Author: | Published: 30 Sep 2004
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After its establishment in April 2003, the China Banking Regulatory Commission (the CBRC), responsible for the authorization and regulation of banks, has improved its financial supervision by formulating and implementing a series of regulations and guidelines in corporate governance, capital requirements, risk management, commercial trade and other aspects. The CBRC has also been deepening domestic banks' reform, further liberating state-owned banks by recapitalization through restructuring, listing and disposal of non-performing loans.

Foreign banks have more opportunities in this emerging market after the CBRC made measures to further open up the market: 100 foreign banks and their operations in different localities have been licensed so far to conduct renminbi business and 53 foreign banks and their operations in different localities have been approved to provide services to domestic corporate customers. Also, the CBRC's new regulation encourages foreign banks to purchase stakes in domestic banks and conduct business in cooperation with their local banking partners.

The macro-economic adjustment and control policy adopted by the Chinese government since May 2004 hindered investments and rapid economic growth. It also shadowed imprudent loan advances by local banks in such hot industries as property, steel and infrastructure projects. People's Bank of China (PBOC), responsible for formulating monetary policy and regulating the money market, has taken harsh measures to tighten the circulation of renminbi. Figures up till July 2004 show that China's economic growth has slowed down. The banking market is waiting for readjustment policy soon.

Restructuring state-owned banks

State-owned banks in China have faced low capitalization and large amounts of non-performing loans (NPLs) for years. As part of banking reform, the Chinese government pushed harder than ever to recapitalize the large state-owned banks two years after its commitment to the WTO. In late 2003, it approved the listing schemes of two of the biggest state-owned banks, Bank of China and Construction Bank of China. The government injected additional capital of $225 billion into each of these two banks in late 2003 to put them in better financial condition when listed. A special purpose company, Hui Jing Corporation, was established to hold stakes on behalf of the government. In July 2004, another state-controlled bank, Bank of Communications, first completed its restructuring scheme and obtained listing approval from the State Council. To prepare for listing, it reduced its NPLs by selling NPLs with a face value of Rmb47 billion to China Cinda Assets Management Company, a special arm to dispose of NPLs for state-owned banks. Meanwhile, Bank of China and Construction Bank of China are still in the process of their restructurings. In June 2004, Construction Bank of China disposed of its NPLs with a face value of Rmb4.7 billion by auction to a consortium of international financial investors, including Morgan Stanley and Deutsche Bank. These three banks are expected to list their shares on the market in 2005. Other stated-owned banks will most likely follow them.

Strategic investments by foreign banks

Following Citibank's strategic investment in a listed commercial bank, Shanghai Pudong Development Bank in late 2002, Hang Seng Bank and International Finance Corporation signed strategic investment agreements with another Chinese commercial bank, Industrial Bank, acquiring 17% and 3% stakes respectively. In August 2004, Hong Kong and Shanghai Banking Corporation (HSBC) paid $17.5 billion to buy 19.9% shares of Bank of Communications. By forging a strategic alliance with foreign banks, Chinese banks aim to meet looming challenges from foreign rivals, which according to China's WTO commitment will enjoy full banking licences by the end of 2006. Meanwhile, such strategic investments also help to recapitalize Chinese banks and their proposed public listings. It is expected that international strategic investors will also be involved in the restructuring of Bank of China and Construction Bank of China. For foreign banks, strategic investments in Chinese banks will provide business opportunities that are not otherwise open to them before the end of 2006. The credit card business is one market that foreign banks so far have not been allowed to go into directly. Early in 2004, Citibank's local strategic partner successfully issued co-branded credit cards in the national market.

In December 2003, the CBRC promulgated a regulation encouraging foreign banks' strategic investment in Chinese banks. However, it caps the investment at 20% for a single foreign investor and 25% for foreign investors in total in one Chinese bank.

Issuing subordinated debts

After years of discussions in the market, the CBRC finally allowed domestic banks to issue subordinated debt so that they can raise their capital adequacy ratios before public listing. In December 2003, the CBRC issued a circular regarding subordinated debt followed by the Regulation on Issuance of Subordinated Bonds by Commercial Banks on June 17 2004. Since the end of 2003, domestic banks have been rushing to issue their subordinated debt in the markets. Industrial Bank issued the first subordinated debt of Rmb3 billion at the end of 2003, followed by several other commercial banks. The big state-owned banks, including Bank of China and Bank of Communications, have all been involved in the process of such issuances. According to reported figures in August 2004, Rmb53 billion-worth of bank subordinated debts have been approved by the CBRC so far. The CBRC requires the subordinated debts to be sold to corporate investors. However, the market has shown that the investors are mainly commercial banks and insurance companies because of the large cash requirement.

General framework and conduct of business

The CBRC regulates banks and their conduct of business in China. Established in April 2003, the CBRC is an independent banking supervisory authority under the State Council of the government. Its powers were transferred from the original central bank, PBOC, which previously carried out banking supervisory duties in China. PBOC is now an authority focusing on making monetary policy and regulating the money market and clearance and settlement system.

In December 2003, the Law of Banking Supervision was promulgated, which formally set out the roles of the CBRC. Meanwhile, the Law of People's Bank of China (1995) and the Law on Commercial Banks (1995) were amended correspondingly to reflect the changes in the framework.

The CBRC's supervisory powers include: authorizing the establishment, changes, closing and business scope of banking institutions; regulating and supervising the activities of banking institutions; and issuing sanctions when laws are violated.

The State Administration of Foreign Exchange (SAFE) is in charge of foreign exchange matters, including banks' conduct of foreign exchange business in line with the Regulation of Foreign Exchange (1996) and its amendment (1997). The main functions of SAFE are to supervise the remittance and settlement of foreign exchange, regulate foreign debt and foreign security, and enforce actions on violation of relevant laws.

Banks require authorization to conduct banking business under the Law on Commercial Banks (1995) and its amendment (2003) as well as the Law of Banking Supervision (2003). All banks must apply for banking licenses from the CBRC. To clarify and simplify the authorization procedures, the CBRC issued the Administrative Rules on Banking Licences in May 2003, which clearly set out timeframes for licensing and the documents required.

The main banking activities authorized in China are commercial banking businesses, that is, taking deposits, providing finance and other relevant services. According to the Law on Commercial Banks, banks are not allowed to conduct or invest in other financial business, such as securities, trusts and insurance. It is expected that this will change in the coming years, when banks will be allowed to carry on financial businesses in multiple financial areas.

Foreign-invested banks

Foreign banks may conduct business in China through different presences. They may establish a branch or a wholly owned foreign invested bank, or a joint-venture bank with domestic banks (together foreign-invested banks). These foreign-invested banks and their business activities are not only subject to the Law on Commercial Banks and the Law on Banking Supervision but also to the Administrative Regulation on Foreign Invested Financial Institutions (2002).

Foreign-invested banks require authorization from the CBRC to conduct business, and their accession to the market has been restricted in terms of setting up in different localities, providing services to domestic customers, conducting renminbi banking business and offering some banking products, such as credit cards. In its accession to the WTO, the Chinese government has committed to opening the banking market and eliminating the differences in treatment of foreign and domestic banks before the end of 2006. In line with this commitment, after several opening-up measures adopted since 2001, the CBRC released a circular regarding further opening renminbi business to foreign-invested institutions on October 24 2003. It allows foreign-invested banks to conduct renminbi business in more cities, including Jinan, Fuzhou, Chengdu and Chongqing, taking the total of cities accessible for foreigners to 13. In early 2004, three local branches of foreign banks were approved ahead of WTO schedule to provide banking services to domestic corporate customers. Foreign-invested banks are still unable to serve domestic individuals in renminbi business or provide credit cards, car loans and some other products that domestic banks are authorized to carry out.

Following the Regulation on Foreign Invested Financial Institutions in 2001 made immediately after China's entry into the WTO, the CBRC issued its detailed implementation rules on July 27 2004. The rules provide the various conditions for foreign banks to establish a foreign-invested bank, the scope of business, the qualifications of and supervision on senior management personnel, the reporting system, dissolution and liquidation and sanctions on violations of laws.

Supervisory requirements and recent regulatory development

Risk control is a tough challenge for domestic banks and the CBRC. Following the efforts of PBOC for years since China started reform, the CBRC has taken various prudential measures designed to minimize systemic risks since its establishment last year. Among these measures are the capital requirements, internal control, equity investment prohibition, loan loss provision, corporate governance and connected transaction.

Capital requirements

On capital adequacy, the Law on Commercial Banks (1995) has followed the 1988 Basel Capital Accord requiring the minimum 8% capital ratio. In his letter to the Basel Commission in July 2003, the chairman of the CBRC, Liu Mingkang, expressed the position of the CBRC towards Basel II. Considering China's reality, China will not follow Basel II's requirements, especially Pillar 1, but will follow the requirements of Pillar 2 and Pillar 3 and will try to narrow the gap with the requirements of Basel II as soon as possible. In February 2004, the CBRC announced a new regulation, the Administration Rules of Capital Adequacy of Commercial Banks. Although it still requires 8% minimum capital adequacy ratio, it also stipulates 4% minimum core capital. The qualifying capital is the sum of core capital (Tier 1) and supplementary capital (Tier 2) less required deduction. Supplementary capital cannot exceed 100% of core capital.

The requirements deserving attention in these rules are the fundamental requirements of Pillar 2 and Pillar 3: supervision, examination and information disclosure. Commercial banks are required to report periodically to the CBRC their capital adequacy before and after consolidation of their financial statements. The CBRC may supervise or examine on site commercial banks' capital adequacy. Commercial banks must also disclose their capital information to their shareholders and relevant persons, and report the same to the CBRC before disclosure.

Shareholders and shares

The banking authority requires certain qualification for shareholders of commercial banks (except for holders of traded shares in listed banks) under the Rules of Investments in Commercial Bank (1999). In the banking regulatory regime, any share issued by banks or any sale or purchase of more than 5% shares of one bank requires the CBRC's prior approval. The amendment to the Laws on Commercial Banks in December 2004 lowered the sale-and-purchase percentage from 10% to 5%, indicating its tightened control over changes of shares in banks.

Any purchase of shares in domestic banks by foreign investors needs prior approval under the new Regulation on Investment in Domestic Financial Institutions by Foreign Financial Institutions (2003). It stipulates various qualification requirements on foreign financial investors, including $10 billion minimum asset volume at the end of the immediate previous year, an international rating recognized by the CBRC and other prudent conditions. The highest share percentage purchased by a single foreign investor cannot exceed 20% and 25% by all foreign shareholders in one domestic bank.

Corporate governance

The CBRC requires prior review of the qualifications of a bank's directors, supervisors and senior management. The relevant regulations and rules set out conditions for taking up a director, supervisor or senior management position. Commercial banks must report to the CBRC as required on their 10 largest shareholders and their controller. All shareholder resolutions must be filed with the CBRC.

The relevant guidelines require commercial banks to set up an audit committee, risk management committee, remuneration committee and a nominating committee under a board of directors. A board of supervisors must be established to supervise the performance of directors and senior management. All reports required by the CBRC must be accompanied by the supervisors' report on the same issues.

The CBRC also introduced an independent director and outside supervisor system into commercial banks. Under the Guideline on Independent Directors and Outside Supervisors of Commercial Banks (2002), the banking authority requires each commercial bank to have at least two independent directors on the board of directors and at least two outside supervisors on the board of supervisors. Their qualifications must be in line with the guidelines and are subject to the review of the CBRC. Independent directors are invested with special powers, including giving independent opinions on matters such as the hire or dismissal of senior management, profit distribution schemes and taking up head position in connected transaction control.

Internal control

A sound internal risk control system is pivotal to a commercial bank's regulatory regime. The banking authority has repeatedly emphasized this through different circulars. Under the Guideline on Internal Control of Commercial Banks (2002), all domestic banks and foreign-invested banks must meet its requirements on internal authorization, risk-evaluation systems, business-decision operations and information exchange as follows:

  • A special risk-control department must be set up, responsible for identifying and managing risks.
  • An internal control evaluation system must be created and periodically reviewed.
  • Internal audit must be independent from senior management and have full access to the bank's business and management information.
  • A legal department must be established for legal review of business and documents.
  • One credit-review committee must be set up for credit review and authorization. Senior management cannot be members of the committees.
  • An information exchange system must ensure the board of directors, the board of supervisors and senior management have access to business operation and risk information.
  • Risk liabilities must be clearly provided for operation staff and management.

In October 2003, the CBRC issued the Guideline on Credit Risk Control over Corporate Group Customers, requiring banks to establish risk-control systems regarding granting credit to corporate group customers in line with the guideline, and to file it with the CBRC. This measure reflects the market practice where domestic banks have not established sound and complete credit line systems in their nationwide branches to control credit risks over group companies.

Connected transaction

In April 2004, the CBRC issued the Rules on Connected Transactions between the Commercial Banks and their Insiders or Shareholders. It requires commercial banks to set up a connected transaction management system, which must be filed with the CBRC.

All connected transactions must be managed by a special committee under the board of directors headed by an independent director. A quarterly report on connected transactions must be submitted to the CBRC and material connected transactions must be reported within 10 working days.

Information-disclosure requirements

Commercial banks are subject to information-disclosure requirements. Under the Rules of Information Disclosure by Commercial Banks (2002), a commercial bank is required to disclose the following information at least to its shareholders and relevant persons in its annual report, before being submitted to the CBRC:

  • its financial report, including capital adequacy and material commented transactions;
  • its audit report;
  • its risks, including credit risks, liquidity risks, market risks and operational risks;
  • its corporate governance, including shareholder meetings, board of supervisors' meetings, senior management and their performance; and
  • other important matters, including the names of the 10 largest shareholders and any changes regarding them, as well as changes in registered capital.

Bank insolvency

Bank insolvency is subject to the general provisions of the Civil Procedure Law (1991) and the Law on Commercial Banks (1995). Under Article 71 of the Law on Commercial Banks, the principal and interest of deposits paid by individual customers must be repaid in priority when banks become insolvent. The Regulation on Close of Financial Institutions made by the State Council in November 2001 focuses on the situation where a financial institution is ordered to close by the banking authority for violation of laws or bad management to protect public interest. The only case of this so far is Hainan Development Bank, which was ordered to close by PBOC in 1998. No banks have been made insolvent through court proceedings. Recently a new Insolvency Law was drafted. It is expected that a new Insolvency Law will be promulgated soon.

Author biography

David Liu

David Liu is the founding partner of Pu Dong Law Office. Liu is a leading banking lawyer with 15 years' experience in advising international and domestic banks on regulatory matters. He has also been involved in structuring, negotiation, document preparation and rendering of legal opinion in many finance projects, including General Motor's $800 billion project finance in China and the first BOT project finance in Shanghai. In recent merger and acquisition deals in the banking industry, he advised on HSBC's investment in Bank of Communications, Citibank's acquisition of Shanghai Pudong Development Bank, Hang Seng Bank's strategic investment in Industrial Bank and IFC's investment in Bank of Shanghai.

Liu is an arbitrator of the China International Economic and Trade Arbitration Commission and the legal adviser to the Shanghai Banking Association.

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