Chinese banks respond to tighter regulation

What has China learned from the 2008 global financial crisis? Unlike banks in most other countries, Chinese banks went on a lending binge in 2009 and 2010, increasing loans by almost 60%, or Rmb18,900bn ($2920bn). Beijing was determined to maintain high economic growth and has done precisely that, with the World Bank forecasting 9.3% growth in gross domestic product in 2011. But China closely watched the impact of the crisis and did not believe its lending boom could last for ever. And so, over the past six months or more, the country has entered a phase of tightening with stricter banking requirements, very much aware of the dangers of excessive leverage that banks in the West overlooked.

China needs to adopt a "cautious macroeconomic framework" and should require financial institutions to boost their stores of capital, People’s Bank of China governor Zhou Xiaochuan said in a speech at the Lujiazui Forum in Shanghai in May. Large, systemically important banks especially should be subject to higher capital requirements, he added.

Earlier in May, the China Banking Regulatory Commission announced new rules bringing the country’s banking sector into step with the new global banking regulatory framework, Basel III. The rules set tougher criteria for lenders’ capital adequacy, provisions, leverage and liquidity conditions and will take effect at the beginning of 2012.

Tighter regulations

Under the new regulations, systemically important financial institutions will need to maintain a minimum capital adequacy ratio of 11.5%, and other non-systemically important financial institutions must sustain a capital adequacy ratio of 10.5%. The weighted average capital adequacy ratio among Chinese banks reached 12.2% at the end of 2010, 0.8 percentage points higher than the previous year (see box on China's banking behemoth, below).

Along with catching up with international standards based on the Basel II and Basel III agreements, the Chinese authorities have added leverage and liquidity ratios to the regulatory parameters. They have also set provision ratios for outstanding loans and retained some traditional Chinese requirements, such as a loan-to-deposit ratio of no more than 75%, and increased the amount of stress-testing in certain volatile sectors. Commercial banks, according to the China Banking Regulatory Commission, are expected to apply the new standards from 2012 and are expected to meet all requirements by 2016, two years ahead of the Basel III schedule.

The required leverage ratio, the ratio of core capital to total assets, will be set at 4%, one percentage point higher than required under Basel III. The ratio of loan loss reserves (the amount set aside to cover non-performing loans against outstanding loans) is set at 2.5%, with a grace period of two years for the larger banks.

Prudent measures?

Along with higher capital adequacy requirements, the authorities are tightening control of credit through other measures. Concerned by inflation, which hit 5.3% in April, and the impact of China’s huge foreign exchange reserves (which topped $3bn in March) as a major cause of excess liquidity, the central bank has been tightening monetary policy. Among its ‘prudent’ measures, the People’s Bank of China has raised reserve requirement ratios for banks six times this year to reach a record high of 21%, putting the squeeze on credit and interest which rates have been raised four times since October 2010 and are expected to be raised at least twice more this year. As a result of this, corporate loan growth more than halved to an estimated 12% in the first quarter of 2011. 

Will all this tightening cool inflation and prevent over-leveraging and possible property bubbles? The answer is possibly, but not necessarily. Some analysts warn the lending binge in 2009 to 2010 may hold unknown risks for the future. This year certainly represents a degree of slowdown from a bank lending perspective and some analysts suggest a downturn is unavoidable if under credit tightening there is a fall in asset quality.

So are China’s banks suffering as a result of this tightening? While banks achieved record profits in 2010, the application of more cautious, prudent policies does not appear to have damaged profitability. Banks appear to have a sufficient profit cushion to cope with any contingencies and profits in the first quarter of this year indicate that the strong earnings trend will not be overturned by applying more caution. Analysts suggest that banks are likely to take the new requirements in their stride.

Flourishing in a cool climate

For two of the largest banks, Industrial and Commercial Bank of China and China Construction Bank, net profits in the first quarter of 2011 rose 29% and 34%, respectively, compared with 2010; not a sign of an imminent downturn. 

While a HSBC report in May indicates that China’s manufacturing sector is growing at its slowest pace since July last year, the report says it is still consistent with strong economic growth of 9% over the year. HSBC adds that the cooling is likely to assist the Chinese government’s efforts to rein in inflation with the price of manufacturing inputs and output both easing closer to long-term averages. While HSBC believes there will be a focus on reducing inflation in the coming months, it does not expect an economic hard landing for China.

Meanwhile all of the top four commercial banks, plus China Minsheng Banking Corporation, are reported to have applied to establish second headquarters in Shanghai, which will help the city achieve its goal of becoming an international financial centre. China’s banking ambitions hold no bounds.

China's banking behemoth

China’s banking sector is both huge and complex and, at the end of 2010, included two policy banks and China Development Bank, five large commercial banks known as the ‘big four’ plus Bank of Communications, 12 joint-stock commercial banks, 147 city commercial banks, 85 rural commercial banks, 223 rural co-operative banks, 2646 rural credit co-operatives, one postal savings bank, 40 locally incorporated foreign banking institutions and 90 foreign bank branches. Overall, banking institutions numbered 3769, possessing a staggering 196,000 business outlets and 2.99 million employees.

At the end of 2010, the total assets of China’s banking institutions, according to the China Regulatory Banking Commission, rose to Rmb95,300bn ($14,700bn), a 19.9% increase year on year, with the five large banks accounting for 49.2% of the total (down from 51.3% the previous year), followed by the 12 joint-stock commercial banks with 15.6% and the small and medium-sized rural financial institutions and postal savings bank accounting for 14.9%.

Signifying the continuing strong growth, total banking assets as of the end of March 2011 reached Rmb101,200bn, an 18.9% increase year on year with the assets of the large commercial banks up 13.8% at Rmb49,800bn, the joint-stock banks up 25.2% at Rmb15,900bn, and the city commercial banks up 34.4% at Rmb8100bn. 

With total assets at end-2010 at Rmb95,300bn, four times what they were at the close of 2002, China's banking sector has undergone robust growth along with extensive structural reforms, which have substantially strengthened the sector. Asset quality has improved significantly. Total loans grew to Rmb50,900bn at the end of 2010, a huge growth of 59%, or Rmb18,900bn, over 2009 and 2010. 

In 2002, non-performing loans and the non-performing loan ratio for commercial banks were Rmb1900bn and 22.5%, respectively, while by the end of 2010 the figures had been reduced to Rmb433,600bn and 1.13%, respectively, a massive improvement.

Capital strength

In terms of capital strength, at the end of 2003 the overall weighted average capital adequacy ratio of China’s commercial banks was -2.98%. The ratio turned positive in 2004, rose to 4.9% in 2005 and further jumped to 12.2% at the end of 2010, with all commercial banks meeting the minimum requirement of 8%.

Provisioning has been expanded dramatically. The provisioning coverage ratio soared from 6.7% at the end of 2002 to 24.8% in 2005 to a significant 217.7% at end-2010, with the balance of banking provisions amounting to Rmb1300bn, providing an enhanced capacity to cover potential losses. The provisioning coverage of large commercial banks increased to 206.8%, up 61.9 percentage points on the year before.

These changes have been enabled by continuous improvements in profitability. The post-tax profit generated by banking institutions grew 15-fold from Rmb61.5bn in 2002 to Rmb899.1bn in 2010. The five large commercial banks contributed 57.3% of that end-2010 total, or Rmb515.1bn, with the 12 joint-stock banks contributing 15.1% of the total or Rmb135.8bn. Also the return on assets and the return on equity of commercial banks increased significantly from 0.1% and 3%, respectively, in 2003, to 1.03% and 17.5%, respectively, at the end of 2010.

Liquidity down

In terms of liquidity, the ratio of the banking sector slipped by 2.1 percentage points to 43.7% at the end of 2010. The loan-to-deposit ratio, another measure keenly watched in China, was also down 0.1 percentage points to 69.4% at the end of 2010.

Chinese banks are slowly but surely increasing their presence abroad and at the end of 2010, the five large commercial banks (Industrial and Commercial Bank of China, Bank of China, China Construction Bank, Agricultural Bank of China and Bank of Communications) had set up 89 branches and subsidiaries outside China and acquired or invested in 10 foreign banks. Six of the 12 joint-stock banks (China Citic Bank, China Everbright Bank, Huaxia Bank, China Guangfa Bank, Shenzhen Development Bank, China Merchants Bank, SPD Bank, Industrial Bank, China Minsheng Banking Corporation, Evergrowing Bank, China Zheshang Bank and China Bohai Bank) have established five branches and five representative offices overseas and two of the city commercial banks have opened two representative offices abroad.

Meanwhile, although the number of foreign banking institutions in China almost doubled between 2004 and 2010 and the volume of foreign banking assets almost trebled, their proportion of total banking assets in China stayed almost the same at less than 2%.

As at the end of 2010, 185 banks from 45 countries and regions had set up 216 representative offices in China while 37 banks from 14 countries and regions were locally incorporated and 223 branches were kept. At the end of 2010, foreign banks maintained outlets in 45 cities of 27 provinces, 25 cities more than at the end of 2002. Curiously, while the volume of foreign banking assets rose from Rmb582bn in 2004 to Rmb1740bn in 2010, this as a percentage of total banking assets only rose from 1.84% to 1.85%, remaining virtually unchanged.