new standards to
- promote the build-up of capital buffers that can be drawn down in periods of stress;
- strengthen the quality of bank capital;
- introduce a leverage ratio as a backstop to Basel II.
Under this program, the BCBS took measures to mitigate any excess cyclicality of the minimum capital requirement and to promote a more forward-looking approach to provisioning.
The CBRC has taken great efforts to implement new Basel accord. To align China’s practice with international standards, the CBRC revised seven policy documents following the Enhancement to Basel II Framework by the BCBS, namely,
- Supervisory Guidance-Internal Model Approach to Capital for Market Risk;
- Supervisory Guidance-Interest Rate Risk on Banking Book;
- Supervisory Guidance-Information Disclosure on Capital Adequacy Ratio and its template;
- Supervisory Guidance-Validation of AMA Approach;
- Supervisory Guidance-Calculation of Capital Adequacy Ratio;
- Supervisory Guidance-Regulatory Capital for Exposure in Asset Securitization;
- Supervisory Guidance-Supervisory Review for Capital Adequacy Ratio;
In the field of implementation preparation, the CBRC conducted two rounds of Quantitative Impact Studies (QISs), to assess the likely influence on capital ratios on related banks from implementation of new Basel Accord.
Although there are some critics and reservations towards new Basel Accord, the CBRC is determined to push forward its implementation in China. The CBRC believes that the new Basel Accord is a great boost to corporate government and risk management, and will greatly uplift Chinese Banking Industry’s international profile. The CBRC has setup its implementation roadmap. By the end of 2010, the 7 new-Basel-accord banks should apply for implementation from the CBRC, and the rest of Chinese banks should follow suits, and by the end of 2013 all Chinese banks should implement new Basel Accord.
4.3 International cooperation for banks and supervisors
In the 1970s, with the increase of overseas bank operations, people had a heated debate on who should supervise the liquidity of these operations and the potential solvency risks. The Basel Agreement in 1975 laid down the principle of consolidated supervision, and the Basel Accord in 1988 resolved the issue of unfair competition caused by difference in capital requirements of different countries. The Basel Agreement was further improved in 1996 and 2004 respectively. It is safe to say the Basel Agreement is an excellent example of global financial supervisory cooperation. At present, the globalization of financial market has entered a new stage. On the whole, however, global financial cooperation is mainly about the coordination and cooperation between parent and host countries and about the framework for capital supervision, which is not sufficient to facilitate the establishment of a unified, effective global financial supervisory system. The liquidation of Lehman Brothers fully revealed the legal barriers and political resistance in cross-border liquidation. Even in the euro zone where a single monetary system and a single central bank are established, financial supervision is local, although the sovereign of monetary policy has been transferred and the financial market has been unified.
Financial globalization is inevitable. Localization of financial services and aggregation of financial transactions are two trends of the financial globalization. Large-size cross-border financial institutions and international financial centers are important force driving these trends forward. Mutual entry of large financial institutions and localization of financial services will promote the interaction between the supervisory authorities of the countries concerned and the unification of supervisory rules, and the emergence of international financial centers will push the global community to accept unified transaction and supervisory rules. In this sense, in order to build Shanghai into an international financial center, we need to strengthen the international supervisory cooperation and participate in the development of and abide by globally shared transaction and supervisory rules.
The Chinese Government is active in international supervisory cooperation. In 2009, the CBRC became an official member of FSB and BCBS, and since then it has fully participated in the dialogues on financial supervision policies under the framework of FSB and BCBS. In addition, The CBRC have participated in the multilateral dialogue and consultation on financial supervision policies under the G20, actively joined the FSAP organized by IMF and World Bank, and carried out effectiveness self-assessment as per the Core Principles for Effective Banking Supervision. The CBRC are also actively promoting the implementation of the Basel II Capital Accord in Chinese commercial banks.
4.4 Likely change from regulators
Recently rumors are circulating around Beijing about possible regulators’ reshuffle. One plan is like this, to combine all regulators, such as the CBRC, the CIRC and the CSRC into a super watch dog, just like FSA in United Kingdom.
However, no fact so far has verified definitive relationship between financial stability and supervisory framework. The complicated, overlaying supervisory architecture of the US has failed to effectively guard against the global financial crisis. Similarly, the unified supervisory architecture in the UK has performed no better. Just like there is no unified corporate governance model in the world, there is no one-fits-all supervisory architecture either.
So long as the supervisors of a nation can make independent and responsible supervisory decisions, the confidence of the financial intermediaries and investors will be increased and the risk premium will be lowered, thus enabling the financial sector to boost the real economy. The CBRC have also noticed that although the supervisory architecture has no necessary relation to supervisory independence, all countries are trying to enhance the independence of supervisors through the reform of supervisory architecture.
China has, in light of its own development stage and financial market deepness, established the system of segregation of financial business, the system of segregation in the supervision of financial institutions, as well as the system of primary supervisory bodies under the supervisory collaboration framework. The practices have proved that this supervisory architecture is in line with the current development stage of China’s financial market.
3. Annual Reports from ICBC, ABC, CCB, BOC and BoCom;
 For the purpose of this article, China does not include Hong Kong SAR, Macau SAR and Taiwan.
 For the purposes of this article, the term “banking” or “banks”, is equivalent of commercial banks, meaning enterprise legal persons that are established in conformity with Commercial Bank Law and the Company Law of the People’s Republic of China and that take in deposits from the general public, grant loans, handle settlements, etc., excluding non-banking institutions, such as Trust companies, finance companies, etc.
 Central Huijin Investment Ltd. (“Huijin”) is a wholly state-owned company incorporated in accordance with the Company Law of the People’s Republic of China. Established on 16 December 2003, Huijin has a registered capital of RMB552.117 billion and paid-in capital of RMB552.117 billion. Its legal representative is Mr. LOU Jiwei. Wholly-owned by China Investment Corporation, Huijin makes equity investments in key state-owned financial institutions, as authorized by the State Council. On behalf of the state, Huijin exercises the rights and fulfils the obligations of an investor, in accordance with laws aimed at the preservation and appreciation of state financial assets. Huijin does not engage in other business activities.
 The CBRC has designated ICBC, ABC, BOC, CCB, BoComm, SDB, CMB and Pudong Development Bank as the first batch of banks to implement the new Basel Accord.
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