China must stand by its new bank rules

By Stephen Harner

Published: July 7 2004 18:58 | Last Updated: July 7 2004 18:58

Abrupt declines in bank lending in China have raised fears of both a credit crunch and a hard landing for the Chinese economy. Local governments and some Beijing think-tanks have urged the State Council to rescind its orders for banks to curb lending to over-heated sectors such as steel. Yet that would be futile. China 's banks have stopped lending not so much in dutiful compliance with State Council orders as in a near-panic response to the "new paradigm" regulatory regime brought in by the China Banking Regulatory Commission.

The CBRC's bold new approach is sending shock-waves through the banking sector. But it may be essential if China is to restore solvency to its financial system, remove the bias against private-sector borrowers and reverse the disastrous decline in productivity of capital investment seen in recent years.

The essence of the new regime is a shift from a "funds constraint" to a "capital constraint" system of controlling growth in banking system assets. It is a profound change. Since their establishment in the 1980s, Chinese banks - virtually all state owned - have basically functioned as aggregators of domestic funds (deposits) and dispensers of loans and investments. In the tradition of central planning, the primary goal of the regulator (which before the CBRC's establishment last May was the People's Bank of China, the central bank) was to ensure that bank loan growth did not exceed a prudent proportion - generally about 75 per cent - of deposits. For the banks, the "loan-to-deposit ratio" - the funds constraint - has been the only really "hard" regulatory target they have been required to meet.

The loan-to-deposit ratio requirement has driven a number of phenomena: the tendency to build vast, expensive, deposit-gathering networks; the relentless, relationship-driven drive for deposits; breakneck growth of loans when, as in 2002 and 2003, economic activity has been robust; and inattention to the credit quality or profitability of asset growth. The reality is that the loan-to-deposit ratio constraint has often not been a constraint on banking at all; rather it has driven periodic credit-driven boom cycles and economic overheating.

For a banking system accustomed to the loose-fitting and expansive world of business based on deposit growth, the CBRC's new "capital constraint" regime, effective from March 1, appears like a straitjacket. It requires China 's commercial banks to meet requirements of 8 per cent for total capital adequacy and 4 per cent for core capital adequacy by January 1 2007 . In the interim, the banks must "formulate and implement a feasible phase-in plan to comply with the regulations". It is in coming to grips with the new rules that China 's banks have slammed the brakes on lending.

The new regulations require banks to calculate capital adequacy based on full provisioning for potential loan losses, more conservative risk weightings for various asset classes, and the requirement for capital to cover market risk as well as credit risk. They remove a bias in favour of the state sector by assigning a risk weighting of 100 per cent to loans to very large and large state-owned companies (the weights were 50 per cent and 70 per cent under the previous system). Local government projects too are now accorded a 100 per cent risk weighting.

Most importantly, the CBRC seems determined to enforce the regulatory regime, under which boards of directors are responsible for managing capital adequacy and must report to the CBRC every quarter. In extreme cases, of undercapitalisation, the CBRC can take over the bank.

During 2003 many Chinese banks raised additional capital. Many more plan to do so this year, by, for example, attracting investment from foreign banks. But even those banks that thought they had met capital adequacy standards are finding that under the new regulations they now fall a long way short. Having just made cash calls on old investors and promised returns to new ones, these banks are agonising about how to close the newly opened gap (issuing subordinated debt seems to be the first and easiest option).

If banks are to meet the CBRC's new standards, they will need a completely different management ethos and model: one based on asset quality and profitability. This, certainly, is the central objective of the CBRC's bold new regulatory regime. It is also the reason why successful implementation of that regime is critical for China 's economy - and for that of the world.

The writer is a financial industry consultant in Shanghai and sits on the board of Hangzhou City Commercial Bank as an independent director


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