China Attempts to Get Ahead of the Bank Solvency Problem

Bloomberg reports that China is taking steps to address potential problems in its banking system before they become acute.

Like the US and Europe, the steps focus on a mechanism to alert regulators sooner if there is trouble and requiring banks to hold more capital.

The only proven mechanism for alerting regulators sooner about potential problems and restoring bondholders and equity investors absorbing losses is requiring the banks to disclose their current asset-level data.  With disclosure of this data, then it is not only the regulators who are looking at this data but also credit and equity market analysts and competitors.

Since investors and competitors are at risk of loss from their investment exposure (debt, equity, inter-bank loans), they have an incentive to cap the risk that an individual bank takes.  They can do this by raising the prices they charge the bank for funds or by reducing the bank's access to funds.  Either way, they send a strong message to reduce risk.

By having in place a mechanism for addressing potential problems before they threaten the solvency of a bank, it also makes recapitalizing a bank by conversion of hybrid securities a more attractive proposition.  At the time the securities are converted, the investor knows that the bank is still solvent.

Should it adopt current asset-level disclosure for its financial institutions, China would set a global standard that US and European regulators and financial institutions would have to adopt.  The failure to adopt would be the equivalent of the regulators and financial institutions saying that they have something to hide.  [emphasis added]

China’s banking regulator plans to require lenders to set up procedures to allow them to restore their finances in the event of a crisis, a person with knowledge of the matter said. 

Banks considered systemically important may have to adopt safeguards including selling debt that can be converted into equity, the person said, declining to be identified because the watchdog’s deliberations are confidential. 

Regulators will also be given broader powers to supervise those lenders’ decision- making and operations to help discover potential risks early, the person said. 

China is seeking to avoid a repeat of its last banking crisis, when the government spent more than $650 billion over a decade to bail out banks after years of state-directed lending. 

Concerns about lenders’ asset quality resurfaced after credit expansion surged to 96 percent in 2009, prompting the banking regulator to push through more stringent capital requirements. 

China’s major banks cut their combined bad-loan ratio to 1.15 percent as of Dec. 31 from 17.2 percent in 2003, when the China Banking Regulatory Commission was created, official data show. 

Setting up “self-rescue” mechanisms is part of efforts to make sure equity and bond holders take greater responsibility for salvaging a bank should it encounter financial difficulties, the person said. One possible measure is selling “bail-in” debt, the person said without elaborating. 

A CBRC official, who declined to be identified citing agency policy, said in a text message response to questions that the regulator is studying the issue of self-rescue mechanisms. 

... Regulators will have the power to decide when a bank in trouble must activate its self-rescue mechanisms, the person said. The government may seek revisions to China’s Commercial Bank Law to accommodate the new requirements, according to the person. 

Global regulators spent the past two years devising ways to ensure taxpayers won’t be on the hook in the event of another banking crisis. 

The Basel Committee on Banking Supervision announced last month that hybrid debt securities need to include triggers that force banks to convert them into common stock or write them off, averting government bailouts by providing capital buffers that can fund a “bail-in” by stakeholders if a bank gets into trouble. Hybrid securities blend characteristics of equity and debt. 

China’s systemically important banks may also be subject to higher liquidity standards than domestic competitors, and may be required to have lower concentration of loans to a single borrower, the person said. 

Should a troubled lender’s own measures fail to revive it, the government would seek to broker an acquisition by a healthy bank to avoid the consequences of a closure, providing support with favorable tax and credit policies if needed, the person said. When public funds become necessary to rescue a bank, management will be held accountable, according to the person. 

The CBRC may raise the five biggest state-controlled lenders’ capital adequacy requirement to as high as 14 percent, from 11.5 percent currently, if credit growth is deemed excessive, a person familiar with the matter said last month. That includes an additional 1 percent of capital charged on them to reflect their systemic importance, the person then said.