Supervisory developments in China’s banking industry and
a macro perspective to banking supervision

Liu MingkangChairman of the China Banking Regulatory Commission

Profound structural changes have taken place recently in China’s banking industry. The financial restructuring of the four large banks - Bank of Communications (BoCom), China Construction Bank (CCB), Bank of China (BOC) and Industrial and Commercial Bank of China (ICBC) is complete.

The BoCom and CCB both have successfully completed their listings in Hong Kong. US＄1.89bn was raised for BoCom’s initial public offering on June 23, 2005. The landmark IPO in October brought the CCB US$9.23bn, which makes it the world’s biggest IPO since 2001 and the biggest one for a bank worldwide. As the CCB is the first Chinese state-owned bank listed overseas, the listing serves as a litmus test for similar initial public offerings in the years ahead. It can be expected that the listing in the developed global markets will help enhance transparency, thereby introducing strong market discipline and positive management incentive into these banks.

Clearly, the government’s efforts to restructure the banking sector have gained further momentum. Following US$45bn capital injection into BOC and CCB in December 2003, the government again injected another US$15bn of foreign exchange reserves into the ICBC this April. By the end of September，the core capital adequacy ratio is 9.23％, and the capital adequacy ratio is 10.26％ respectively. Its non-performing loan ratio stood at 4.63% at the end of September. Following its official incorporation on October 28, 2005, the bank has been transformed into a share holding limited company, Industrial and Commercial Bank of China Limited.

These banks, ICBC together with BOC, CCB and BoCom representing approximately 50% of market share in terms of assets, have restored solvency. This has strong implications for the supervisor as it has helped create an essential element for a sound banking industry. It is encouraging to note that by the end-September, nearly 70% of banks measured in terms of assets, are in compliance with the supervisory capital requirement.

Indeed, following the financial restructuring, all reforming banks have also taken positive steps to upgrade their business model. These steps include the setting up of commercially oriented corporate and management structures. For example, the reforming banks have engaged independent directors, who are by and large international talents, to chair the specialized committees under the Board. They are putting more emphasis on management accountability and have started to centralize operations, thus increasing an effective control over branches, and strengthening internal audit and internal controls. Reforming banks are actively seeking to hire, with success, experienced international talents to fill in such key positions as CRO, COO and CFO. As a result, the credit ratings for these banks have all been upgraded by international rating agencies.

Given the mandate, the CBRC has the responsibility to closely monitor the performance of the reforming banks. With a view to keeping abreast with new developments in this area, the CBRC has recently started to review the assessment criteria or goalposts, in our jargon, that we set out two years ago in terms of corporate governance for those large banks. While leveraging off the experience learnt over the past two years as well as guidance globally in corporate governance, we expect the revised guidance for corporate governance to be more comprehensive and specific, where appropriate, for evaluation purposes.

The reform of rural credit cooperatives (RCCs) has also made further progress. With capital injection and non-performing loan carve-off, the financial strength of RCCs has been substantially improved, and their capital position has improved significantly. By the end of October 2005, 11 rural commercial banks and 44 rural cooperative banks have been set up or been approved to prepare for incorporation.

On another front, the CBRC believes that foreign financial institutions have the potential to make our banking sector stronger and more resilient to various shocks. Therefore, we, the supervisor, have worked decisively to promote foreign participation in local Chinese banks. Indeed, following the issue of the rule for foreign participation in local Chinese banks, which for the first time sets out a clear and favorable supervisory framework in this area, 19 foreign investors so far have taken equity shares in 17 local banks. Approximately US$13bn of foreign direct investment in local banks accounts for 14% of domestic banks’ capital base. The initial impact of foreign participation on local banks is significant indeed, particularly in terms of sound corporate governance.

A major challenge for the banking supervisor in China continues to be the reduction of non-performing loans in the banking industry and, what is more, to prevent the resurgence of NPLs going forward. Over the past year, we have stepped up the monitoring of loan quality, with the help of three new tools, such as peer group analysis, measuring the deviation of loan classification and loan migration. It is encouraging to note that banks’ balance sheets have improved and the trend is likely to continue. By end-September 2005, the NPL ratio for commercial banks as a whole dropped to 8%.

As is increasingly the case in the developed markets, the supervisor should address not only micro aspect of prudential supervision but also macro aspect. In other words, in addition to stressing the safety and soundness of individual banks, the supervisor should consider the systemic or macro issues relating to banking supervision. From a supervisory standpoint, many of the measures that we have taken and will be taking in years ahead are closely aligned with macro-prudential supervision. These measures are aimed at enforcing prudential rules, promoting sound risk management so as to avoid an excessive build up of exposures in individual banks and the banking system as a whole. To a large extent, our supervisory rules and policies are intended to have a consistent and appropriate impact on the economic cycle. Let me be a little bit specific.

First, as we are taking serious efforts to enforcing capital rules, we also believe that capital standards should reflect a long term view of risks in the system rather than the most recent events, be they optimistic or pessimistic. Chinese banks have come to fully recognize, for better or worse, the size of capital as a binding constraint for balance sheet expansion. In so doing, they have taken drastic measures to reduce risk-weighted assets, particularly the exposures to high-risk borrowers or investment projects. Indeed, bank credit in 2004 grew at a rate of 14.5%, much below the 21% growth rate in 2003. And for 2005, credit growth is most likely to fall far below the 15% target as well. Clearly, prudential rules in form of capital regulation serve as an effective tool to address reckless growth of bank lending while producing much less side effects than administrative instruments. And this also partly explains why there is so much liquidity in the system but bank credit is no longer readily available, a Chinese conundrum perhaps.

Second, we have urged our banks to limit risks from large exposure and loan concentration. Banks are required now to report to the supervisor detailed account information on large borrowers over and above Rmb100 m or US$12m. We will then send to bank aggregated exposures to each individual borrower for their reference so that they will have an overall picture of whether they have overextended themselves to an individual customer, which helps reduce a potential threat to banks and the economy at large. A similar approach has been adopted as our response to real estate lending, with a strong emphasis on enhanced risk management for property loans, such as a minimum of 35% of own fund requirements for property developers, 80% loan to value ratio (LTV). As a result, partly at least, property lending was up by 21% by end-August this year, in sharp contrast to 47% growth rate in 2004. As of August, property loans amounted to Rmb 2.93 trillion, 14.7% of the total loan portfolio.

Last but not the least, we have asked banks to consider a change in mindset towards lending to small businesses, following the issue of a set of guidelines on banking lending to small businesses. The importance of promoting access by small businesses to banking services and banks’ innovations in lending to small businesses should be seen in the broader context of a sound development strategy for the entire banking sector and a proactive adjustment of banks’ balance sheet. Indeed, the impressive growth of small businesses in China over the years justifies more banking services. They account for 90% of enterprises in China, generating one third of the GDP. And as private sector businesses mostly, they also have a relatively clearer ownership structure and value their creditworthiness and opportunity to access to banking services. In essence, what we encourage here is innovations in banking practice that has the potential to contribute to a sound banking sector and a sound economy in general.

Overall, in its efforts to build a strong banking sector and a robust supervisory system, the CBRC has developed a roadmap for the future. With a view to benchmarking the bank supervision to international standards and practices, the CBRC launched a self-assessment against the Basel Core Principles for Effective Banking Supervision in the early days of its inception. The purpose of this exercise was to identify the gaps and deficiencies and set out an action plan for improvement. Over the past years, the CBRC has worked hard to improve its record of compliance. On the regulatory side, the CBRC issued a number of new rules on bank’s internal controls, market risk and operational risk. Further, specific guidance on securitization, derivative instruments and wealth-management has also been made available. On the supervisory side, in addition to improving the supervisory reporting system, procedures and processes for on-site examination and off-site surveillance processes have been strengthened, incorporating international best practice at the same time. The CBRC has also taken concrete measures to enforce clear lines of responsibility and accountability internally. Our objective is to put in place all the essential elements for banking supervision in 2006 and achieve broad compliance of the Basel Core Principles in 2012. However, the improvement of banking supervision cannot proceed in isolation. We would very much like to see further progress in the strengthening of capital markets, bankruptcy law, foreclosure rules as well as enhancement of overall credit culture.

To conclude, China continues to dominate newspaper headlines by its one of the most sustained and rapid economic transformations seen anywhere in the world economy. The output growth has averaged 9.5% over the past two decades. However, further economic expansion can not be based on increased consumption of resources but the rise of productivity. To address the challenges, China’s leadership recently released its economic blueprint. It calls for raising living standards while improving the efficiency of China’s use of energy and other resources. The draft proposal also reiterates China’s determination to build international competitiveness of its industries, improve social welfare and reduce incidence of poverty. The rapid and substantial pace of economic developments in the real economy and orientation of government’s macro-economic policies constantly remind the supervisor of the need to look at banking supervision on a system-wide basis. While working hard to improve the resiliency of our banking system, we, the supervisor, stay focused on the pursuit of public policy objectives. These objectives remain the same as always: protecting the interests of depositors and maintaining stability in the banking system that will in turn foster a sustained economic growth.