People’s Republic of China
Detailed Assessment Report: Basel Core Principles for Effective Banking Supervision

A detailed assessment report on the observance of China’s compliance of Basel Core Principles for effective banking supervision is presented. Regulation and supervision of China’s banking system has made impressive progress in the past few years, led by an activist, forward-looking regulator, the China Banking Regulatory Commission, with a clear safety and soundness mandate that has been supported by banks and by the State. The macroeconomic environment is characterized by rapid growth, with concerns about overheating and asset price overvaluation.

Abstract

A detailed assessment report on the observance of China’s compliance of Basel Core Principles for effective banking supervision is presented. Regulation and supervision of China’s banking system has made impressive progress in the past few years, led by an activist, forward-looking regulator, the China Banking Regulatory Commission, with a clear safety and soundness mandate that has been supported by banks and by the State. The macroeconomic environment is characterized by rapid growth, with concerns about overheating and asset price overvaluation.

I. SUMMARY, KEY FINDINGS, AND RECOMMENDATIONS

1. Regulation and supervision of China’s banking system has made impressive progress in the past few years, led by an activist, forward-looking regulator China Banking Regulatory Commission (CBRC), with a clear safety and soundness mandate that has been supported by banks and by the State. Significant improvements in risk measurement and risk management have occurred. These improvements are backed up by a regulatory system that demands high-quality capital and liquidity, often through simple and basic regulatory requirements. However, as further opening up and innovation occurs, and China’s banks expand, complexity and risks will increase. CBRC and banks must evolve quickly in the short term to be ready to meet those challenges. The framework of laws and guidance is generally of high quality, but much of it is relatively recent. Implementation by banks needs to be improved, in some cases materially. CBRC is widely-respected and has demonstrated its willingness to act in pursuit of its safety and soundness mandate. It urgently needs to have a plan to enhance its experience and expertise, ensure progress to date is sustainable, and needs continued support of government in that endeavor. Enhanced vigilance is required by banks and the regulator to keep risks under control in China’s system, in which banks are looked on by the State to be heavily, directly involved in achieving economic and social goals.

2. Less than fully compliant ratings in certain areas in this assessment generally reflect deficiencies in the legal framework, which can be amended, or that banks have yet to fully implement CBRC guidance. CBRC itself is performing excellently in a challenging and fast-changing environment. It is on the right track with its reform agenda and needs to persevere in a sustained way in its current direction. It will need the full support of all other parties in the government to succeed in the goals it has set for itself.

A. Introduction

3. This assessment of the current state of the implementation of the Basel Core Principles for Effective Banking Supervision (BCP) in China has been completed as part of a Financial Sector Assessment Program (FSAP) undertaken jointly by the International Monetary Fund (IMF) and the World Bank between June 7 and June 25, 2010, and reflects the regulatory and supervisory framework in place as of the date of the completion of the assessment. An assessment of the effectiveness of banking supervision requires a review of the legal framework, both generally and as specifically related to the financial sector, and a detailed examination of the policies and practices of the institutions responsible for banking supervision. In line with the BCP methodology, the assessment focused more on the major commercial banks and their regulation and supervision, given their importance to the system.

B. Information and Methodology Used for Assessment

4. The assessment team1 reviewed the legal framework for banking supervision, held extensive discussions with the staff of the CBRC and two of its regional offices. The assessors also met with officials of the central bank—the People’s Bank of China (PBC), the Ministry of Finance (MoF), the National Audit Office (NAO); several commercial banks, audit firms, rating agencies, and the China Bankers Association. The team examined the current practice of on-site and off-site supervision of the CBRC. The assessment team had the benefit of working with a comprehensive self-assessment completed by the CBRC, enjoyed excellent cooperation with its counterparts, and received the information it required. The team extends its thanks to the staff of the CBRC for their participation in the process and their comprehensive self-assessment.

5. Reaching conclusions required judgments by the assessment team. Banking systems differ from one country to another, as do their domestic circumstances. The banking system has undergone tremendous change in China in the recent period and this process is still ongoing. The CBRC is a relatively young agency, having been created in 2003 from the PBC as part of the major banking sector reform instituted by the Chinese authorities. In addition to the strengthening of financial sector regulation and supervision, these reforms have also led to the conversion of four large state-owned banks into joint-stock companies; consolidation of rural credit cooperatives; restructuring of joint-stock banks and securities companies; and reform of the insurance sector. Several Chinese banks now lead the list of global banks in terms of market capitalization and are gradually increasing their global footprint. Furthermore, banking activities are changing rapidly around the world after the crisis, and theories, policies, and best practices for supervision are swiftly evolving. The Basel Committee on Banking Supervision (of which China is now a member) is in the process of agreeing upon major reforms to the regulatory framework which, when implemented, will substantially impact the capital and liquidity regimes and how banks manage their risks. Nevertheless, by adhering to a common, agreed methodology, the assessment should provide the Chinese authorities with an internationally consistent measure of the quality of its banking supervision in relation to the Core Principles (CPs), which are internationally acknowledged as minimum standards.

6. The assessment of compliance with each principle is made on a qualitative basis. A four-part assessment system is used: compliant; largely compliant; materially non-compliant; and non-compliant. To achieve a “compliant” assessment with a principle, all essential criteria generally must be met without any significant deficiencies. A “largely compliant” assessment is given if only minor shortcomings are observed, and these are not seen as sufficient to raise serious doubts about the authority’s ability to achieve the objective of that principle. Under the BCP methodology a “materially non-compliant” assessment is given whenever there are severe shortcomings, despite the existence of formal rules, regulations and procedures, and there is evidence that supervision has clearly not been effective, that practical implementation is weak, or that the shortcomings are sufficient to raise doubts about the authority’s ability to achieve compliance. A “non-compliant” assessment is given when no substantive progress toward compliance has been achieved. In interpreting ratings, it is also important to note that for some CPs the assessment takes into account both compliance by banks and compliance of the supervisors.

C. Institutional and Macroeconomic Setting and Market Structure—Overview

7. The macroeconomic environment is characterized by rapid growth, with concerns about overheating and asset price overvaluation. The March 5, 2010 National People’s Congress meeting reiterated the Government’s proactive fiscal policy and moderately loose monetary policy. Cheap money and credit growth have facilitated output growth, but there are increasing concerns of a potential asset price bubble and increased inflationary pressures. Nonetheless, the government’s 2010 target for broad money growth is 17 percent, down from 30 percent set in 2009. The authorities have started adopting regulatory measures for tightening liquidity and credit to real estate sectors and have raised reserve requirements 3 times since the end of 2009. The 2010 GDP growth rate target was set at a moderate 8 percent (most forecasts are at about 10 percent) and the Customer Price Index (CPI) at 3 percent (in line with most forecasts). Efforts are being made to rebalance the economy, with measures to boost domestic consumption alongside creating rural and social safety nets. At the time the mission was in China, the authorities announced that they would move towards a greater market determination of the Renminbi exchange rate, simultaneously underscoring that any movements would be gradual.

8. The Chinese financial system is dominated by the rapidly-growing banking sector, with nonbank financial institutions accounting for only a fraction of the system. The banking system accounts for nearly 80 percent of the net new lending every year. China’s capital markets remain relatively shallow, and over 60 percent of outstanding bonds issued by the government and the majority of the remaining being issuances by the large financial institutions, with policy banks (which are state owned and provide a range of development finance services in support of infrastructure, agricultural development, export insurance, etc.) being the second largest issuers. The insurance sector, however, is rapidly growing, though, as are linkages between banks and insurance companies.

9. Although the banking sector is extraordinarily large with assets over 200 percent of GDP, and a couple of banks are in the top three globally by market capitalization, the financial systems is still relatively new, simple and evolving. Key financial prices remain regulated which distorts the incentives to save and invest, can limit the ability to price for risk, insulates banks from market risk and constrains the conduct of monetary policy. Despite gradual interest rate liberalization over more than a decade, retail interest rates remain partly regulated—deposit rates are subject to a cap and lending rates to a floor. Banks can price lending above the floor to a degree, and do so in practice.

10. The reform of the banking system began in the 1980s, when commercial banking was separated from the PBC. In the next decade, policy banks were created to separate policy lending from the commercial banks. The stock exchanges and the bond markets also date to the 1990s. Since then, the banking system has undergone an extraordinary consolidation with the number of banking entities having been reduced from more than 40,000 to fewer than 5,000 through a series of restructuring and mergers of credit cooperatives in to commercial banks. The 4 state banks have also been restructured with capital injections from the state and purchases of nonperforming loans (NPLs) by state Asset Management Companies (AMCs) over time estimated to be in excess of 15 percent of 2001 GDP, and have since been listed. Bank assets have grown rapidly, with total banking sector assets growth around 20 percent in the last five years. Efforts are being made to improve access to bank finance by SMEs and households, and, at a local level indirectly to projects sponsored by the local governments, as bank finance in the past has remained largely limited to large corporates (typically state owned).

11. Within the banking sector, the five large commercial banks account for just over half of the banking system assets. The next Tier of banks are the joint stock commercial banks, followed by city commercial banks and rural commercial banks which have been formed by the merger of city credit cooperatives and rural credit cooperatives respectively. The next Tier of banks are deposit taking institutions such as rural and city credit cooperatives, postal savings banks, village and township banks. Despite over 200 branches and subsidiaries operating in China, foreign banks remain a small presence with assets less than 2 percent of the total. However, in recent years, overseas financial institutions have made significant equity investments in Chinese banks.

12. The CBRC was established in 2003 as a stand-alone prudential authority and is widely credited with having made significant achievements in its short existence. All the banks, auditors, rating agencies and other market participants that the mission interacted with were unhesitating in their regard for the role that the CBRC has played in driving professionalism, risk management and international recognition of the Chinese banking system. In particular, the mission observed that it has been the key driving force in driving improvements in risk management, corporate governance and internal control and disclosure in Chinese banks. The prudential ratios on capital adequacy, NPLs, and liquidity, for instance for the banking system have improved significantly. However, more than one third of the bank assets continue to be in exposures to the government or central bank (more if local government related vehicles are taken into account) and there remains scope for further gains to be made in wider intermediation.

D. Preconditions for Effective Banking Supervision

13. The legal system in China brings together a number of distinct legal traditions within the overarching framework of a civil law system. The structure of the legal framework has undergone a series of phased transitions, first to enable complete state ownership until the 1970s, and more recently to facilitate China’s move towards a more market-oriented economy within a socialist political and economic framework. The main law-making bodies are the National People’s Congress and its Standing Committee, the State Council, Ministries, Commissions, Committees, provincial People’s Congress, and provincial Governments, etc.

14. The court system of China consists of: (i) the Supreme People’s Court; (ii) the higher courts instituted at the levels of provinces and autonomous regions as well as municipalities directly under the Central Government; (iii) the intermediate courts established at levels of prefectures (including autonomous prefectures), provincial capital (including cities under direct control of the provincial or autonomous region government), relatively big cities and within the municipalities directly under the Central Government; and (iv) others including basic courts, military courts, maritime courts; and railway transport courts. Chinese courts handle about 10.5 million cases annually. The presidents of courts and the procurator-generals of procuratorates (who exercise some degree of judicial power) are selected and appointed by the people’s congresses on the same level. The judges and procurators are appointed by the standing committees of the respective People’s Congresses, and assistant judges and assistant procurators are appointed by the respective courts and procurator-generals.

15. The first source of law is the Constitution. Then, there are other basic laws such as the General Principles of Civil Law of 1986, the 1979 Criminal Code (revised in 2009) and the 1991 Code of Civil Procedure (revised in 2007). Next come laws promulgated by the Standing Committee of the National People’s Congress. Actual day-to-day law consists of regulations, orders, decisions, etc., promulgated by the State Council—in effect the administrative cabinet of the government. Regulations, orders and decisions enacted by provincial and municipal People’s Congresses and equivalent legislative/executive authorities in autonomous regions are part of the legislative framework. Some international conventions and treaties endorsed by the National People’s Congress are also part of the legal framework.

16. There is no Commercial Code in China. In its place, the government has legislated a series of distinct measures to regulate commercial relations, for example, through the Company Law (revised 2005), laws to regulate the participation of foreign investors in Chinese markets, secured lending (Security Law 1995), and negotiable instruments (Negotiable Instruments Law 1995). More recently, a number of symbolically and legally important measures have been passed, notably the Property Law of 2007, that further recognizes private property rights, as well as the Enterprise Bankruptcy Act 2007, which seeks to give greater protection to secured creditors than has otherwise been accorded under Chinese law (e.g., by giving secured creditors priority over worker’s wages on winding up). There is little data with reference to enforcement of bank debts, but available data suggests that that enforcement of contracts in general by Chinese courts has improved dramatically in some urban centers to keep pace with economic reform. According to the annual working report of the Supreme people’s Court, the number of contractual cases and financial cases completed by courts amounted to 3.15 million and 519 thousand respectively in 2009, up by 8.6 percent and 12.9 percent on a year-on-year basis. Other studies suggest that a significant portion of contractual cases are voluntarily withdrawn by the plaintiffs or settled through judicial mediation.

17. China is gradually building up an infrastructure that promotes and supports market discipline. With the deepening of China’s reform and opening up, the market mechanism has been gradually developed. Information disclosure is required by various laws and regulations. The Company Law, Law on Commercial Banks, Law on Banking Regulation and Supervision, Securities Law, and Insurance Law all provide specified requirements on information disclosure. In practice, all banks are required to publicly disclose their information in their annual reports, including audited financial statements, corporate governance, capital adequacy, risk exposures, risk management strategies and practices, and other quantitative and qualitative information. In addition, the listed banks are subject to information disclosure requirements set forth by the China Securities Regulatory Commission (CSRC). Market discipline could be enhanced if the CBRC publishes a more uniform and more extensive bank performance data on a regular basis. Currently, the CBRC publishes basic aggregate financial data in its annual report and website. However, some key financial ratios such as net interest margin and trends in capital adequacy ratio (CAR) for various types of banks are not made available. In general a culture of disclosure is still evolving.

18. Considerable efforts have been made by the financial regulatory agencies to improve the corporate governance of financial institutions. On the basis of the corporate governance requirements provided by the Company Law and the Commercial Bank Law, specific rules and policies have been issued to promote corporate governance culture and practices. The CBRC recently issued the Supervisory Guideline on Compensation Practices of Commercial Banks, which requires banks to adopt deferred payment and clawback arrangements, and align the incentive package with the results of long term performance and risk control results. Under corporate governance rules banks have a dual board. There is a full-time board of directors. There is also a supervisory board which oversees the performance of the board and senior management. It is not involved in strategy formulation, but receives reports from audit and control functions to ensure that the board and management are performing as expected and following the board-approved strategy.

19. Since 2005, China accounting standards have substantially converged with International Financial Reporting Standards (IFRS) and International Standards on Auditing, respectively. In February 2006, the MoF which sets accounting and audit standards promulgated the Accounting Standard for Business Enterprises, which replaced the previous China Accounting Standards and became effective in January 2007. The new accounting standards consist of one basic standard and 38 specific standards, which have substantially converged with the international standards and were recognized by the International Accounting Standards Board (IASB). Currently, all listed companies, financial institutions and non-listed large and medium-sized enterprises have adopted the new accounting standards. The IFRS has been widely adopted internationally by many advanced economies and following a single set of internationally accepted standard would facilitate comparability of financial statements across borders and provides confidence to users of financial statements. Also, in 2006, the MoF issued a new set of auditing standards; one review engagement standard; two other assurance engagement standards; two related service standards; and one quality control standard, which have also converged with the international standards and were thus recognized by the International Federation of Accountants.

20. Accounting and auditing professions have grown considerably, though certain areas need improvements. Over the past three decades, China’s Certified Professional Accountant (CPA) industry has been growing steadily. Currently, there are more than 6,800 accounting firms registered in China, with more than 92,000 CPAs in practice. In accordance with the Law of the People’s Republic of China on Certificated Public Accountants, the MoF is responsible for regulating the accounting and auditing professions, with the regulatory responsibilities including qualification review and approval, professional performance supervision, and overseeing the activities of relevant industry associations. In the period January to October 2010, the MoF and the provincial finance departments conducted examinations on the professional performance of about 1000 accounting firms, and took enforcement actions against those found in violation of related rules.

21. Coverage of bank audits is adequate as the CBRC requires banks with total assets exceeding RMB 1 billion to receive financial statement audits; however, some weaknesses exist. In particular, while most of the major banks and listed companies are audited by the Big Four accounting firms, many smaller and medium sized banks and companies are audited by smaller accounting firms. Both the World Bank Report on Observance of Standards and Codes (ROSC) report and market participants interviewed by assessors have cited that the audit quality of smaller accounting firms needs improvements. The credibility of the audit profession would be enhanced if the authorities develop a standard auditor independence regulation and increase their oversight of the profession by performing regular and more frequent review of accounting firms’ audit quality.

22. Internal control attestation requirements will continue to enhance the robustness of banks’ internal control system. Currently, the CBRC encourages publicly listed banks to disclose their results of self assessments of internal control systems. The Basic Standard for Enterprise Internal Controls, which requires public companies (including banks) to assess the adequacy of their internal control systems and their external auditors to opine on the adequacy of their assessments, came into force on July 1, 2009 while the Implementing Guidelines for Enterprise Internal Controls are to be phased in for listed companies from January 1, 2011. The focus of this new standard extends beyond internal controls over financial reporting and includes other aspects of internal controls. While implementation of this standard appears to be a daunting task for publicly listed banks, the robustness of their internal control systems will likely be enhanced.

23. In recent years, the PBC has carried out a major reform of the National Payment System (NPS), by launching the China National Advanced Payment System (CNAPS). The CNAPS consists of the High Value Payment System (HVPS) and the Bulk Electronic Payment System. The HVPS is a real time gross settlement systems and mainly used for large value transfers. It is used to provide fast, efficient, secure and reliable payment clearing services to banking institutions, private and public entities and financial markets. Currently the system has more than 1600 direct participants. In 2009, the HVPS processed 248 million transactions amounting to RMB 804 trillion.

24. China is also evolving to a more intensive use of non-cash payment instruments, especially cards. The relationship of cash (M0) to GDP has been declining since the beginning of the 2000 from a level of 16.1 percent of GDP in 2001 to 11.4 percent in 2009. Cards issuance has been increasing at a high pace and approximately 2.1 billion cards had been issued at end 2009, of which 1.88 billion were debit cards. The card industry estimates that—at a minimum—600 million Chinese possess at least one payment card. Bank cards have therefore become the primary non-cash payment instruments in China accounting for over 90 percent on the total non-cash volume in 2009. The PBC is working on a number of projects to further improve the safety and efficiency of the NPS. They include: the launch of a “second generation” version of the CNAPS; a reform of key aspects of the legal and regulatory framework; initiatives to further increase the penetration of retail payment services, in particular in rural areas.

25. China does not have an explicit public safety net in the form of deposit insurance. The central bank has authority to make lender of last resort loans to banks. Given the high level of government ownership of banks, there may be a public perception that the State would stand behind all depositors in the case of a closure.

26. China is considering introducing explicit deposit insurance arrangements. It will be important as it does so that it carefully consider the roles of the various organizations in a resolution and not dilute the responsibility and accountability of the bank regulator for determining whether a bank is solvent and viable. Nor should it dilute the responsibility and accountability of CBRC for ongoing regulation and supervision of banks. There also is the issue of whether the public perceives introduction of explicit deposit insurance (presumably with a cap on coverage) as increasing or decreasing protection from what the public perceives protection to be currently. The impact on the marketplace, and competitive position of different banks, can be affected by these perceptions.

27. There have been restructurings of several banks with serious financial difficulties. These have tended to involve “whole bank,” going concern solutions whereby another bank has been convinced to take over the assets and liabilities of the problem institution (or at least the deposit liabilities). There is no explicit resolution framework for such eventualities but the authorities have demonstrated the ability to achieve such solutions using the existing bankruptcy and other laws. There are several aspects of the bankruptcy laws that deserve consideration in order to increase systemic protection and reduce contagion risk in the event of bank failures The first is that intra-day positions in the clearing and settlement system can be unwound in bankruptcy. The second is that netting and close-out of eligible financial contracts (certain derivatives contracts) between counterparties is not protected in bankruptcy, as it is in many other countries. This increases the chance of knock-on effects in the case of failures and increases risk for banks. The authorities should consider whether a separate insolvency regime for banks may serve them better especially given the increasing internationalization of the large banks and the current global focus on developing more compatible cross-border resolution frameworks.

E. Main Findings

Objectives, independence, powers, transparency, and cooperation (CP 1)

28. The objectives and responsibilities of authorities involved in banking supervision are clear. CBRC’s mandate has enabled it to focus on a single mission of safety and soundness and that has helped it become a high-quality organization. Using this mandate, CBRC has been very successful in articulating to banks and the public the need to achieve both safety and soundness and the needs for economic and social progress through the banking system. Indeed, safety and soundness contributes to development goals. CBRC has pushed for high-quality risk management by banks as part of their delivering on economic and social objectives. Following its mandate, and as a result of observed or potential deficiencies in risk management practices, CBRC has recently introduced a range of prudential measures, including more stringent credit risk management of loans to local government platforms and real estate lending. It has also successfully pushed banks to hold more capital and more provisions in the face of rapid loan growth as part of the stimulus package.

29. The potential conflict between safety and soundness objectives and other objectives exists in many countries but can be more acute in China because of the predominant use of the banking system, much of which is state owned, to achieve economic and social goals. The 12th plan for the financial sector being developed as part of the 12th five year economic plan under the State Council for the NPC should reinforce the importance of safety and soundness and CBRC’s early intervention to resolve potential problems before they become serious. It should also make a priority for continued improvement in banks’ risk management with a focus on assuring all banks, not only the most advanced, make needed improvements and ensure that improvements already made are well entrenched in their operations. The importance of safety and soundness and high quality risk management to economic and social objectives should be explicitly recognized by the authorities. Current CBRC leadership has played a key role in promoting prudential goals and dealing with issues of possible conflict of safety and soundness objectives with national economic policies. It will be important to continue this.

30. The arrangements for resourcing in CBRC leads to potential independence issues, and hampers effectiveness, particularly as banks become more complex and innovative, and expand abroad. So does the potential ability for the State Council to override CBRC rules, though this has never been exercised. The CBRC law mandates it to take decisions free from interference from any party, and CBRC reports that no interference has occurred since its creation. However the existing arrangements could be problematic in future. The laws, rules and guidance that CBRC operates under generally establish a benchmark of prudential standards that is of high quality and was drawn extensively from international standards and the BCP themselves.

31. However, much of the guidance is relatively new and the issues raised in assessment of various CPs are often ones of better implementation. In many ways, the strength of CBRCs regulation to date lies in the deliberately simple, conservative approach it has taken, often relying on specific prudential ratios that banks must meet. This is true for liquidity and for capital adequacy, for example. The challenge going forward is that this approach, by itself, will not be sufficient as markets and banks evolve. CBRC is well governed within the constraints it faces and has steadily and materially increased its transparency. There is need for: more forward resource planning; an urgent government-supported strategy for material upgrading of skills especially specialist skills; and more flexibility in budgeting and pay to support this strategy and attract and retain talent. CBRC’s performance reporting has greatly improved but more is possible.

32. The legal framework for banking supervision has been revised to incorporate legislation, guidelines and rules (which all have legal standing) based on international standards. CBRC has authority to take a wide range of corrective and remedial actions, and is clearly willing to use them. CBRC staff is legally protected from the consequences of acts committed in good faith. CBRC also has the legal authority to share information with other regulators, domestically and internationally and does so through networks of Memorandum of Understanding (MOUs).

Licensing and structure (CPs 2–5)

33. China defines the permissible activities of banks and operates an extensive licensing and approval process for banks. Considerable staff is involved in approving new institutions, new branches or sub-branches of existing institutions, new products, as well as changes in ownership. Fit and proper criteria apply to board and senior management, but also extend to many other positions in a bank. The use of the name ‘bank’ is properly controlled and shell banks are not permitted. Minimum capital requirements to start a new bank depend on the type of bank and are in line with or higher than international norms.

34. CBRC implements an appropriate approval process for changes in ownership and major acquisitions. However, the Chinese system is evolving from a system of state ownership to more private ownership, opening up the possibility of more complex ownership structures for banks. In this context CBRC legal authority could impede their ability to review beneficial owners or indirect changes of control. They report that they do usually get information on beneficial/indirect owners through the direct acquirer or through other indirect means. The assessment team is not aware of instances where supervision effectiveness has been compromised because of this issue but this legal authority should be bolstered. Other CBRC rules that also involve potentially-more complex bank ownership structures (e.g., related party rules) should also be reviewed to ensure that such structures are clearly covered by the rules. Investments by banks, including in overseas branches, require approval as part of the general approval system. While banks are generally prohibited from investing in nonbank activities, in the recent past exceptions have been permitted for investment in financial leasing and asset management. Bank-insurance and bank-fund management company investments have not been allowed until recently, when four cross-ownership pilots are in process. In those cases CBRC imposes firewalls between the banks and the other entity. Among other considerations, there are also explicit provisions that these pilots must earn at least average industry returns or they are to be dissolved.

Prudential regulation and requirements (CPs 6–18)

35. The capital adequacy rules are based on Basel I. Basel II is being introduced over the 2011–2013 period for 6 banks who must adopt it on a mandatory basis. Some other banks have also decided to adopt it on a voluntary basis. Basel II was not formally assessed as it was not in place at the time of the mission. The choices China has made in implementing Basel I have generally been conservative, and result in Chinese banks uniformly having capital ratios above the Basel minimum. Banks’ capital is composed primarily (approximately three-quarters) of high-quality core capital. The minimum required capital is 8 percent. Recent measures have raised expected capital ratios above the Basel minimum to 11.5 percent for the five major banks and 10 percent for all other banks, as part of a move to counter-cyclical buffers. How these buffers will work in a counter-cyclical way has not been specified. CBRC needs to review and communicate what its ongoing expectations are for banks to hold capital above the minimum and the criteria it will use to decide how to alter the buffer. There are a few aspects of the rules that are less conservative than the Basel I provisions, that should be reviewed.

36. Risk management is evolving in Chinese banks. CBRC has played a major role in the significant and impressive improvements that have occurred. Less than fully compliant ratings in certain areas in this assessment generally reflect deficiencies in the legal framework, which can be amended, or that banks have yet to fully implement CBRC guidance. CBRC itself is performing excellently in a challenging and fast-changing environment. It is on the right track with its reform agenda and needs to persevere in a sustained way in its current direction. It will need the full support of all other parties in the government to succeed in the goals it has set for itself. Most major banks have developed risk management systems for each of the major individual risks they face, though improvements are required in certain cases. CBRC guidance is generally of high quality and was often developed directly from Basel documents. Framework guidance in some risk areas is relatively new, with some being issued as recently as the last half of 2009. A period of settling in is required for effectiveness to be enhanced, for those banks who are not the most advanced to catch up, and for CBRC to ensure that all banks have risk management systems commensurate with the risks they are assuming.

37. The new risk governance, risk measurement and risk management systems have not been tested under stress and some areas for material improvement are clearly evident. Board-approved strategies are often too focused on target loan growth in various sectors and not enough on targeted risk measures linked to the bank’s own risk systems, as opposed to regulatory requirements. Comprehensive, enterprise-wide risk management that takes account of interactions between risks in measuring, managing and stress testing, and that relates capital to risk is at an early stage in some banks, including some major banks. For many banks the priority is not to move to this stage quickly, but rather to ensure that a sound risk management framework is fully in place, imbedded in their culture and group-wide operations, and sustainable. While much of banking in China is deposit taking and lending, major Chinese banks are some of the largest in the world, and the Chinese lending market is complex by virtue of its scope and diversity, and banks are getting into new areas of lending and other activities. So risk management needs to be commensurate with these realities.

38. Credit risk is the most important risk facing Chinese banks and will remain so for some time. It has received the most focus by banks and CBRC and is generally well controlled. However there is intense focus on NPL experience by banks, policy makers and by a considerable part of CBRC staff. This is understandable given the serious bad-loan experience in the early part of the decade. But this almost sole focus sometimes is at the expense of attention to other early, forward-looking measures of credit risk that need to be responded to. Senior leadership in CBRC and some banks understand the need for forward-looking judgment but assessors sensed that this message has yet to flow fully through their organizations. The rules and practice for problem assets, provisioning for listed banks are otherwise adequate. They are based on IFRS-equivalent accounting rules and regulatory requirements for classifying loans. CBRC does regular, extensive and in-depth reviews of asset quality and replication of the provisioning system. Major audit firms audit the majority of listed banks. The regulatory system has encouraged additional provisions and requires further buffers to be held as part of firm’s equity.

39. Traded market risk in the Chinese banking system is low in aggregate and for major banks individually. This will likely increase as market liberalization occurs. The exchange rate liberalization announced recently could increase foreign exchange (FX) risk for banks and their customers. Risk management tools, information technology (IT) and data infrastructure to support them are generally commensurate with the level of risk, though there are areas for improvement. However, sophistication will likely need to increase considerably in the near future. The move to Basel II will assist. Interest Rate Risk in the Banking Book (IRRBB) is a more-prevalent risk for a wide number of banks. This will also likely rise as further liberalization occurs. Tools need to move rapidly beyond the static gap analysis based on contractual maturities of assets and liabilities that many banks are now employing. CBRC could also enhance its outlier analysis for this risk. This affects more than just the listed banks, and the improvement does not require adoption of models.

40. Operational risk has been a focus of banks for a number of years. The two main operational risks have related to possible internal control breakdowns and fraud, and IT risk. These have received considerable focus at banks and they and other observers reported that such incidents have trended down significantly in recent years. The challenge now is to put in place more comprehensive frameworks to deal with all elements of operational risk relevant to individual banks, which has started. More bank business units should be doing regular risk and control self assessment (RCSA) and developing, monitoring and refining key operational risk indicators. Again, a move to complex Advanced Measurement Approaches (AMA) models for capital purposes is not required to make improvements.

Methods of ongoing banking supervision (CPs 19–21)

41. Supervisory approaches are increasingly risk focused. However, use of the CAMELS+ rating system and various other aspects of the supervisory methodology (including its newness in some respects) mean that supervisory assessments are not as forward looking as desirable. As well, heavy reliance on the few basic simple ratios, while appropriate, may discourage more judgment-based assessment of inherent risk and the quality of individual bank’s risk management and governance. There is need to maintain the benefits of simple basic indictors while reinforcing banks complying with CBRC guidance which requires use of more sophisticated approaches than some banks are using. That would also encourage more of a risk culture in banks as well, rather than them relying excessively only on complying with regulatory requirements.

42. More attention may need to be placed on mid-size and smaller banks to ensure that they upgrade their risk management and governance performance. CBRC has all the necessary tools of on-site and off-site supervision. There is an extensive system to capture frequent and periodic information from banks. However, disclosure by banks or CBRC of important safety and soundness information, such as capital and liquidity position is less than in a lot of other markets. This should be examined and improved.

Accounting and disclosure (CP 22)

43. China has developed an accounting system that has substantially converged with the IFRS. A recent World Bank study also commended China’s effort though certain areas of improvements were identified. Continued attention will need to be given to the development of the private accounting and audit profession in China to ensure that financial statements are professionally prepared and audited. The CBRC should be empowered to reject and rescind the appointment of an external auditor who is deemed to be unfit to perform a reliable and independent audit.

Corrective and remedial powers of supervisors (CP 23)

44. CBRC has the authority and demonstrated willingness to act to resolve problems. Dealing with problem banks has been on the basis of going concern solutions. Capability to close institutions may need to be enhanced going forward.

Consolidated and cross-border banking supervision (CPs 24–25)

45. Consolidated supervision of banks and their direct subsidiaries and branches on the mainland or offshore is of high quality. However, existing laws may permit more complex structures where consolidated supervision may not be possible. On occasion, CBRC has used indirect and informal means to deal with the situation and bring about needed changes in structure. The mission’s recommendations (CP 4) to amend laws to formally require CBRC approvals of ultimate beneficial ownership and indirect changes in control would also help address this issue. Reliance by one supervisor on the work of others in mixed corporate groups (bank/insurance/fund management /pilots) may not always work well in practice and has yet to be tested. In terms of home-host relationships, CBRC has a wide network of formal and informal arrangements and has used these effectively as both a home and host.

Table 1.

China: Summary Compliance with the Basel Core Principles—Detailed Assessments

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Aggregate: Compliant (C) – #, Largely compliant (LC) – #, Materially noncompliant (MNC) – #, Noncompliant (NC) – #, Not applicable (N/A) – #
Table 2.

China: Detailed Assessment of Compliance with the Basel Core Principles

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