Guiding Principles of China’s Banking Regulation
The Asian Banker Summit 2009 Opening Keynote Speech

 By Mr. LIU Mingkang, Chairman, China Banking Regulatory Commission
May 11, 2009, Beijing

Good morning ladies and gentlemen. I would like to take this precious opportunity to share with you some of our experiences and understandings of China’s banking regulation.

Although severely tested by the global financial crisis, the Chinese banking industry still successfully maintained its safety and soundness. Let’s take a look at some important figures of the sector, so as to have a snap shot of its momentous improvements. As of end-2008, the total assets of China’s banking institutions recorded RMB62.4 trillion, increased by RMB34.7 trillion in comparison with that of end-2003, profit-after-tax reported at RMB583.4 billion, up RMB414.5 billion. Talking about Return of Equity, five years ago our banks didn’t have a clue, but at the end of 2008, they have an average ROE of 17.1%. Whereas, the NPL ratio of major commercial banks was reduced from 17.9% to 2.4% of total loans, while the number of banks satisfying the minimum capital ratio of 8%, has increased from 8 to 204, with their assets accounting for 99.9% of the total assets of the industry. At the end of last year, the ICBC, CCB and BOC became the world’s three biggest banks in terms of market value, while regarding tier-one capital, they were also among the world’s top fifteen. These figures and standings demonstrate that our banking industry has ushered in a whole new era of development.

This is not fortuitous. It is only under the guidance and support of the Central government, that made the Chinese banking industry fulfill such profound achievements within thirty years of reform and opening-up. It is also a combined result of the continuous growth in macro economy, the improvements of banks’ own internal controls and the evolution of the market mechanisms. When China’s economy soared in these three decades, other major economies also experienced the Great Moderation period with high growth and low inflation. Nevertheless, in this boom, different philosophies and macro-economic policies of different economies have led to different results. Some have proven risk resilient in their financial systems, while the cases of others are vice versa. This story tells us that booming economy alone could not guarantee the safety and soundness of a financial system. Indeed, in the context of robust economic growth, how to move ahead with the banking sector’s structural reform, and prevent the risk contagions across markets? This is no easy task, and this is exactly what I would like to elaborate in my speech.

Now banking regulators across the world are reviewing and analyzing the lessons drawn from the global financial turmoil, and so are we. Although we are in a distinctively different market environment, but speaking of the basic elements and fundamentals, every financial market is more or less the same. In the past few years, we have systematically developed a series of methodologies and effective on-going regulatory and supervisory approaches for the Chinese banking system that could fit into Chinese situations. These efforts have protected our banking sector and allowed it to advance despite the global crisis.

First of all, we applied international best practices upon Chinese realities. It is widely acknowledged that, the ultimate purpose of banking regulation is to intensify market discipline, strengthen banks’ corporate governance and internal controls, and enhance their risk management capacities. Upon our establishment, we materialized this notion in our regulatory principles, and put forward the regulatory methodology of Conducting consolidated supervision, Staying focused on risk-based supervision, Urging banks to improve internal controls, and Enhancing supervisory transparency. We persisted in strengthening prudential risk-based supervision, and in the meantime, promoting the development of financial institutions and having them take their own initiatives to forge the first defense line against risks. As a matter of fact, our regulatory objectives and criteria have proven effective in formulating the prudential regulatory structure which is appropriate for Chinese realities, and have become the fundamental principle and roadmap for China’s banking regulation.

Secondly, we kept on improving both rule-based and principle-based regulation, and developing our abilities to timely capture signs of potential risks. Practice indicates that, it is vitally important for the regulators to timely discover the movements and changes of risks in the financial market. However, this is not easy at all, as the initiatives of the market are always one step ahead of regulatory responses. Soon after our establishment, we have publicized the rules and regulations on credit risk, market risk, operational risk and IT risk, structuring an effective framework for rule-based supervision. In the meantime, we also developed some useful regulatory principles. For instance, we worked out a roadmap for on-going supervision on credit risk, namely, Ensuring accuracy of loan classification---Drawing adequate loan loss provisions---Truthfully reporting profit--- and Meeting minimum capital requirement. In order to reduce risks arising from financial innovation, we put forth the principle of controllable risk, measurable cost and adequate information disclosure, and the principle of supervising not only products, business operation and institutions involving in financial innovation, but also their activities and behaviors. With the establishment of these important regulatory principles, our supervisory ideologies have become the benchmark to standardize and direct the banks’ activities.

Thirdly, we stroke a balance between micro- and macro-prudential regulation, so as to improve regulatory effectiveness. After the outbreak of the crisis, one globally recognized fact is that, the regulators have put too much emphasis on capital adequacy ratio, while paying little attention to reinforce their capacity and structure of macro-prudential regulation. On the contrary, the CBRC has always kept a close eye on individual banking institution as well as systemic stability. On the one hand, we stayed focused on the capital constraint, loan loss provisions, large exposures, NPL management and recovery, corporate governance structure and internal controls within individual banks; while on the other hand, we strengthened macro-prudential regulation on the entire banking sector. Ever since the inception period of CBRC, we highlighted the strategy of prioritizing the reform of state-owned commercial banks and rural credit cooperatives, while deepening the supervision on other banking institutions, which demonstrated our concern on the most systemic players in this industry. We held meetings with the CEOs of major banks on regulator basis, and informed them about the latest developments of macro-economy and the adjustment and restructuring in some major industries, and alerted them to the potential systemic risks. We instructed the banks to conduct stress testing, especially on the credit risk and market risk of a few overheating industries with high risk exposure. And we also did a good job in systemic peer group comparison and rated our banks with CAMELs rating system. In addition, we also activated our regulatory approaches to prevent cross-market and cross-border risk contagions. These moves proved fruitful in building up a macro-prudential regulatory framework and ensuring the systemic stability of the industry.

Fourthly, we enhanced counter-cyclical regulation capacity and took a series of measures.

• In view of the pro-cyclicality of some prudential regulatory targets, such as capital adequacy ratio and mark-to-market value of collaterals, we always required the banks to pay equal attention to their asset quality and their capital adequacy ratio, and requested that the banks’ shareholders should have a steady capital flow from their core business, so as to maintain sustainable capacity to replenish capital and avoid insolvency. And when using mark-to-market accounting to prevent credit risks, we took into account the potential volatility from short-term market turbulence and other extreme situations that might misguide us in risk identification and assessment.
  
• Regarding the risks arising from a few speculative sectors, we were very strict in controlling credit leverage ratio and concentration from the origin. For instance, we tightened our oversight on credit to commercial real estate business, by enforcing strict caps on the real estate company’s debt to equity ratio, and increased the mortgage rate for second or multiple house purchase, so as to prevent the real estate bubbles from spreading into the banking sector. We effectively prevented risk contagions from the capital market, by strengthening the supervision on securitization business, guiding the banks to prudently conduct asset-backed securitization, and thus warding off the housing loan risk to be amplified through securitization process.
  
  
• We kept a close eye on banker’s remuneration package to make sure it is scientific and reasonable, so that we could minimize the pro-cyclicality generated from their short-term risk-taking activities.
  
  
• We intensified the supervision on wealth management products, requiring banks to be fully responsible for their products while advising the customers to be fully aware of potential risks. Commercial banks must make sure that the relevant information and risk profile are fully disclosed before and after the product is sold to the customer. Also, the investors are required to sign twice or even more times on the risk-signaling document so as to prevent misleading sales of such products.

In 2009, we continued with our counter-cyclical regulatory approaches, with special focus on countervailing the influence of financial crisis on the real economy. We urged the banks to increase provisions and reserves for potential losses, enhance their risk resilience, and balance their desire of business expansion with mitigation of potential risks. They are required to stand firm at the bottom line of risk, diligently conduct sound lending procedures and process, guard against any risks arising from commercial papers, enhance their management on large exposures, and comply with the minimum capital requirement on project financing.

Fifthly, we continued to expand our regulatory coverage in a bid to oversee all risky institutions. The lesson drawn from the financial crisis indicated that, a clear-cut regulatory boundary and the total coverage of regulatory jurisdiction could be vitally important. One reason for the outbreak of crisis was that investment banks, hedge funds, commercial banks and some other non-regulated financial intermediaries avoided regulation via structured investment vehicles (SIV) and derivatives, imposing systemic damage to the financial industry. The CBRC has attached great importance on the issues concerning regulatory boundary and coverage. We have set up functional supervisory departments, and realized the matrix management and information sharing of such departments with the institutional supervisory departments. We upheld adequate risk segregation between the banking sector and the capital market and real estate market. We kept on enhancing effective regulation on different categories of risks, from traditional credit risks and market risks, to the emerging IT risks and reputational risks. In mitigating those risks, we did the job in depth and in details. In addition, we also improved our prudential regulation on not only banking institutions, their business operation and products, but also on their behaviors.

Sixthly, we persisted in prudential and effective regulatory indicators. Before the crisis, the regulators of some developed economies have misjudged the overall risk of the financial market, especially regarding some complex structured products. They became too optimistic in the boom and abandoned some basic prudential requirements on regulatory indicators. In face of the evermore sophisticated financial market, we always insisted on the traditional regulatory requirements and principles, and always kept a close eye on the banks’ corporate governance, capital adequacy ratio, large exposure, liquidity, non-performing assets, loan loss coverage ratio, and transparency. We also required the banks to watch closely at their lending procedures and process, so as to reinforce their foundation of risk management. We noted that, at present, many regulators also started to embrace such “back to basics” regulatory approach.

Nevertheless, we are fully aware that we still have to pay particular attention to some challenging issues.

First of all, it is necessary to further deepen the reform of China’s banking system. We have progressively deepened our development in three decades of reform and opening-up, however, we are also aware that, thirty years is only a short period of time, comparing with the development of the western banking industry. In this regard, we still have a long way to go, and a lot to catch up with. Some of our problems are systemic and complicated, so our reform task would be long and arduous.

Secondly, China’s current development pattern still has to be modified in a scientific manner. Now China is still undergoing the period of urbanization and industrialization. It is determined by the endowment of our resources, that the labor-intensive industries will remain to be the core driver for economic growth, and to be our comparative advantage in the global market. This in turn determines that the Chinese banks will, in a very long period, be prepared to cope with potential risks arising from credit issued to urbanization constructions and large-scale infrastructure constructions. Over the years, there has been a convergence in Chinese banks’ operational behaviors and risk management patterns. We are very concerned that such convergence should generate material risk concentration, which would become the biggest challenge of regulation.

Thirdly, the infrastructure of China’s financial market still needs to be further enhanced. At present, China’s financial infrastructure is not sound enough. For example, we are still using different clearing systems for standardized- and non-standardized contracts of OTC derivatives trading, without sufficient regulation. In addition, a clear-cut deposit insurance scheme, as well as the bankruptcy law for financial institutions and bankruptcy court is not in place. We are also short of highly-qualified credit-rating agencies, auditing houses, appraisal offices and law firms.

In the fourth place, the banks should further cultivate a customer-oriented culture in their services. Currently, Chinese banks still need to further improve their culture and ideology in customer service, and should make sure that every employee bears in mind that the customer is the god. To develop such awareness, the banks can not simply require their employees to serve the customers with smiles on their faces, but to really understand the specific demand of each customer, classify their customers to provide targeted services, be well-acquainted with customers’ information, and add more value to their services. In particular, the front-desk employees should enhance their services, by means of, firstly, becoming the end-person of customer complaints and inquiries, which means to help the customers through with their questions and try their best to thoroughly solve these issues. Secondly, they should provide on-going and follow-up services in wealth management, timely inform the customers with the latest developments of the market, their profits and losses, and the assessment results of overall investment strategies.

Ladies and gentlemen, we are now in a new historical starting point. China’s banking industry has finished its initial reform and development, and is ready to set out for its new trek. For us, the financial crisis is both a material challenge, and at the same time, an opportunity. Following the scientific development theory, we shall, in compliance with objective principles, and based on the economy’s realities, further push forward the reform and opening-up of the banking sector, and make every effort to enhance the effectiveness of our regulation, so as to maintain the healthy and sound development of the industry. I am fully convinced that, once getting through this crisis, we will be in a better position for a more promising tomorrow.   

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