Supervising the health of a banking system
By Liu Mingkang (China Daily)
Updated: 2004-07-05 10:41

In the first quarter of this year, the Chinese economy grew at 9.7 per cent, which by far exceeded the official target of 7 per cent.

Fast growth itself should not constitute a problem. This high growth rate is, however, largely fuelled by a surge in investment, and we have already seen clear signs that some sectors of the economy such as energy and raw materials are experiencing serious constraints, although there is no full consensus on whether the economy as a whole is overheated.

As a rule, the government once again acted, calling for macro-economic adjustment featuring a combination of market-oriented and necessary administrative measures so as to maintain sustainable growth and prevent the excessive fluctuation of the business activity.

We, at China Banking Regulatory Commission, clearly recognize the important role of banks in the economy.

Despite the dramatic structural change in China's financial system, the banking sector continues to dominate the financial landscape. As the banking supervisor, we closely monitor the health of the banking system and examine banks' lending risks in light of the recent developments in the economy.

As we look at the recent statistics for the growth of investment in fixed assets and growth of bank lending, we are particularly concerned about the close association between the two.

Indeed, at present bank lending represents in general more than 60 to 70 per cent of the project finance for such capital-intensive industries as iron and steel, aluminum, automobile and property development.

Clearly, a boom in business activity influences the demand for credit and at the same time expanding money supply increases demand pressures. Therefore, it is important for the banking supervisor to pay close attention to avoiding the build up of excessive risk in the banking system when the economy is heading to a peak.

We consider that it is our responsibility to help strengthen the financial system, which in turn will support sustainable growth.

It is generally recognized that sound risk management can help banks to ensure diversification of risks arising from the potential of default. However, the banking system as a whole would find it difficult to avoid the risk when the economy takes a downturn, with higher inflation, rising cost and squeezed profits.

Risk management crucial

More often than not, risk tends to build up during the expansionary phase of the business cycle. Put it differently, the potential for banks to incur significant losses on their lending portfolios increases towards the peak of the expansionary phase of the business cycle. At this stage, banks' financial conditions appear to be quite sound.

Non-performing loans may well drop and profits grow rapidly. However, when the economic activity slows down, the risk inherent in banks' lending portfolio is likely to materialize when the borrowers no longer enjoy the benefit of buoyant economic activity.

Addressing this type of financial distress is a real challenge for the banking supervisor.

Based on my own experience both as a banker and a bank supervisor, I am not so sure that we can accurately predict or anticipate the economic cycle or the potential financial distress of banks.

In fact, policy makers in developed markets tend to share the same view. For example, Federal Reserve Chairman Alan Greespan once noted that "Uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic."

I believe that this comment also holds true for banking market and banking supervisory policy. Therefore, in developing a supervisory response to macro-economic adjustment or the change of status of business cycles, we inevitably return to the basic prudential supervisory policies, particularly their implementation, such as capital adequacy, risk diversification, limit on risk concentration and sound risk management procedures and processes by banks, or in other words banks' due diligence in loan processing.

While supervisory policies could hardly be designed to be counter-cyclical, the adoption and effective implementation of prudential policies will certainly be in the interest of promoting the safety and soundness of the banking system, which then helps in turn to ensure sustainable growth of the economy.

Measures to ward off risks

Indeed, the supervisory response that we have introduced recently and most likely going forward to the developments in the economy follows exactly the same approach as I described above. Let me highlight our policy response.

The first is enforcement of capital adequacy standards. The supervisor is taking very concrete steps to enforce capital adequacy standards. The new capital adequacy rule governing commercial banks was introduced in March.

As a follow-up, we asked all commercial banks to prepare a detailed capital restoration plan and send it to the supervisor before end June.

Banks are required to fully recognize in their operations capital as a major constraining factor for the expansion of their balance sheet. They need to introduce a set of procedures and processes for managing capital and increase their capital base to meet the supervisory requirement.

Not surprisingly, in doing so, they may need to reduce the risk-weighted assets, particularly the exposures to high-risk borrowers or investment projects, and explore various channels now made available to strengthen their capital base.

In contrast with the previous approach, we stress that calculation of capital adequacy is based on the adequate provisioning in accordance with the supervisory provisioning standards.

Based the newly introduced capital rules, capital adequacy for many banks drops quite significantly, which is largely attributed to the shortfall of provisions.

This does not come as a surprise for us. Indeed, even for the Bank of China, which was re-capitalized by the government last December, the reported capital adequacy for 2003 actually falls instead of rising presumably to around 15 per cent if measured using the old rule. There should be no tolerance on provisioning although banks are allowed some time to phase in capital requirements.

Secondly, we asked our banks to improve loan quality. At a minimum, banks should manage their lending portfolio using the supervisory five-category loan classification.

They should ensure the accuracy of the classification system within their entire institutions and monitor non-performing loans on a loan-by-loan basis. Special attention should be given to bank branches that report an increase of non-performing loans and those that operate in violation of government rules and regulations.

Banks should closely watch the cyclical developments in the economy, heighten their vigilance to the changes in the credit and financial standing of their clients, adjust their loan portfolio from time to time and halt reckless lending to any investment projects that are not duly authorized by the government.

Banks are also encouraged to channel more funds to viable infrastructure projects that have the potential to promote a balanced development of the economy.

Thirdly, banks should limit their exposures to the single large borrower and its related parties.

We have learnt the lesson the hard way that a number of corporate groups or connected business enterprises borrowed heavily from banks under different names, thus resulting in excessive exposures by many banks.

Based on the newly issued rule on risk concentration and lending to related borrowers, banks should report to the supervisor detailed customer information on large borrowers in excess of 100 million yuan (US$12 million). This information is much more helpful in piecing the Chinese large exposure jigsaw puzzle together and the supervisor will send the warning signals to banks concerned so that banks will get an overall picture of the total exposures to a particular customer and its connected parties and know which pieces of the jigsaw puzzle make sense.

Fourthly, the supervisor will issue very shortly a set of supervisory guidance on due diligence of banks in lending operations. Such guidance will cover a detailed job description of banks' lending officers and due procedures and processes for loan origination and approval.

With this guidance, banks are expected to do their homework in a more effective way that underlines precision over direction, i.e., stop and go.

Of course, banks are also expected to come up with more detailed and operational rules for themselves with reference to the supervisory guidance.

I believe that we have offered what we could the best protection for our banks at this critical moment. All the rest depends on their own actions. Hope they drive in calm waters.

As I indicated earlier, it would be difficult to vary regulatory requirements such as capital adequacy, provisioning standards etc, during boom or bust of the business cycle. The attempt to do so for the purpose of dampening financial conditions might have a lot of drawbacks.

On one hand, it may create uncertainties in the banking market with market participants trying the very best to second-guess when and whether the prudential policy is going to change again. On the other hand, market participants may rely on the supervisor's assessment of risks.

This may well lead banks to take on more risk at a time when they should in fact be more cautious. The preferred option then is to apply supervisory policies consistently and enhance the credibility of these policies.

However, in addition to regulation, the supervisor is always in a position to promote better risk management in banks as we have been trying quite vigorously.

Indeed, improvement in banks' risk management, along with others, is the key to the development of a sound and robust banking system.

In concluding, I stress the need to take a system-wide or macro-economic prudential perspective of banking supervision.

It is important that the supervisor should keep a finger on the pulse of the developments in the economy. As a new institution, we are facing the challenge of improving the overall resilience of our banking sector and limiting the buildup of significant exposures both within the banking system and individual banks.

I believe that monetary, fiscal and banking supervisory authorities should work closely to share the information about risks developing in the economy and banking system. Better communication and co-ordination would help to ensure the financial stability, which is absolutely essential to fully support a sustainable economic growth.

Close