The Guidelines on the Implementation of the New Basel Accord by China’s Banking Sector

In June 2004, the Basel Committee on Banking Supervision published the International Convergence of Capital Measurement and Capital Standards: A Revised Framework (also called the New Basel Accord, hereinafter referred to as the “Basel II”). The Basel II introduces three pillars for effective capital regulation, namely: minimum capital requirements, supervisory review and market discipline. The Basel II represents the future direction for the development risk management and enhances the risk sensitivity and flexibility of capital regulation, which is conducive to the improvement in risk management and business innovation of commercial banks. The implementation of the Basel II will promote the development of banking supervisory technology, enhance the effectiveness of market discipline, and improve the security of the international banking system. In view of these reasons, the Basel Committee actively pushes forward the worldwide implementation of the Basel II, and in response, almost a hundred countries or regions have clearly expressed their intention to adopt it.

The Guidelines on the Implementation of the New Basel Accord by China’s Banking Sector are formulated with a view to steadily pushing forward the adoption of the Basel II in China and enhancing the effectiveness of the capital regulation, thus underpinning the stability of the Chinese banking system.

I. The strategic significance of the Basel II Implementation

（i）The Basel II provides tools and impetus to commercial banks for risk management improvement. Based on the risk management theories and practical development, the advanced approaches under the Basel II provide banks with direct reference aids to update their risk measurement techniques, make a sound organizational framework for risk management, and re-engineer risk management procedures as well. What’s more, the banks’ construction of risk management system in line with the requirements of the Basel II will be helpful to disclose and dynamically monitor banks’ credit risks in time and make banks’ credit activities and operating behavior more rational.

（ii）To implement the Basel II is an inevitable choice for Chinese commercial banks to sharpen their international competitive edge. As China’s transitional period of WTO entry has come to an end, foreign banks in China will soon compete with domestic banks in an all-round way. In the mid to long term, the large Chinese commercial banks will also venture out into the international market for further growth, where they will face much extensive and fierce competition. Consequently, it is necessary to promote the adoption of the Basel II among large complex commercial banks in China so as to guide them to improve their risk management capacities and help them build up into real modern commercial banks.

（iii）The Basel II implementation is of significance for the improvement of the effective banking supervision. The Basel II attaches great importance to the evaluation of banks’ capabilities to identify, monitor and control risks, with a view to promoting the communication and interaction between banks and supervisors, which enables the capital regulation to be better aligned with banks’ risk management capacities and is consistent with the CBRC’s supervisory concept of principle-based supervision.

II. Objectives and Principles of the Basel II implementation

（i）          Objectives of the Basel II implementation

The promotion of the Basel II implementation aims to help banks improve their risk measurement methods and set up a sound risk management system in a bid to sharpen the Chinese banks’ international competitive edge. In the meantime, the capital regulation and the effectiveness of banking supervision are expected to gain further development with the implementation, thus promoting the sound and sustainable development of the banking industry.

(ii)  Principles of the Basel II implementation

In view of the current development status and external environment, it is not yet mature for all the banks in China to fully adopt Basel II. Therefore, the China’s banking sector should stick to the following three principles when implementing Basel II:

First, banks in different size are subject to different capital regulation requirements. Commercial banks in China vary largely from one another in terms of asset scale, business complexity, risk management level, as well as the degree of internationalization. Therefore, different banks should be treated differently and it is not mandatory for all banks to implement the Basel II. To be in detail, it is better for those numerous small and medium-sized banks to adopt an appropriate capital regulation mechanism that fits their business scale and complexity so as to reduce the compliance cost on capital regulation. However, as for large-scale banks, to implement the Basel II will be conducive to not only the improvement of their international competitiveness, but also the long-term development objectives. Moreover, it is technologically practicable and economically accords with the cost-benefit principle.

Second, the implementation of the Basel II by the Chinese banking sector should be proceeded gradually. Given that large banks in China are not at the same scratch line with regard to the development of internal rating system, quantitative risk measurement models, as well as the organizational framework process for risk management, the CBRC is aware that they will accordingly vary from one another in terms of the time limit to satisfy the requirements for the Basel II implementation. Therefore, the CBRC not only encourages banks to improve their risk management and to adopt the capital measurement approach with high risk sensitivity, but also allows banks to move to the Basel II at different period of time. This principle aims to make sure that banks are fully prepared for rather than irrationally rushing into the implementation, thereby ensuring the effectiveness of the Basel II adoption.

Third, banks are permitted to meet the Basel II standards step by step. Basel II stipulates many conditions for banks to use capital measurement approach with high risk sensitivity, which covers many aspects such as the asset classification, quantitative risk measurement, organizational framework and policy process for risk management, etc. Obviously, it is a gradual and long-term course to meet all the standards; therefore, banks must, base on their own situation, make an overall plan and gradually meet the Basel II standards in a phased, well sequenced manner. In face of the three kinds of risks, namely, credit risk, market risk and operational risk, large banks should develop measurement models for credit risk and market risk in the first place. As far as the credit risk is concerned, the internal rating system should be advanced at the current stage with priorities given to the loans (including corporate risk exposure and retail risk exposure).

III. Scope of the Basel II implementation

According to the first principle, the CBRC classifies commercial banks into two categories, which are subject to different capital regulation requirements.

（i）Banks required to adopt Basel II (the Basel II banks). Those large banks with operational entities in other countries or regions (including Hong Kong, Macao and Taiwan) and with large proportion of international businesses, should adopt Basel II.

（ii）Other banks. Commercial banks in this category (including foreign bank subsidiaries) will continue to follow the exiting capital regulation requirements but are allowed to voluntarily comply with the Basel II. The CBRC will revise the existing capital regulation requirements (hereinafter referred to as the “revised capital regulation requirements”) by benchmarking to relevant standards in the Basel II for other banks to implement. 

iv. Approaches of the Basel II implementation

（i）Capital measurement approach for credit risk

a. Banks should adopt internal ratings-based (hereinafter referred to as “IRB”) approach to calculate the credit risk capital. And the CBRC encourages banks to apply advanced IRB approach.

b. Banks that are to adopt IRB approach should meet the supervisory requirements and be subject to the CBRC’s approval before the adoption.

c. The CBRC allows banks to adopt the IRB approach in a phased manner, but when the bank is approved to apply the IRB approach, the asset coverage ratio to apply the IRB approach should be no lower than 50 per cent (asset coverage ratio=risk weighted assets calculated by the IRB approach / [risk weighted assets calculated by the IRB approach + the risk weighted assets of other credit exposure calculated by the revised capital regulation]). The plans for applying the IRB approach in a phased manner need to be laid out as well to ensure the asset coverage ratio reach 80 per cent within three years.

d. Regarding the credit risk exposure uncovered by the IRB approach, the risk weighted assets should be calculated according to the revised capital regulation requirements.

（ii）Capital measurement approach for market risk

a. Banks should adopt internal models approach to calculate the market risk capital. Where a bank has not yet met the requirements of using internal models approach at the appointed time, it may choose to adopt a standardized approach but simultaneously make a transition scheme for applying the internal models approach in a bid to meet the requirements within three years from the time to start Basel II implementation.

b. In the transitional period, banks are allowed to calculate market risk capital by using the combination of the standardized approach and internal models approach. However, only one of the approaches is allow to be applied to one particular type of risk.

C. Banks that are to adopt internal models approach should meet the supervisory requirements and be subject to the CBRC’s approval before the adoption.

（iii）Capital measurement approach for operational risk

The CBRC will accelerate the development of capital regulation for operational risk and announce, before the end-2007, the capital measurement approach for operational risk, conforming to the banks’ realities. Though the approach has not come out yet, banks should make adequate preparation by strengthening the operational risk management and accumulating related data.

（iv）oversight of capital adequacy ratio (CAR)

a. Banks should put in place sound procedures for internal capital assessment, set internal capital goals and work out strategies to maintain the capital strength. The internal capital assessment procedures should include the following five aspects, namely: oversight by the board of directors and senior management; sound capital assessment; overall risk assessment; monitoring and reporting system; and review of the internal control.

b. Banks’ capital should cover all material risks exposed. Apart from the risks stipulated in the Pillar I, banks should also make prudent assessments on at least the following three kinds of risks, including: first, the risks mentioned but not fully covered in the Pillar I, e.g. loan concentration risk; second, the factors that are not considered by the Pillar I, such as bank account interest rate risk and liquidity risk; third, external environment of banks, etc.

c. The CBRC will put in place supervisory review procedures to assess banks’ CAR, verify the soundness of assessment procedures of internal risk and capital in order to evaluate banks’ overall risk management capabilities and capital adequacy. On this basis, the CBRC will take appropriate supervisory measures to urge banks to improve risk management and risk resistance capacities.

（v）market discipline

a. Banks should put in place sound information disclosure policies, including information-disclosing methods for choosing contents as well as relative internal controls to ensure the appropriateness of the disclosure.

b. Banks should disclose all the important information related to the CAR calculation so as to facilitate the assessment by market participants on the prudence of capital measurement, thus enhancing the effectiveness of market discipline.

V. Timetable for the Basel II Implementation

（i）Before the end of 2008, the CBRC will successively issue supervisory rules regarding the Basel II implementation and make amendments to the existing capital regulation requirements by taking into account public opinions.

（ii）The CBRC will conduct Quantitative Impact Study (QIS) in 2009 so as to evaluate the impact of the Basel II implementation on the capital adequacy of banks.

（iii） Basel II banks should start the implementation from the end-2010. If by then banks fail to meet the minimum requirements set by the CBRC, they may, with the CBRC’s approval, postpone their implementation but not later than 2013.

（iv）The bank, which plans to adopt the Basel II, should make an official application to the CBRC at least six months prior to the adoption. The CBRC will start to accept such applications from the beginning of 2010.

（v）Other banks may propose an application for the Basel II implementation after 2011, by going through the same procedures as the Basel II banks do.

（vi）Other banks should be subject to the revised capital regulation requirements from the end-2010. Besides, if the Basel II banks have, by then, not started the Basel II implementation, they will also be subject to the revised capital regulation requirements.

VI. Main measures to promote the Basel II implementation

Being a crucial systematic project, the Basel II implementation is complex in techniques and strongly policy-oriented. Therefore, both supervisors and bankers, particularly the banks’ senior executives, should further understand the significance and implications of the Basel II, and make joint efforts to well prepare for the Basel II implementation. The main measures include, among others, the followings:

（i）To organize the preparation for the Basel II adoption. The preparation work is highly professional and requires large input of resources. Given this, the board of directors and the senior management of every Basel II bank should attach great importance to the implementation and set up its own task force headed by the bank’s senior executive(or designate a specific department to take the charge) in order to make an overall plan and coordinate the Basel II implementation in the bank. The said task force should also equip the bank with the necessary resources and ensure the steady progress of the preparation. The board should be responsible for reviewing and approving the implementation plan and material issues, listening to the reports of senior executives on a regular basis and overseeing the progress of the preparation. The senior management should work out and then implement the detailed schemes, acquire a good knowledge of the practical operations of the internal rating system as well as the risk measurement model, thus safeguarding the effectiveness of the risk management system.

（ii）To lay out feasible plans for the implementation. The adoption of internal ratings-based (IRB) approach for credit risk and the internal models approach for market risk requires banks to improve risk measurement techniques, re-engineer business procedures and nourish a risk-mitigation culture. These tasks can never be fulfilled overnight and need to be carried out in a gradual manner. The Basel II banks should make their own implementation plan in accordance with these Guidelines and the Basel II requirements. The implementation plan should include but not be limited to: capital calculation approaches for credit risk, market risk and operational risk, schedule (transition plan included); the to-be-developed sub-projects and relative contents, targets, timetables, and priorities in each stage; and the resources to support these projects as well as the relevant organizations or teams. The Basel II banks should complete the design of the plans by the end of October 2007, and submit the relevant documents to the CBRC for record.

（iii）To strengthen the supervisory review over the preparation work. The CBRC will further improve its working mechanism and provide banks with more guidance on the preparations. The supervisory departments in the CBRC should also keep an eye on the banks’ preparations during their daily supervision. Besides, when making a supervisory rating to a bank, the CBRC will take into account the positive impacts of the Basel II implementation on corporate governance and risk management with a view to exploring more incentives from the supervisor’s perspective to push forward the Basel II adoption.

（iv）To enhance communication and cooperation so as to reduce the cost of implementation. Due to the complexity of the Basel II implementation, the CBRC will, on the one hand, strengthen the information sharing with banks, and on the other hand, encourage banks to make further cooperation among one another. To be specific, first, the CBRC will take the lead in organizing the exchanges with overseas advanced banks and supervisory authorities to learn from their successful experiences in the Basel II implementation. Moreover, the CBRC will organize training courses and workshops on the Basel II. Second, the CBRC task force on the Basel II research will invite the banking specialists to resolve the typical technical issues through the brain storm. The commercial banks should establish an effective cooperation mechanism with respect to data sharing, model development and technology transfer and make joint efforts to conquer the barriers in the implementation process. Third, the CBRC will further improve the transparency of the rule-making process, enlarge banks’ involvement, and provide explicit guidance to banks for their improvement of internal risk management system.

（iv）To make more efforts in lying a good foundation for the implementation. The year 2007 and 2008 will be the initial stage of the preparation work, during which the fulfillment of the following basic tasks is very important.

First is to have in place complete, strict and consistent data standards and relevant data processing platforms as well as policies on the data quality in accordance with the Basel II requirements so as to ensure the timeliness, accuracy and integrity of the data.

Second is to accelerate the development of internal rating system and risk measurement models. Banks should promote the development of internal rating systems based on the dimensions, structures, standards and approaches stipulated in the Basel II. Also, they should develop models to measure credit risk and market risk of their own asset portfolios. At the same time, the risk measurement models that have already been developed should be reviewed and tested to improve prediction capability and stability of the models. Furthermore, banks should actively apply the quantitative risk results in their design of plans and strategies, measurement and management of risk exposures and improvement of reporting systems.

Third is to set up sound operational processes and procedures together with organizational systems, and thereby ensuring an independent, fair and consistent outcome of the internal ratings.

Fourth is to strengthen the construction of the management information system (MIS) and include the data warehouse and IT system development, as required by the Basel II, into the overall IT planning program so as to reduce the cost.

Fifth is to improve the documentation and file-keeping work. The Basel II sets high standards for the internal risk management system with regard to the documentation; therefore, banks should have documents and files to record the design process and operational details of internal rating systems and risk measurement models as well as the status of observing minimum standards.

Sixth is to attach more importance to the cultivation and maintenance of professionals. Because of the rich technical contents of the Basel II, the involvement of professional talents is of great significance with regard to the development, and use of the internal risk management system. Accordingly, banks should, on the one hand, recruit professionals through multi-channels; and on the other hand, banks should reinforce feasible and appropriate staff trainings at different levels in a bid to provide the practitioners a better understanding of the Basel II and expand the application scope of the internal risk management system.