China's Road to Greater Financial Stability
Chapter

Chapter 8. Practical Experiences in Strengthening Banking Supervision and Regulation

Author(s):
Udaibir Das, Jonathan Fiechter, and Tao Sun
Published Date:
August 2013
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Since the global financial crisis erupted in 2008, strengthening financial supervision and regulation has become the consensus of the international community. As a member of the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS), the China Regulatory Banking Commission (CBRC) has been an active participant in the international policy dialogues regarding financial regulatory reform and new standard-setting. At the same time, the CRBC is also a determined implementer of reforms, endeavoring to put in place internationally agreed-upon reforms in line with the Chinese reality. In a bid to promote industry stability and improve supervisory effectiveness, the CBRC has participated in the Financial Sector Assessment Program (FSAP). And in its effort to promote the sustainable development of the banking sector, the CBRC is introducing a set of new capital, liquidity, and leverage rules that signify the integrated implementation of Basel II and Basel III in China. Given the unique situation in China, the CBRC has, in practice, paid particular attention to the seven areas of work described below.

First is to strengthen the supervision and regulation of large, complex banks. The FSB has confirmed the Bank of China as one of the 29 global systemically important financial institutions. Considering that many other Chinese banks have the potential to be listed as global systemically important banks, the CBRC is working to build the domestic supervisory framework, including drafting supervisory guidelines on the assessment and supervision of the systemic importance of commercial banks, strengthening the consolidated supervision and increasing the supervisory frequency and intensity of large banking groups, hosting supervisory colleges for large and internationally active Chinese banks, and formulating recovery and resolution plans for such banks in cooperation with other related government agencies. Starting as early as 2010, large, complex banks in China were subject to an additional 1 percent capital surcharge in addition to the conservation and countercyclical capital buffer applied to all banks.

By drawing upon our past lessons, we have also attached great importance to improving the corporate governance, internal controls, and compensation practices of large banks, which we believe is an important backstop to effective supervision. In order to facilitate early warning as well as dynamic monitoring of the overall risk profile of each large banking group, we have improved the supervisory rating system to cover 13 prudential regulatory indicators under seven categories: capital adequacy, asset quality, risk concentration, provisioning coverage, affiliates and subsidiaries, liquidity, and operational risk control.

The CBRC’s second area of work is to strengthen the supervision of risk concentration. In China, local government funding platforms (LGFPs) have, for many years, played an important role in funding local infrastructure construction and welfare programs. In particular, these LGFPs were instrumental in stoking local economic recovery in recent years. However, the rapid expansion of bank loans to the LGFPs triggered our concerns as early as 2009. To mitigate the potential risks, we required banks to review and revaluate each and every loan, to classify their LGFP exposures in accordance with underlying project cash flow and collateral, and, where necessary, to promptly reschedule or resolve potential problem loans. In the meantime, we are exploring market means to attract social capital to participate in the LGFPs, and working closely with the relevant government agencies to have local governments set aside a portion of their fiscal budget as an additional buffer. All these measures have been proven effective to underpin the commercial viability of the LGFP loans.

The third area of work is to strengthen the supervision of real estate lenders. As part of joint ministerial efforts to control property prices, the CBRC has leveraged its policymaking to differentiate reasonable demand for home ownership from speculative investment in the real estate market. For instance, we apply dynamic loan-to-value (LTV) ratios as well as different down payment policies for purchasing the first and second home, respectively. We require banks to conduct diligent review of the creditworthiness of borrowers and determine mortgage rates based on stringent risk assessments. We support lending for affordable housing projects, but this must be done with proper controls and under the principle of commercial viability. To stay on top of the risks that come along with real estate lending, we require banks to launch intensive stress testing with multidimensional stress scenarios. Such exercises help both banks and regulators maintain dynamic monitoring and evaluation of banks’ resilience and accurately assess the impact of price declines and macroeconomic changes on the quality of banks’ real estate loan portfolios. Finally, banks are required to develop their risk management strategies by factoring in the full picture of exposures to key geographical regions and related industries.

The fourth area is to strike a balance between financial innovation and prudential supervision. Financial innovation and related supervision have always been the focus of the CBRC’s endeavors to highlight the role of the banking sector in serving the real economy. In our view, the effectiveness and desirability of financial innovation should be measured by banks’ performance in meeting the fundamental demand of real economic activities. The CBRC encourages financial innovation as long as it helps banks nurture the diversity and advisability of financial products, lower the cost to customers, and effectively manage inherent risks. For instance, by providing wealth management services, commercial banks offer their customers a diversified range of tailor-made products and services, and help their customers maintain and increase the value of their assets against market volatility. The increasing engagement in financial innovation, however, also exposes banks to greater risks of different types. As a solution, the CBRC has issued Guidelines on the Financial Innovation of Commercial Banks, which requires that financial innovation be conducted under the principles of “cost accountable, risk controllable, and information sufficiently disclosed.” We have also introduced a host of detailed rules governing banks’ wealth management activities, credit card business, derivatives trading, bond underwriting, etc. In addition, we constantly improve our tools and techniques for offsite surveillance and onsite examinations, enhance the synergy of different supervisory functions in the supervision of financial innovation, and strengthen our undertakings in consumer protection and public education.

The CBRC’s fifth area of work is to prudently carry forward the pilot programs for cross-sector operations and financial holding company supervision. When China enacted its banking law in 1995, it adopted the Glass-Steagall approach to separate banking from other financial businesses. In recent years, with the approval of the State Council, some banks have been permitted to engage in insurance and securities businesses on a pilot basis. In carrying out such pilot programs, the CBRC has pursued a three-step strategy: (1) prepare a solid regulatory and policy framework; (2) conduct rigorous application review and approval; and (3) limit the pilot scope to a few selected eligible banks. Accordingly, a “primary supervisor” arrangement is adopted in light of the shaping of financial holding companies as a result of the pilot operations. Undoubtedly, the trend toward cross-sector operations is posing new challenges to both banks and bank regulators. In response, the CBRC is careful to ensure that banks engage in cross-sector business with compatible corporate governance, necessary firewalls and controls, and adequate consolidated management capability. We closely monitor the performance of banks’ cross-sector operations and take prompt supervisory actions when the returns on assets and equity of banks’ nonbanking business fall below the average levels of the corresponding industry, and when the overall performance of banks is negatively affected by the cross-sector operations. Finally, we are promoting collaboration and information sharing with other regulatory authorities in order to avoid gaps and overlaps in institutional oversight.

The sixth area of work is to attend to the supervision of shadow banking activities. In the current international financial arena, the shadow banking sector mostly consists of mutual funds and structured investment vehicles, which are either under-regulated or not regulated at all. The assets of these shadow banks involve virtual off-floor trading, which is typically highly leveraged. Shadow banks as so characterized have yet to be found in China. As banking regulators, we pay close attention to the financial activities and assets that have dealings with banks but are not fully or not at all reflected in banks’ financial statements. Such activities are identified in the following areas: business cooperation between commercial banks and trust companies, credit asset transfers between financial institutions, banks’ wealth management activities, bond underwriting, private equity participation by commercial banks, etc. The CBRC has been keeping these activities on its radar screen. We require banks to fully account for and build adequate buffers against the underlying risks that may arise from the off-balance-sheet activities of commercial banks. We also set forth the requirements for better information disclosure by banks and trust companies, the setup of effective firewall mechanisms between banks and nonbank financial institutions, and more stringent large exposure limits. Our goal is to extend out regulatory coverage as much as to prevent regulatory arbitrage, deal with hidden risks, and ultimately ensure financial system stability.

The seventh and final area of the CBRC’s work is to support and regulate the development of a diversified financial system. In this respect, the CBRC enters into close partnership with local governments with shared goals of fostering an ecosystem favorable to the development of microfinance firms. This ecosystem has in turn enhanced the financial inclusion of farmers, small businesses, and communities neglected by the regular banking sector. To this end, we are also working to promote the development of lending-related services such as credit guarantees so as to enhance the credit capacity for intermediation. As the financial system has grown increasingly diversified over recent years, the CBRC is also working together with the relevant government agencies to regulate the safe and sound development of various financing entities and vehicles. At the same time, the CBRC is engaged in various endeavors involving the financial education of the public, including launching nationwide education campaigns under such themes as “Better Finance for a Better Life,” and “Understand Finance Better, Protect Wealth Better” in a bid to enhance public awareness and fend off financial risks.

Huaqing Wang was the disciplinary commissioner of the China Banking Regulatory Commission when contributing this chapter. He now serves as the disciplinary commissioner of the People’s Bank of China.

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