International Banking Regulation and Supervision after the Crisis

- Implications for China -

Prof. Dr. Horst Loechel China Europe International Business School, Frankfurt School of Finance & Management

German Centre of Banking and Finance at CEIBS 699 Hongfeng Road, Pudong, Shanghai 201206, P. R. China

hloechel@ceibs.edu, h.loechel@fs.de

Prof. Dr. Natalie Packham Frankfurt School of Finance & Management

Sonnemannstrasse 9-11, D-60314 Frankfurt am Main, Germany n.packham@fs.de

Helena Xiang Li Frankfurt School of Finance & Management

Sonnemannstrasse 9-11, D-60314 Frankfurt am Main, Germany h.x.li@fs.de

 

    

         

EU‐CHINA BMT WORKING PAPER SERIES                          No. 013                                       

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International Banking Regulation and Supervision after the Crisis

- Implications for China -

Prof. Dr. Horst Loechel China Europe International Business School, Frankfurt School of Finance & Management

German Centre of Banking and Finance at CEIBS 699 Hongfeng Road, Pudong, Shanghai 201206, P. R. China

hloechel@ceibs.edu, h.loechel@fs.de

Prof. Dr. Natalie Packham Frankfurt School of Finance & Management

Sonnemannstrasse 9-11, D-60314 Frankfurt am Main, Germany n.packham@fs.de

Helena Xiang Li Frankfurt School of Finance & Management

Sonnemannstrasse 9-11, D-60314 Frankfurt am Main, Germany h.x.li@fs.de

Working paper, December 2010

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Abstract Against the background of the reform wave of banking regulation and supervision over the world, we review the development path of banking regulation and supervision in China to understand how and in which direction the regulatory and supervisory framework in China evolved and how regulation and supervision guarded China’s banking sector in the financial crisis. We further conduct comparative studies on regulatory issues in China, France, Germany, the UK and the USA to draw implications for the development in China. We especially discuss regulatory goals, principles, structure, scope, macro-prudential policy, systemic risk control and activities restriction in the above countries. Our assessment identifies that Chinese supervisors took great effort in the last thirty years to establish and upgrade the regulatory and supervisory framework in China to international standard. The current already very strict regulation in capital, liquidity and business scope even above international levels makes the implementation of even Basel III in China no bigger challenge than in Western countries. In international comparison, regulation in China is characterized with high stability orientation instead of the overemphasis on market competition and efficiency, mainly based on rules with increasing risk orientation, segregation both in activities restriction and regulatory structure, strong macro-prudential oversight and frequent rules updating. However, the increased market and product variety and the surge of cross-sectoral services call for more sophistication and consolidation in regulation and supervision. Keywords: Banking regulation and supervision, financial crisis, China JEL classification: G01, G21, G28

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I. Introduction The shock of the financial crisis triggered a new round of regulatory reform on the global scale. In France, a new banking and financial regulation rule was passed in June 2010. The German cabinet banned short selling and is in consideration of restructuring the supervisory structure. The UK issued the new Banking Act in February 2009. In the USA, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act on July 21st 2010. The G-20 Seoul meeting passed the Basel III in November 2010 as the new global framework of post-crisis banking regulation and supervision. Banking regulation and supervision draws as usual the focus of political attention after every banking crisis, as evident by the introduction of the Glass-Steagall Act in the US after the 1929 crisis. But current discussions about regulatory reform on national and international levels as well as in international institutions like the IMF and the BIS reached another dimension. Failures in financial regulation and supervision are regarded this time as “fundamental causes of the crisis” as stated in the Leaders’ Statement of the 2009 G-20 London Summit in April 2009. Coffee (2008) blames “regulatory failure” as a cause of the crisis and sharply criticized SEC’s relaxed supervision through the loosening of the maximal ceiling of debt to equity ratio under the “consolidated supervised entity” program launched in 2004 and the ease of the disclosure requirement for asset-backed securities especially through Final Rules for Regulation ABS issued in 2005 in the US. Those rules encouraged the excessive risk taking behavior of major investment banks and led to disastrous failure of all major investment banks ending with bankruptcy, take-over or forced conversion into bank holding company. His opinion is shared by Levine (2010) who deems the crisis as a man-made failure by regulatory agencies. The crisis marks the fundamental switch of the regulatory philosophy from the blind belief in market forces to the call for a stronger hand of supervision. And there is a general consensus that national interests are only protectable in an internationally cooperative manner in the integrated global financial world, despite unequal development stage and heterogeneous market structure of national financial markets. The crisis not only announced the end of the era of the dominance in Western countries of deregulation orthodoxy, but also triggered strong interest in searching for alternative instruments of prudent regulation. Against the background of the global banking crisis, Chinese banks suffered less due to very limited exposure to subprime assets and restrictive access to international financial markets. Top Chinese banks climbed suddenly to the top of global bank ranking (see table 1). The good performance of Chinese banks in the crisis demonstrated in some extent China’s strength in prudent banking regulation. In his article “Basic Rules Helped China Sidestep Bank Crisis” in Financial Times Chinese on June 30th 2009, Liu Mingkang, Chairman of the China Banking Regulatory Commission (CBRC), expressed his strong belief in some “old-fashioned” rules in regulating banks and demonstrated China’s desire for more collaboration in building a global level playing field in financial regulation.

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Bank Country US$ million Bank Country US$ million

1 Bank of America Corp USA 160,388 ICBC China 24,4942 JPMorgan Chase & Co USA 132,971 CCB China 20,3163 Citigroup USA 127,034 Goldman Sachs USA 19,8264 Royal Bank of Scotland UK 123,859 Barclays UK 18,8695 HSBC Holdings UK 122,157 Wells Fargo & Co USA 17,6066 Wells Fargo & Co USA 93,795 Banco Santander Spain 16,9517 Industrial and Commercial Bank of China (ICBC) China 91,111 BOC China 16,3198 BNP Paribas France 90,648 JPMorgan Chase & Co USA 16,1439 Banco Santander Spain 81,578 BNP Paribas France 12,22210 Barclays UK 80,449 Itaú Unibanco Holding SA Brazil 11,52111 Mitsubishi UFJ Financial Group Japan 77,218 Credit Suisse Group Switzerland 8,28312 Lloyds Banking Group UK 77,034 BBVA Spain 8,26513 Crédit Agricole Group France 75,504 Banco do Brazil Brazil 7,95714 Bank of China (BOC) China 73,667 ABC China 7,68215 China Construction Bank Corporation (CCB) China 71,974 Deutsche Bank Germany 7,49616 Goldman Sachs USA 64,642 HSBC Holdings UK 7,07917 UniCredit Italy 56,245 Banco Bradesco Brazil 6,96518 Group BPCE France 54,141 Crédit Agricole Group France 6,74919 Société Générale France 49,990 Bank of Communications (BoCom) China 5,60020 Deutsche Bank Germany 49,576 Westpac Banking Corporation Australia 5,36621 ING Bank The Netherlands 49,013 Commonwealth Bank Group Australia 5,25922 Morgan Stanley USA 46,670 Intesa San Paulo Italy 5,22223 Sumitomo Mitsui Financial Group Japan 46,425 Standard Chartered UK 5,15124 Rabobank Group The Netherlands 46,383 Royal Bank of Canada Canada 5,03825 Intesa San Paulo Italy 43,523 Scotiabank Canada 4,451

Source: The Banker July 2010

Table 1. Global Top 25 Banks 2009Tier 1 Capital Pre-tax Profit

The desire for coordinated regulation and supervision on a global scale is intensified through the crisis. In 2009, jointly with Argentina, Australia, Brazil, Hong Kong SAR, India, Indonesia, Korea, Mexico, Russia, Saudi Arabia, Singapore, South Africa and Turkey, China became a member of the Basel Committee on Banking Supervision and sits in Financial Stability Board. The enlargement of the Basel membership mainly through the participation of emerging countries reflects the necessity of multi-lateral learning in regulatory polices and practices and enables the integration of proven supervisory polices from emerging countries in the revised framework. Against this background, we believe that there is necessity in taking stock of the current regulation and supervision landscape to promote more understanding of different systems and instruments, providing a basis for more intensive exchanges and cross-nation learning. In this paper, we select five countries for our discussions: France and Germany from the Continental European financial system, the UK and the USA representing the root of the Anglo-Saxon financial system, and China with emerging characteristics.1 We integrate state-of-the-art academic research results into regulatory praxis to discuss some key elements of the current regulatory and supervisory reforms. In this way, we try to make recommendations contributing to the ongoing efforts of global regulatory and supervisory reforms. The unique value of this paper lies in filling the gap of the lacking presence of the regulatory and supervisory practice of China in international academic discussions, which increasingly contradicts the role of Chinese banks in the global banking landscape and Chinese supervisors’ participation in major decision making processes on banking regulation and supervision in international organizations. The special focus is put on the differences of the Chinese regulatory and supervisory practices compared to international standards and the implications of the current global regulatory reforms for China to better advise the 1 Due to the limited scope of this paper, we only cover the selected five above mentioned countries. We strongly believe that tasks of such global scale can only be mastered with forces of all countries of the world involved and encourage the extension of comparative studies of such kind to more countries of interest. For a more comprehensive and quantitative study on regulation and supervision over the world, see the World Bank database “Banking Regulation and Supervision” as well as Barth, Caprio and Levine (2001) and Barth, Caprio and Levine (2008).

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development of the Chinese regulatory and supervisory framework. Our key findings include: - A new round of structure reforms of regulatory authorities both on national and

supranational levels starts with the consensus of greater emphasis on stronger coordination among sectoral regulatory agencies, treasury, central bank and other parties involved and the strengthened role of central banks in macro-prudential oversight.

- Greater emphasis is put on macro-prudential regulation and the oversight of systemic risks. New agencies for macro-oversight are established or responsibilities are assigned to existing agencies, mostly the central bank. The link between financial market development and real economic needs will be strengthened by more coordination of monetary, fiscal and economic development policies to meet the overall goal of financial market stability.

- More rule-based regulation including more detailed rules in capital components, ratios on leverage and liquidity will be integrated in the current risk-based regulatory framework and the decrease in complexity is called for by more capital charges for size, complexity and inter-connectivity.

- More cyclical dependant adaption of regulatory rules will be introduced to encounter

the pro-cyclicality of the current framework. Banks are expected to face changing regulatory rules according to economic cycles and are forced to build up flexible management and controlling tools accordingly.

- There will be more capital charge for complexity, inter-connectivity and engagement in non-core business. Back-to-basic, transparency and risk reduction will shape the post-reform financial world.

- Regulatory scope will be broader and intensity stronger. Non-banking financial institutions such as hedge funds, private equity, and non-financial-institution financial services providers such as rating agencies, OTC-exchanges through the financial services value chain are subject to regulation, when not at least are required to be registered and more transparent.

- A new regulation for the balance of risk diversification and risk limitation in

universal banking model will be tested. We draw the following implications for banking regulation in China: - As the banking sector itself and the regulatory framework still show some characteristics

of emerging market and there still exists no explicit deposit insurance system in China, Chinese supervisors usually set more strengthened rules in regulation and supervision the banking sector than international convention.

- A philosophy of stability instead of the overemphasis on efficiency through market

competition is regarded as the highest priority of regulation.

- Rule-based regulation dominates with the gradual introduction of risk-orientation through the phased implementation of the Basel framework and differentiated treatment of

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various banking types.

- Fragmented regulatory structure is gradually complemented with coordination mechanism with a new Financial Supervision Coordination Commission in discussion.

- China has a high level in centralized trading and registration of involved market participants. As hedge funds and private equity increasingly expand activities in China, the coordination with Western countries in introducing reform rules in regulating such non-banking financial institutions urges.

- Chinese regulatory authorities have a strong position in macro-prudential and contra-cyclical regulation through coordinated monetary, fiscal and economic development policies and regular adjustment of such policies.

- Most restrictive activities regulation lies behind international standards and does not correspond to business reality of the integration in markets and products. The new Volcker-rule introduced in the US reform could test as a template to reach a new balance of business diversification and risk limitation in banking.

- Due to the less complexity in market structure and simple business model of Chinese banks, the regulatory success of Chinese regulators is in some extent not a surprise. The challenges lie more in the build-up of regulatory competences and capacities side by side with the increasing complexity of the financial industry.

The following part reviews the regulatory and supervisory framework in China to get a better understanding of the evolution and the forming process of the current structure. Part III deals with detailed comparison in various aspects both from the theoretical and the practical view to consolidate the up-to-date knowledge and practices in banking regulation and supervision to generate a consensus in the global convergence of banking regulation and give some hint on the development of the Chinese regulatory framework. Part IV summarizes the main joint tasks of post-crisis regulatory reforms and points out the challenges Chinese supervisors face in the global reform wave.

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II. Regulatory and supervisory framework in China II.1. Banking regulation in China2 A. Regulation of Chinese banks On October 17th 1984, the central bank People’s Bank of China (PBC), the unified supervisor of financial institutions till 1995, issued the Provisional Rules on the Set-up, Liquidation and Merger of Financial Institutions, which regulated for the first time the requirement of a license for financial institutions and assigned the license approval responsibility to the PBC (rural credit cooperatives licensed by the Agricultural Bank of China (ABC) with authorization of PBC). The first comprehensive regulation rules were issued by the State Council on January 7th 1986 through the release of the Provisional Rules on Banking Regulation, which clarified the banking market structure including the PBC as the central bank, specialized banks and other financial institutions covering trust and investment companies, rural credit cooperatives, urban credit cooperatives and other financial institutions licensed by the PBC. It especially clarified the responsibilities of the PBC in currency issuance, interest rate, foreign currency and credit plan management and the regulation of specialized banks, other financial institutions and insurance companies. It further established the regulation of credit plan set by the central bank and executed by specialized banks within the credit quota. The release also introduced the deposit rate ceiling and lending rate floor system determined by the central bank. The rates for interbank lending were not in the scope of the interest rate regime and determined by contract partners. The credit amount guidance and the guaranteed interest margin regime existing in today’s Chinese banking sector rooted in the 1986 rules. For credit risk regulation, it was not until 1988 that the loan provision system was introduced for specialized banks in China through the issuance of the Provisional Rules on the Establishment of Loan Provision Mechanism at Specialized Banks issued by the Ministry of Finance. The rules clarified the definition of non-performing loans and set ratios between 1% and 2% for different loan classifications as mandatory loan loss provision. On August 5th 1994, PBC issued the General Provisions on the Regulation of Financial Institutions, which was the first comprehensive law on regulation of financial institutions in China. It prescribed the license requirement, defined financial services, differentiated between banks including policy banks, commercial banks, credit cooperatives, postal savings bank, from insurance, securities, fund management companies, trust investment companies, finance companies and leasing companies. It established the segregation of banking, trust, insurance and securities services and the PBC annual and routine inspection mechanism. Banks with national license were required to hold a minimum capital of RMB 2 billion, those with regional license with RMB 1 billion. Extra RMB 100 million was required as operation funds to open a branch, RMB 50 million for a sub-branch. The asset liabilities management was introduced in the same year through the issuance of the Notice on Asset Liabilities Management of Commercial Banks by the PBC on February 15th 1994. It introduced the minimum tier-one capital ratio of 4%, the minimum capital adequacy ratio of 8%, maximum loan-to-deposit ratio of 75%, maximum long-term (over one year) loan to long-term deposit ratio of 120%, minimum liquid assets to liquid liabilities ratio of 25%, minimum deposit reserve ratio of 5% to 7%, maximum loan concentration ratio for the largest lender of 15%, 2 For an overview of the development of China’s finance industry, see for instance Wu (2005), Farrell, Lund and Rosenfeld (2006), García, Gavilá and Santabárbara (2006), Loechel and Zhao (2006) and Neftci and Ménager-Xu (2007).

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for ten largest lenders of 50% of capital and the NPL ratio limit of 2%. It further prescribed the risk weights for calculation of risk assets. The measures were to be implemented over the subsequent years; the capital adequacy ratio however was to be fulfilled at the end of 1996. The year 1995 witnessed a milestone for China’s banking sector with the issuance of a serial of laws: the Law of the People’s Republic of China on the People’s Bank of China on March 18th 1995 and the Law of the People’s Republic of China on Commercial Banks on May 10th 1995, the Insurance Law of the People’s Republic of China on June 30th 1995. The PBC law clarified the function and instruments of the PBC as central bank in implementing monetary, interest rate and exchange rate policies and in financial supervision. The commercial bank law 1995 lowered the minimum capital requirement for opening a nationwide bank to RMB 1 billion, RMB 100 million for the opening of a city credit cooperative bank and RMB 50 million for a rural credit cooperative bank. Appropriate operation funds were required to open branches; the total of the funds however should not exceed 60% of the total capital of the headquarter. The issuance of the Securities Law of the People’s Republic of China on December 29th 1998 supplemented the juridical infrastructure of the financial system. It reinforced the separation of banking, securities, insurance and trust businesses. As the banking structure with central bank, policy banks and commercial banks gradually evolved, the PBC changed the mandatory credit quota to credit guidance to encourage commercial bank’s in making independent loan decision from January 1st 1998. To unify and benchmark the loan classification to international standard, PBC issued on April 20th 1998 the Guidance on Risk Classification of Loans which introduced the five-class loan classification system to categorize loans as “pass, special mention, substandard, doubtful and loss” to overhaul the existing three-class system “overdue, idle and loss”. The implementation of the five-class loan classification however took long time with the disordered phase of the parallel application of three-class or four-class (a transition rule to classify loans to four classes “pass, overdue, idle and loss”) and five-class loan categorization until the CBRC mandated the usage of the five-class system for all state-owned and joint-stock commercial banks in 2004. The five-class loan classification was rolled out to rural credit cooperatives in 2006 with the aid of experts from state-owned commercial banks and joint-stock commercial banks who shared their experiences in the introduction the new system. To increase transparency, the PBC issued the Provisional Rules on Commercial Banks’ Information Disclosure on May 15th 2002. The rules prescribed detailed items in disclosing bank’s financial report, risk management report, corporate governance report and other important items in the annual reports to be disclosed within four months after the closure of the accounting date. Annual reports were to be submitted to the PBC and make available for shareholders and made public in the bank’s major business places. City commercial banks were obligated to implement the rules staged from January 1st 2003 to January 1st 2006. On July 3rd 2007, CBRC released the Rules on Commercial Banks’ Information Disclosure, which established the publication obligation of content and form of detailed items to disclose commercial banks’ financial position, risks and risk management system, corporate governance and other important issues. The CBRC even set up an official website for commercial banks’ information disclosure in November 2007.3 To regulate pricing, the CBRC issued the Provisional Rules on Pricing in Commercial Banks effective on October 1st 2003, which divided two types of pricing: state-guided pricing and market determined pricing mechanism. The former was applied for settlement services and

3 Available at: http://www.cbrc.gov.cn/bankbbs/bankbbs/BbsPageAction.do?operate=getJrpl.

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supervised jointly by CBRC and the State Development and Reform Commission (SDRC) following the cost-plus principle, the later for other services and was in the hands of individual banks, should however be applied throughout the bank’s branch network. Opening and closure of a savings account, depositing and withdraw cash across branches of the same bank in the same city should be without charge. All service pricing should be submitted to the CBRC fifteen days upon application and disclosed publicly ten days before application. On October 23rd 2003, CBRC released the Guidance on Risk Management of Commercial Banks’ Loan Concentration which limited total lending amount to one company Group to 15% of the bank’s capital. The CBRC Corporate Governance and Its Supervision of State-owned Commercial Banks effective on April 24th 2006 further reduced the loan concentration ratio in state-owned commercial banks to 10%. On March 1st 2004, the Administrative Rules on Capital Adequacy Management of Commercial Banks came into effect, which reinforced the 4% tier-one and 8% capital adequacy ratio requirement set in the 1994 rule, concreted in addition the calculation rules. The capital adequacy ratio should be calculated on the consolidated basis. Tier-one capital was limited to paid-in capital or common equity, capital reserve, retained earnings, accumulated surplus and minority interest. Supplementary capital included revaluation gains, general provisions, preference shares, convertible bonds and long-term subordinated debt. Goodwill, non-consolidated equity investment in other financial institutions and investment in non-self-use real estate and in industrial companies should be subtracted from the capital calculation. Supplementary capital should not exceed the amount of tier-one capital and the long-term subordinated debt was capped to 50% of tier-one capital. External ratings were prescribed as risk weights for credit risk assets calculation. The rule regulated further the set-up of the trading book and the risk calculation for interest rate, equity, foreign currency and commodities risks. If the market risk exposure in the trading book exceeded 10% of total on- and off-balance-sheet assets or larger than RMB 8.5 billion, the bank should add market risk in capital adequacy calculation. Banks below the threshold should report the market exposure to the supervisor. Upon approval, banks were allowed to use internal model to calculate market risks. Supervisory review and market disclosure were integrated in the rule. However, operational risks were not considered in the CAR calculation. The required CAR was to be fulfilled till January 1st 2007. With the gradual marketization of interest rate and the increased cross-sectoral products and services in commercial banks, the CBRC released the Guidance on Market Risk Management of Commercial Banks effective on March 1st 2005. The guidance followed the market risk classification in the 2004 rule, clarified the responsibility of Board members and the management for market risk control, prescribed the set-up of market risk management department, market risk control policy and procedure. The valuation of trading book positions should be done on a daily basis. Advanced banks were encouraged to develop internal risk models for market risk management. Back-testing and the limit system were obligated. The guidance was applicable also for policy banks, finance asset management companies, urban and rural credit cooperatives, trust and investment companies, finance companies, leasing companies and the postal savings bank. The guidance however did not prescribe or recommended any parameters for risk calculation. State-owned commercial banks and joint-stock commercial banks were granted with a transition period till the end of 2007, other banks till the end of 2008 to fulfill the requirements. For market risk supervision, CBRC issued the Handbook of Supervising Market Risk in Commercial Banks on November 23rd 2005. On May 20th 2007, the CBRC regulated the usage of interest rate curve for market risk calculation through the issuance of the Notice on the Benchmark Rates for Market Risk

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Calculation of Banking Institutions to be enforced on the first working day in October 2007. The inter-banking government bonds interest rate curve, the central bank bill interest rate curve and the financial bonds interest rate curve issued by the China Government Securities Depository Trust & Clearing Company were obligated to be applied as benchmark rates for calculating the trading book positions. If the results from calculations based on the bank’s own calculated interest rate curve deviate more than 1% for five days within one quarter, CBRC should be informed. To prevent credit risk in real estate lending, CBRC issued the Guidance on Risk Management of Real Estate Loan of Commercial Banks on August 30th 2004. It set loan caps including the cap of 65% of real estate project volume in lending to real estate development companies and the 80% cap for private real estate purchase. The sum of the monthly real estate loan repayment and property management fee should not exceed 50%, and the sum of the total monthly loan repayment and property management fee not exceed 55% of the disposable income in real estate lending to private person. On September 27th 2007, the CBRC released the Notice on the Strengthening of the Management of Commercial Banks’ Real Estate Lending, which reduced the lending cap from 80% to 70% for purchase of private housing of over 90 square meters, and to 60% for private persons’ purchase of the second housing. The lending rate should not be less than 1.1 times of the PBC mandatory lending rate floor. On December 11th 2007, the PBC and the CBRC jointly released the Supplementary Notice on the Strengthening of the Management of Commercial Banks’ Real Estate Lending with three complementary rules: The number of housing is counted on a family basis; if the housing space per person in the family is below the average per person housing space of the region, the lending condition for the first housing was applicable for the second housing; and loans from the housing provident funds was equally treated as bank loans. With the surge of real estate prices in major Chinese cities, the CBRC obligated commercial banks to conduct stress tests for scenarios of the price drop of 10%, 20% and 30% in May 2010. In September 2010, CBRC stopped real estate loan for the purchase of the third housing in one family for all commercial banks and further reduced the lending cap to 70% of the purchase price for the first housing and to 50% for second purchase. Asset-backed securities (ABS) were regarded as a useful tool to reduce the risk concentration in the banking sector, to promote direct financing and to promote financial innovation in China. On April 20th 2005, the Administrative Rules on the Regulation of Asset-backed-securities came into effect, which introduced ABS to the interbank loans market. Accordingly, the Administrative Rules on the Supervision of Asset-backed-securities of Financial Institutions was enforced on December 1st 2005 to regulate the entry, risk management and capital requirement for asset-backed securities business. Following the strengthened risk supervision for ABS products of the Basel Committee, the Guidance on the Capital Calculation of Supervising Risk Exposure in ABS of Commercial Banks was released on December 23rd 2009 to be applicable on January 1st 2010. The rule introduced the standard method based on external rating and the internal rating method for risk capital calculation of ABS positions. On January 1st 2006, the CBRC Key Indicators of Supervising Commercial Banks’ Risk Management was taken into force, which set several key ratios to regulate the risk positions in commercial banks including liquidity risk ratios (25% minimum liquidity ratio, 60% minimum key liabilities of total liabilities ratio and -10% minimum liquidity gap ratio for liquidity gap and assets within 90 days), credit risk ratios (4% maximum of non-performing assets as percentage of total assets, 5% maximum of non-performing assets as percentage of total loans, 15% maximum credit concentration ratio, 10% maximum loan concentration ratio,

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50% maximum of net capital for related party lending), market risk ratios (20% maximum of net capital for foreign currency risk exposure) and risk compensation ratios (45% maximum cost income ratio, 0.6% minimum return on average assets, 11% minimum of return on equity, 100% minimum of asset loss provision coverage ratio, 100% minimum of loan loss provision coverage ratio, 4% minimum tier-one capital ratio and 8% minimum capital adequacy ratio). Regulation and supervision extensively based on ratios was introduced through the 2006 rule. On April 24th 2006, the CBRC Corporate Governance and Its Supervision of State-owned Commercial Banks was put into force, which prescribed the set-up, responsibility, requirements and the relationship among shareholders’ meeting, management Board, supervisory Board and senior management. It introduced the concept of strategic investors which should hold at least 5% equity share with a lock-up period of at least three years and the obligation to send Director to the management Board. As restructuring goals, the rule set several ratios for state-owned commercial banks including asset return of 0.6%, equity return of 11%, cost income ratio between 35% to 45%, NPL ratio under 5%, CAR over 8%, maximal loan concentration ratio of 10% of equity capital, NPL coverage ratio above 60%, and to be increased to 100% in subsequent five years. On October 25th 2006, CBRC issued the Guidance on Compliance Risk Management of Commercial Banks which regulated the set-up of compliance risk policy, organization structure, compliance risk management plan, procedure, management and training systems. To better regulate the increased private wealth management business in banking, the Provisional Rules on Private Wealth Management of Commercial Banks came into effect on November 1st 2005. With the pressure from the entrance of foreign banks after the full opening of the Chinese banking market in December 2006, CBRC issued the Guidance on Financial Innovation of Commercial Banks on December 11th 2006 with the aim to increase product variety and non-interest income business of Chinese banks. The guidance set the four principles of financial innovation: “know your business (KYB), know your risk (KYR), know your customer (KYC) and know your counterpart (KYC)”. Financial innovation was encouraged for well-capitalized banks with good corporate governance structure and prudent internal control system. Core risk indicators of the bank should fulfill the supervisory requirements and there was no case of serious violation of laws and rules in the last there years. On August 11th 2007, the CBRC issued the Guidance on Syndicated Loan Business which prescribed the responsibilities of lead arranger, agent bank and participating bank. The lead arranger was supposed to take over at least 20% of the loan amount. Shares of other lenders should be at least 50%. On December 6th 2008, the CBRC issued the Guidance on Risk Management in M&A Loan of Commercial Banks, which set several preconditions including the special loan loss provision coverage ratio of at least 100%, capital adequacy ratio of at least 10%, general provision at least of 1%. On March 22nd 2005, the CBRC issued the Notice on Strengthening Operational Risk Management, which listed thirteen rules such as the introduction of “know your customer (KYC), know your business (KYB) and know your customer’s documents (KYD)” principles for new customers and large account to prevent operational risks. On May 14th 2007, the CBRC Guidance on Operational Risk Management of Commercial Banks came into effect, which prescribed the set-up of policy, structure, procedure, reporting and oversight mechanism to manage operational risks and encouraged large banks to use advanced and quantitative methods for operational risk management. It regulated at the same time the supervisory oversight mechanism for operational risks. To better prevent risks arising from bank’s information system, the CBRC issued the

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Guidance on the Management of Information System Risk of Banking Institutions on November 1st 2006, which clarified responsibilities and requirements for overall information system risk prevention, risks in system development, operation and system maintenance and risks prevention in outsourcing. The revised version the Guidance on the IT Risk Management of Commercial Banks was released on June 1st 2009, which broadened the risk management from the information system to information technology, prescribed the appointment of Chief Information Officer and strengthened the role of internal and external auditing in IT risk management. Drawn lessons from bank failures in other countries in the financial crisis, the CBRC accelerated the build-up of juridical infrastructure for banking supervision. On September 8th 2009, the CBRC issued the Guidance on the Management of Reputational Risk of Commercial Banks, which assigned the responsibility of reputational risk management to the management Board and obligated the set-up of reputational risk management system and emergency plans. On October 29th 2009, the Guidance on the Management of Liquidity Risk of Commercial Banks was released to be enforced on November 1st 2009. The guidance clarified the principles, management responsibilities, requirement for structures and methods of liquidity risk management and followed the existing minimum liquid assets to liquid liabilities ratio of 25%. As the new Chinese corporate accounting standard which introduced the International Financial Reporting Standard was prescribed for listed Chinese companies from January 1st 2007, the CBRC required the usage of the new standard with fair value accounting for all listed Chinese banks in 2007 and granted one year transition period for other commercial banks, trust, finance, leasing and money brokerage companies and two years transition for rural banks and credit cooperatives. On February 18th 2008, the CBRC issued the Guidance on Consolidated Supervision of Commercial Banks (Trial) to better supervise the capital adequacy, large risk exposure, group internal transactions, liquidity, market and reputational risks of financial groups. To better control the credit risk, the CBRC issued the Provisional Rules on Fixed-Assets Loan Lending effective on October 23rd 2009, the Guidance on Project Financing, the Provisional Rules on Working Capital Loan Lending effective on February 20th 2010 and the Provisional Rules on Lending to Private Persons effective on February 20th 2010. The “three rules and one guidance” introduced the processing-based regulation covering the whole lending processes lender investigation, risk evaluation, loan approval, contracting, payment and loan management. The private person lending rule required in general the personal appearance of the borrower for the assignment of the credit contract. On December 16th 2009, the CBRC released the Guidance on the Disclosure of Capital Adequacy Ratio of Commercial Banks to be enforced on January 1st 2011. The guidance obligated commercial banks applying Basel II to publish timely the changes in paid-in or common equity and other capital instruments, to disclose quarterly information about core capital, supplementary capital, tier-one ratio and capital adequacy ratio, and obligated Basel II banks to publish semi-annually information about consolidation scope, credit risk exposure, non-performing loan information, changes of loan loss provisions, risks in asset-backed-securities, and information about market risks and operational risks. On November 23rd 2009, the Guidance on the Validation of the Usage of Advanced Methods in Capital Adequacy Calculation was released which was applicable from December 1st 2009, to regulate large commercial banks in validating the development of internal risk calculation

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models. On December 24th 2009, the CBRC issued the Guidance on the Interest Rate Risk Management in Banking Account of Commercial Banks to be effective on January 1st 2010. The Guidance prescribed general requirement in interest risk management, encouraged commercial banks to use various quantification methods such as pricing gap, duration, sensitivity, simulation and stress testing. Following closely the FSB Principles for Sound Compensation Practices, the CBRC Guidance on the Supervising of Sound Compensation Practices in Commercial Banks was issued on February 21st 2010 to be effective on March 1st 2010. The guidance regulated that the fixed base compensation should not exceed 35% of the total compensation, 40% of the variable compensation for senior executives and those who have material impact on the risk exposure of the bank, 50% for major senior executives and if possible if even up to 60% should be paid under deferral arrangements over at least three years. Clawback system should be established to enable banks to call back the total amount of bonuses even after the retirement. Facing the increasing uncertainty of sovereign risks, the CBRC issued the Guidance on Country Risk Management of Banking Institutions on June 8th 2010 with the transition period to June 1st 2011. The guidance regulated banks to consider country risk in risk capital calculation with the minimum risk weights of 0.5%, 1%, 15%, 25% and 50% for countries with five classes from low to high risk. B. Regulation of foreign banks The regulation of the entry of foreign banks was first introduced through the Administrative Rules on Foreign Banks and Joint-Venture Banks in Special Economic Zone effective on April 2nd 1985, which restricted foreign banks and joint-venture banks’ activities mainly in foreign currencies lending and settlement, supporting foreign companies and joint-venture companies’ trade-related financing needs. The minimum requirement of registered capital for foreign banks and joint-venture banks was set at RMB 80 million or equivalent foreign currency, half of which should be paid-in capital. The branch of a foreign bank should hold RMB 40 million or equivalent foreign currency as operation funds. On September 7th 1990, the PBC released the Administrative Rules on Regulation of Foreign Banks and Joint-Venture Banks in Shanghai, which differentiated foreign bank incorporation and foreign bank branch. Three years experience with a representative office in China was required for the set-up of foreign bank and foreign bank branch. The total assets requirement of the parent bank of the prior year before the application should exceed USD 10 billion and USD 20 billion for foreign bank and foreign branch respectively. The registered capital requirement for foreign bank, joint-venture bank and joint-venture finance company was USD 30 million, USD 30 million and USD 20 million respectively. Foreign bank branch was obligated to have USD 10 million as operation funds. Foreign bank，joint-venture bank or a joint-venture finance company shall retain 25% of the after-tax net income as supplementary capital until the total amount of the paid-in capital and reserve funds is twice that of the registered capital. A foreign bank branch should keep 25% of the net income inside China to supplement its operating funds until the kept profit is equal to its required operating funds. The rules further limited bank’s activities only to foreign currency businesses. Additionally, it set several thresholds to limit the asset expansion, investment activities, interest rate and service fee charges.

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On April 1st 1994, the Administrative Rules of the People’s Republic of China on Foreign-funded Financial Institutions came into effect, replacing the 1985 rule and 1990 rule. The new regulation followed the structure and ratios of the 1990 rule, increased however the capital requirement for foreign banks and joint-venture banks to RMB 300 million, for foreign finance companies and joint-venture finance companies to RMB 200 million. Foreign branch should hold at least RMB 100 million from headquarter as operation funds. The 1994 rule reduced the required experience from three to two years with representative office but kept the minimum total assets requirement of USD 10 billion in the year prior to the application. The asset threshold for foreign branch was set at USD 20 billion and for joint-venture USD 10 billion. Parallel to China’s WTO negotiations, the first eleven cities were opened for foreign financial institutions in August 1994. In regard to the business scope, the 1994 rule limited foreign banks’ business to sole foreign currency businesses. In January 1999, the geographic restriction for foreign banks’ branching was lifted. For representative office, the PBC issued the Administrative Rules on Representative Office of Foreign Financial Institutions in China on April 29th 1996, which explicitly limited the activities of foreign representative offices to non-operating supporting services such as advisory and market research. The RMB business of foreign banks was allowed first in the Shanghai Pudong area in December 1996. In August 1998, the PBC approved the expansion of the trial in foreign banks’ operation with RMB currency from the Shanghai Pudong area to Shenzhen SEZ. At the time China’s accession to WTO, four cities Shanghai, Shenzhen, Tianjin and Dalian were already opened for foreign banks’ RMB business. Another five cities Guangzhou, Zhuhai, Qingdao, Nanjing and Wuhan were added one year after the accession to WTO as promised. On December 1st 2003, Liu Minkang, the Chairman of CBRC declared the expansion of the RMB business of foreign banks from the first nine cities to four more cities Jinan, Fuzhou, Chengdu and Chongqing. The RMB business client scope of foreign banks were expanded from sole foreign companies and foreigners also to Chinese companies in the first opened nine cities. And the cap of single foreign financial institutions’ equity participation in Chinese banks of 15% was raised to 20%, total foreign participation was limited to 25%. On December 1st 2004, the CBRC extended the RMB license cities to five more Kunming, Beijing, Xiamen, Xi’an and Shenyang, with 18 cities opened for RMB business in foreign banks. Five years after the recession, the geographical restriction of foreign banks’ RMB business was fully lifted. In regard to customer restriction, with China’s accession to WTO on December 11th 2001, foreign banks’ foreign currency business was fully opened also for Chinese enterprises and private clients. Two years after the accession in 2003, foreign banks’ RMB business was opened also for Chinese enterprises. And five years after the accession in 2006, the RMB business could also serve Chinese private clients. On February 1st 2002, a revised version of the Administrative Rules of the People’s Republic of China on Foreign-funded Financial Institutions replaced the 1994 rules. The new rule kept the capital requirement of RMB 300 million, RMB 200 million and RMB 100 million for foreign banks, foreign finance companies and foreign branches respectively, required however all capital to be paid-in capital, replacing the 50% paid-in capital requirement of the 1994 rule. The two years representative office experience as pre-condition and total assets of USD 10 billion and USD 20 billion for foreign banks and foreign branches respectively remained unchanged as in the 1994 rule. For foreign branches, the minimum capital adequacy ratio of 8% of the parent bank was introduced as requirement. For foreign finance companies, the pre-condition remained the same with USD 10 billion and the presence with a representative office. With the increasing lifting of RMB business for foreign banks, the 2002 rule abandoned the foreign currency limitation, however introduced the requirement for RMB

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business: three years operation in China plus two successive profit years before application. The 2002 rule kept several prudent regulation ratios as in the 1994 rule such as: 30% of the operating fund in foreign branches should be kept as interest-bearing assets including banking deposits as introduced in the 1990 rule; the maximum of 40% equity in fixed assets investment as introduced in the 1994 rule. The 2002 rule introduced the minimum capital adequacy ratio of 8% to foreign financial institutions for the overall positions and additionally for RMB business, obligated the minimum liquidity ratio of 25%, increased the maximum of foreign currency deposits from China from 40% introduced in the 1990 rule to 70% of total assets and lowered the credit concentration from 30% introduced in the 1990 rule to 25% of total capital. The total assets threshold of 20 times of the capital, the limit of investment to 30% of the capital in the 1994 rule and the obligation to retain 25% of yearly profits as capital reserve introduced in the 1990 rule were abandoned. The detailed implementation rules for the 2002 rule were also enforced on February 1st 2002, which especially clarified the requirements for the set-up of branches of foreign banks including three years operation in China with two successive profit years, the minimum capital ratio of 8% and RMB 100 million for each branch as operation funds, the total of which for all branches was limited to 60% of the registered capital. The application was in addition possible at the earliest one year after the last branch approval. From December 31st 2003, the Administrative Rules on Foreign Financial Institutions’ Equity Participating in Chinese Financial Institutions came into effect to allow foreign financial institutions with total assets of USD 10 billion, USD 1 billion and USD 1 billion and capital adequacy ratio over 8% to invest in Chinese banks, Chinese urban and rural credit cooperatives and Chinese non-bank financial institutions respectively. The single equity participation was limited to 20% and the total foreign participation up to 25%. December 11th 2006 was the milestone for the opening of China’s banking market. To fulfill the WTO requirement, China opened fully the banking market and foreign banks began to enjoy national treatment without restrictions in operating regions, local currency and customer type if locally incorporated. A revised version of the Implementation Rules on Foreign-funded Banks in the People’s Republic of China replaced the 2004 rule. The revised rule encouraged local incorporation of foreign banks which were regulated equally as Chinese banks. Foreign branches were allowed to accept RMB deposits of over RMB one million from private persons. Locally incorporated foreign banks were equally treated as domestic banks in branching with RMB 100 million operating funds as precondition. Foreign banks could hold at the same time a locally incorporated bank with full license and one foreign branch for whole-sale business. At the same time, foreign banks were granted a transition period of five years to fulfill the 75% loan-to-deposit ratio. Additionally, foreign banks should reach the 70% ratio of foreign currency deposit to total foreign currency assets. C. Basel Accords in China Chinese regulators followed closely the development of the Basel Accords and showed consistent strong will to integrate international regulatory rules into Chinese regulatory practices with adaption to the emerging market features. Within the CBRC, a Council of International Advisors was set up in 2003 to best integrate international best practices. The Notice on Asset Liabilities Management of Commercial Banks issued by the PBC on February 15th 1994 integrated the 4% tier-one and 8% capital adequacy ratio of the 1988 Basel Accord into banking regulation in China. Chinese banking regulators observed closely the development of the Basel Accord and considered timely its adoption into Chinese regulatory framework. On March 25th 1998, the PBC published the Chinese version of the

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Basel Core Principles for Effective Banking Supervision. In May 2003, CBRC released Chinese version of the New Basel Accord and requested for comments from Chinese banks. On July 31st 2003, Liu Mingkang, the Chairman of the CBRC, commented on the third consultation paper of the Basel II accord. In his comment, he stressed China was at the stage of the Basel I implementation since banks were not capable to adopt the internal rating based approach, would however integrate Pillar II and Pillar III into the capital rule. Comprehensive capital adequacy rules came into effect on March 1st 2004 with the issuance of the Administrative Rules on Capital Adequacy Management of Commercial Banks. The 2004 rule reinforced the 4% tier-one and 8% capital adequacy ratio of the 1988 Basel Accord and integrated the second pillar of supervisory review and the third pillar market oversight of the Basel II into the new rules. It adopted the Basel II rule to use external rating for risk assets calculation, introduced market risk capital requirement, established capital adequacy supervision mechanism and obligated banks’ disclosure of capital adequacy ratio. State-owned commercial banks, joint-stock commercial banks and the majority of city commercial banks were to fulfill the capital adequacy ratio till January 1st 2007. With the release of the Basel II Accord in June 2004, CBRC introduced timely the new capital accord in China on July 1st 2004. On February 28th 2007, the CBRC released the Basel II implementation time line in the Guidance on the Implementation of Basel II in the Banking Sector. The guidance divided Chinese banks into tier-one internationally active large banks including the “big five” banks ICBC, ABC, BOC, CCB, BoCom and China Merchants Bank and other banks. Eight joint-stock commercial banks were determined as tier-two banks. The implementation of the former banks should start at the end of 2010, the later at the latest end of 2013. The implementation followed the principles: “staged implementation according to banking type, successive increasing level, step-by-step up to standard with first focus on credit risks”. In the preparation period, banks should focus on the data collection, model development for internal rating and risk evaluation, the build-up of risk management organizations, procedures and information system. On October 17th 2008, the CBRC concreted the Basel II implementation in China through the release of five sets of guidance: Guidance on the Classification of Credit Risk Exposure in Commercial Banks’ Banking Book, Guidance on the Supervision of Internal Rating Based Credit Risk Calculation of Commercial Banks, Guidance on the Risk Capital Calculation of Specialized Lending of Commercial Banks, Guidance on the Credit Risk Minimization in Risk Capital Calculation of Commercial Banks and Guidance on Risk Capital Calculation of Operational Risk of Commercial Banks. However, the implementation deadline for Basel II was extended the end of 2011 for tier-one banks.4 On March 16th 2009, China joined the Basel Committee on Banking Supervision and the Financial Stability Forum. On September 17th 2010, the CBRC presented in a press conference the possible impact of Basel III on China. As Basel III increased the common equity ratio, tier-one ratio and capital adequacy ratio to 7%, 8.5% and 10.5% respectively and the average tier-one and capital adequacy cap ratio of China’s banking sector reached 9% and 11.1% at the end of June 2010 (The ratios increased to 9.5% and 11.6% at the end of September 2010), the short-term impact of Basel III is limited. For the long-term, CBRC will integrate the Basel III to China to improve the regulatory and supervisory level to international standards. The implementation of Basel III in next two years is striven for. To integrate Basel III into the Chinese regulatory framework, the CBRC issued the Implementation of Four New Supervisory Instruments (Draft Discussion) in September 20105 to integrate Basel III new tools in capital adequacy, anti-cyclical capital charge, liquidity and 4 See Economic Observer, November 26th 2010, available at: http://www.eeo.com.cn/finance/banking/2010/11/26/187316.shtml. 5 See China Business News, November 15th 2010, p. T41.

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leverage regulation. The new draft rule required the common equity ratio, tier-one ratio and capital adequacy ratio of 6%, 8% and 10% with above Basel III levels of 4.5%, 6% and 8%, a capital conservation ratio up to 4%, a counter-cyclical ratio up to 2.5% and a surcharge of 1% for systemically important banks. The ratios were supposed to be reached at the end of 2012 for systemically important banks and at the end of 2016 for other banks. In addition, a leverage ratio of 4% risk capital as percentage of total on- and off-balance-sheet assets (above the Basel III 3%), the application of the higher amount between the provision coverage ratio of 150% and the loan provision ratio of 2.5%, a liquidity coverage ratio of 100% and a net safe fund ratio of 100% were introduced. The classification of systemically important banks will be based on the overall evaluation of size, complexity and inter-connectivity. The impact study of the new rule was conducted among 78 banks including China Development Bank, the “big five” banks, all twelve joint-stock commercial banks, ten city commercial banks, fifteen foreign banks and fourteen rural commercial banks. II.2. Banking supervision in China Until 1992, the central bank PBC was the sole supervisor for banking, securities and insurance. As Shanghai Stock Exchange and Shenzhen Stock Exchange were commenced on November 26th 1990 and on December 1st 1990 respectively, there was call for a special oversight body. In October 1992, the Securities Regulatory Commission (SRC) within the State Council and the China Securities Regulatory Commission (CSRC) were set up. The former was the rule-setter for securities markets oversight and the later the executive body. The supervision of securities companies however remained the responsibility of the PBC. In 1997, the responsibilities of the oversight of stock exchanges and securities companies were transferred from the SRC and the PBC to the CSRC respectively. In April 1998, SRC was merged into CSRC and CSRC became the sole regulatory and supervisory authority for securities companies and markets. On November 18th 1998, the China Insurance Regulatory Commission (CIRC) was founded as the insurance supervisor and on April 28th 2003, the China Banking Regulatory Commission (CBRC) was set up to take over the banking supervisory tasks from the PBC. Till the end of 2003, the total operation costs of CBRC were included in the government budget. On January 1st 2004, a fee-based financing system was introduced for the CBRC. The system differentiated between institution supervision fee as 0.08% of bank’s paid-in capital (for foreign branches of the operation funds), and business supervision fee (between 0.01% to 0.02% of total assets up to the asset threshold of RMB 5,000 billion). CSRC and CIRC were financed through fees from the beginning. On February 1st 2004, the Law of the People’s Republic of China on Banking Supervision came into effect, which clarified the goals, authorities, responsibilities, measures of banking supervision. According to the law, banks, asset management companies, trust and investment companies, finance companies, leasing companies and other financial institutions in the scope of the law should apply for approval or register products and services at the banking supervisor. Risk management, internal control, capital adequacy, asset quality, loss provision, risk concentration, related-party transactions and liquidity should be included in the supervisory scope. It also prescribed supervisor’s on-site examinations, consolidated supervision, supervisory rating and early-warning systems. On April 5th 2004, the CBRC issued the Procedures on the Off-site Monitoring of Joint-stock Commercial Banks on a Trial Basis and clarified rules on off-site monitoring procedures including information collection and confirmation, information analysis and Processing, feedback and information usage as well as documentation and information management.

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Integrating international standards, CBRC introduced the CAMEL rating system for joint-stock commercial banks on February 23rd 2004. The yearly five-class rating was based on the evaluation of five aspects: capital adequacy (60% quantitative, 40% qualitative measurement), asset quality (60% quantitative, 40% qualitative measurement), internal management (50% corporate governance, 50% internal control system), profitability (60% quantitative, 40% qualitative measurement) and liquidity (60% quantitative, 40% qualitative measurement). Market risks were taken into consideration, however did not affect the rating since the market risk exposure was limited due to the segregation of commercial and investment banking in China. Similar rating systems were issued for foreign banks with the Handbook of Risk Evaluation of Foreign Banks and the Risk Evaluation and Early Warning System in Rural Credit Cooperatives (Trial) both issued in 2004. On December 2nd 2005, the CBRC unified the banking rating system for all Chinese, foreign and joint-venture banks with the release of the Internal Guidance on Supervisory Rating of Commercial Banks (Trial), which used the “CAMEL +” rating system based on the weighted evaluation of six factors capital adequacy, asset quality, management quality, profitability, liquidity and market risks, combined with other fine adjustment based on other qualitative evaluation to classify banks into six rating classes. For banks rated in class five or class six, the guidance introduced measures such as the change of senior management, restructuring, supervisory take-over and closure. In 2005, CBRC installed the early warning system to quarterly evaluate the overall risk situation of commercial banks based on the assessment of 22 quantitative measurements and qualitative evaluation to issue the warning sign classified in four categories: normal, blue signal, orange signal and red signal. The CBRC launched a personnel exchange program between CBRC and commercial banks in March 2006 to increase supervisors’ knowledge about banking practices and to improve capacities of commercial banks in compliance. First exchanges were realized with not only the big four state-owned commercial banks ICBC, ABC, BOC and CCB, but also joint-stock commercial banks BoCom, China Merchants Bank and Minsheng Bank. In April 2007, the off-site supervisory information system started operation after three years preparation and testing period. Banks were obligated to submit 23 worksheets through the system, which automatically generated 227 analysis reports. Chinese banking supervisors followed closely the Basel Core Principles for Effective Banking Supervision and started the self-assessment in 2000. The evaluation report was released in October 2003. In 2007, CBRC finished the second self-assessment. CBRC participated in the revision work of the Basel Core Principles of Effective Banking Supervision and promoted the integration of the 2006 new Basel core principle into the supervisory work. On December 4th 2009, the CBRC released the Guidance on the Supervision and Examination of Capital Adequacy Ratio in Commercial Banks to be applied from January 1st 2010. The guidance listed principles and requirements to evaluate commercial banks’ ability to manage credit risk, market risk, operational risk, concentration risk, interest rate risk in banking book, liquidity risk, reputational risk, strategic risk.

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III. Reforming focuses between academics and policies – where do the reforms lead to? III.1. Regulatory goals: goal hierarchy and goal conflicts Banking supervision has the primary goal to retain market confidence, protect deposits, ensure profound market conduct, protect customer and oversight market stability. Functionally, the supervisory tasks are divided into solvency supervision, market conduct, customer protection and macro-supervision. To look at the overall mission of the supervisors in respective countries: the French supervisor Commission Bancaire sets the goal to “protect depositors as well as to act as watchdog over the French banking and financial system to ensure its profitability and financial stability.” The German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) aims to “to ensure the proper functioning, stability and integrity of the German financial system.” The UK Financial Services Authority (FSA) lists five statutory objects: “market confidence, public awareness, financial stability, consumer protection and the reduction of financial crime”. The US Federal Deposit Insurance Corporation (FDIC) describes its goal to “maintain stability and public confidence in the nation's financial system” especially by “examining and supervising financial institutions for safety and soundness and consumer protection”. The Chinese CBRC claims to “protect the interests of depositors and consumers, maintain market confidence, enhance public knowledge of modern finance and combat financial crimes”. The regulatory goals of those countries are very similarly stated. The primary goal of regulation is set to ensure the stability of the financial system, retain market confidence in financial institutions and to protect depositors and clients. The special feature of regulatory goal in China is the emphasis on bank’s role in promoting economic growth. CBRC stated officially in its annual report 2006several measures to “guide the banks to support the macro-economic policies and regional development policies”. A growing economy indeed helped the banking sector to reduce the non-performing loan ratio to 1.6% at the end of 2009. However, the stability goal requires high prudency in lending based on commercial calculations instead of economic development consideration. For instance, monthly average of RMB 1.5 trillion of new loans was pumped into economy in the first quarter of 2009 in line with the stimulus package. This surge of loans buffered the downturn in the crisis but bore potential risks of lower credit quality, which contracts the stability goal. As contra-cyclical measure, Chinese regulators are more willing to use yearly credit quota guidance to prevent pro-cyclical lending and to issue lending guidance for support sector reform and regional development. In parallel, the competition policy reflects the clear favor of Chinese regulators for stability instead of efficiency as the primary goal. The high profitability of Chinese banks is protected through combined high entry restriction for both national and foreign newcomers and an interest rates regime with guaranteed margin. The relatively high requirement for registered capital of RMB one billion (USD 146 million) is much higher than the entry requirement in the EU (including France, Germany and the UK) with EUR 5 million (USD 7 million). In the USA, the states set the requirements of registered capital, which lies on comparative level as in the EU. The current mandatory deposit rate cap of 2.50% and lending floor of 5.56% for one-year maturity 6 avoids deteriorating profit due to fierce competition. Interest rate regulation is not rare in granting banks certain level of profitability to ensure the stability of the financial sector. Interest rate regulation also existed in many developed countries in early 6 See PBC: http://www.pbc.gov.cn/detail.asp?col=460&ID=2485.

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development stage of the finance sector like in Germany in the 1960s, in the USA with Regulation Q till early 1980s and in Japan. In course of the banking sector development, the loosening of the high entry burden and the gradual interest rate liberalization as targeted in the newly issued twelfth five-years-plan will put introduce more market forces and competition in the banking sector. Another salient feature of China’s banking sector is the high state ownership of over 50% not only through the market dominance of four state-owned commercial banks but also through equity participation of local governments and state-owned companies in joint-stock, city, urban and rural commercial banks, which in large extent stabilizes the market under the current condition of missing explicit deposit insurance system. With the set-up of a deposit insurance system as planned within the twelfth five-years-plan, more accountability of the individual banks instead of the reliance on the state guarantee is expected. Summarizing the comparison of the regulatory goals, Chinese regulators put the stability goal as the first priority and emphases bank’s role in promoting economic growth. The current structure of high entry barrier, guaranteed interest margin and state-ownership build the foundation of sector stability and are features of the current emerging status of financial markets. A whole set of modernization measures planned for the next five years will gradually upgrade the banking sector to international standards. III.2. Principle-based vs. rule-based regulation: basic rules en vogue? Besides the different emphasis in regulatory goal priority, regulation can be carried out either principle-based or rule-based. Principle-based regulation leaves free room of implementation, encourages financial institutions to develop their own prudential management policy, bears however the risks of loopholes and demands interpretations and further guidelines. Basic rules are reliable, easily understood, can be closely monitored and provide regulators effective and flexible tool for ad-hoc measures, falls however in many cases behind the dynamic innovation of regulatory circumvention. For instance, a general rule of loan-to-deposit ratio prevents the risk taking associated with high leverage, however can not limit the risk of lending to high risk clients Basel accords clearly follow a principle- and risk-oriented approach in regulation, demonstrated in risk weighting in calculating capital adequacy ratio (CAR). The theoretical foundation of capital requirement lies in prevention of moral hazard in deposit insured financial institutions as modeled in Hellmann, Murdock and Stiglitz (2000). The level of 8% set in Basel II comes more from industrial practice than quantified by economic theory. The fact is, in no time of the crisis, the CAR of for Lehman Brothers, Citi Group for instance was under the required 8% level according to accounting value. As the level of this ratio coming from industrial practice failed as early warning indicator in crisis time, Basel III aims to raise “the quality, consistency and transparency of the capital base” with the increase of the minimum common equity ratio in three stages starting in 2013 from the current 2% to 7% till 2019. The introduction of a first world-wide leverage ratio level of 3% of tier 1 capital and obligated liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) independent from the risk position of a bank integrates more components of “hard rules” in the Basel III framework. The Chinese regulatory system differs from that of the Western in the sense of compliance-oriented compared to risk-oriented supervision. While Western regulators are gradually moving to more sophisticated tools in risk calculation for instance, their Chinese

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counterpart still sticks to some basic rules for example the cap of loan-to-deposit-ratio of 75% and the current cap of mortgage loan up to 70% of the property value and 50% for second purchase. Chinese supervisors have very early introduced the flexible adjustment mechanism of contra-cyclical capital adequacy ratio. After the fulfillment of CAR of 8% in the total banking system in 2008, CBRC recommended all banks to hold 2% extra capital as risk buffer and an additional 1% more capital for systemic relevant banks. In the credit expansion in 2009, CBRC urged large banks to put aside contra-cyclical capital buffer of another 0.5%. At the end of the first quarter of 2010, the weighted capital adequacy ratio for China’s banking sector amounted to 11.6% and the tier-one ratio of 9.5%. The risk-orientation of rules in the Chinese regulatory practice is enabled through differentiated rules according to different types of banks (e.g. big five state-owned commercial banks, listed banks, joint-stock commercial banks, rural banks, credit cooperatives etc.) or through rules with exemptions (e.g. exemptions for rural banking). The CBRC is integrating the Basel III rules to differentiate banks to systemically important banks (currently including the “big five”, China Merchants Bank and CITIC bank, also the largest seven bank of total assets) and other banks. Liu Mingkang, Chairman of CBRC, stressed his belief in basic tools: “Small is beautiful and old is beautiful as well”. In Chairman’s Statement of the CBRC Annual Report 2009, he emphasizes: “As tested by the global financial crisis, the CBRC’s practices in holding on to China-specific supervisory principles as well as China’s approach to applying simple, basic and useful supervisory ratios and methods proved effective and useful.” Basic rules function well in the specific Chinese context with highly homogenous business model within banking types in China and the pre-mature stage of sophistication in products and business conduct. The relatively better performance of the Chinese banking institutions confirms in some extent that the current regulatory practices suit the current development stage of the financial sector. The financial crisis has shown that the poor understanding and control of risks from both bank managers and regulators weakens the power of risk-oriented regulation, which can be partially compensated by the introduction of rule-based regulation as prudent measures. III.3. Supervisory structure reforms – the call for more involvement of macro-agencies, more integration and coordination Who should be engaged in regulating and supervising financial institutions and how is the relationship structured among each other? We have seen regulatory structure reforms in many countries in last years, both in the direction of splitting up one agency to several and of unifying several to one. The reform seems to be in large extent driven by historical path and political forces other than from the rational of regulatory effectiveness and efficiency. Moreover, the current financial crisis revealed the weakness in integrating macroeconomic decision makers such as the central bank and the treasury as well as in the coordination between sectoral regulators to cover all systemic relevant areas to fill in the loopholes of regulatory arbitrage. With the co-existence of several regulators and supervisors, better specialization and more cross-check can be achieved and at the same time, the concentration of supervisory power within one agency can be constrained. However, the coordination costs increase with the rising number of agencies involved. There exists even the danger of unclear task-sharing between agencies and the missing responsibility for systemic important sectors uncovered in the regulatory scope. Integrating other macro-prudential agencies involved such as the central bank and the treasury enables a more holistic view on the soundness of the

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whole financial sector. The further involvement of decision maker for national development policy can better align the financial sector development with real economic needs. Mandated by the G-20 leaders at the November meeting in 2008, the Basel Committee on Banking Supervision (BCBS), the International Association of Insurance Supervisors (IAIS) and the International Organization of Securities Commission (IOSCO) Joint Forum issued a “Review of the Differentiated Nature and Scope of Financial Regulation - Key Issues and Recommendations” in January 2010. The review points out the weaknesses in group-wide consolidated supervisory framework in insurance and securities sector and the lack of consistency in insurance and securities regulation on the international level.7 In fact, in many countries, the tri-party-system including the central bank, treasury and one unified regulatory agency for banking, insurance and securities evolves as the dominant structure for financial market supervision. More emphasis is put on macro-prudential supervision after the crisis with strengthened power of the central bank not only for price stability but more for the overall financial system stability. We review in detail the current structure and ongoing reforms of respective countries in the following.

Figure 1. EU Supervisory Structure

Source: European Union, own illustration In line with the EU single market integration for financial services, the legislation power of regulating financial services is in the hands of the European Union with a joint decision process executed by the European Parliament and the Council of European Union in issuing EU Directives and Regulations, which are subsequently implemented by national jurisdiction and supervisors through national laws and regulations. The European Commission, supported by sectoral advisory bodies for banking, insurance and securities, makes proposals to the European Parliament and the Council of the EU. To strengthen financial supervision after the crisis, the Larosière Group made the recommendation to transform the current sectoral committees into European authorities which are integrated in the European System of 7 See BIS 2010, BIS Joint Forum Report, January 2010, pp. 6-7.

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Financial Supervisors (ESFS) to better harmonize and coordinate the current national micro-prudential supervisions and to establish a European System Risk Board (ESRB) to monitor and prevent systemic risks.

Figure 2. Supervisory Structure in France

Banking and Financial Regulatory Committee

(Comité Consultatif de la Législation et de la

Réglementation FinancièresCCLRF)

- Rule setting

Credit Institutions and Investment Firms

Committee

(Comité des établissementsde crédit et des entreprisesd'investissement CECEI)

- Licensing and authorization

Banking Commission

(Commission banque)

- Day-to-day supervision of credit institutions and

investment firms

Banque de France

National Credit and Securities Council

(Conseil national du crédit et du titre)

- Advisory body

Advisory Committee

(Comité consultatif)

Financial Markets Authority

(Autorité des MarchésFinanciers AMF)

- Financial market oversight

Insurance Companies Committee

(Comité de Entreprisesd’Assurance CEA)

- Insurance accrediting

Insurance, Mutual Insurance and Contingency Insurance

Providers Control Commission

(Commission de contrôle des assurances, des mutuelles et

institutions de prévoyanceCCAMIP)

- Insurance supervision

Ministry of Finance

(Ministère de l'Économie,de l'Industrie

et de l'Emploi)

Ban

king

Insurance

Secu

rities

Banking and Financial Regulatory Committee

(Comité Consultatif de la Législation et de la

Réglementation FinancièresCCLRF)

- Rule setting

Credit Institutions and Investment Firms

Committee

(Comité des établissementsde crédit et des entreprisesd'investissement CECEI)

- Licensing and authorization

Banking Commission

(Commission banque)

- Day-to-day supervision of credit institutions and

investment firms

Banque de France

National Credit and Securities Council

(Conseil national du crédit et du titre)

- Advisory body

Advisory Committee

(Comité consultatif)

Financial Markets Authority

(Autorité des MarchésFinanciers AMF)

- Financial market oversight

Insurance Companies Committee

(Comité de Entreprisesd’Assurance CEA)

- Insurance accrediting

Insurance, Mutual Insurance and Contingency Insurance

Providers Control Commission

(Commission de contrôle des assurances, des mutuelles et

institutions de prévoyanceCCAMIP)

- Insurance supervision

Ministry of Finance

(Ministère de l'Économie,de l'Industrie

et de l'Emploi)

Ban

king

Insurance

Secu

rities

Source: AMF, Banque de France, CEA, CCAMIP, own illustration

In France, regulatory rules are set by the Banking and Financial Regulatory Committee (Comité Consultatif de la Législation et de la Réglementation Financières CCLRF) within Ministry of Finance. CCLRF unifies the rules making for regulating banks, insurance companies, investment firms in replacing the Comité de la réglementation bancaire et financière (CRBF), the former regulator for banks and investment firms and the Commission de la Réglementation du Conseil National des Assurances, the former rule-setter for insurance companies. Banking supervision is carried out by the joint-work of sub-organisations of the central bank Banque de France: the Credit Institutions and Investment Firms Committee (Comité des établissements de crédit et des entreprises d'investissement CECEI) which takes care about the licensing and authorization, the Banking Commission (Commission bancaire) who supervises credit institutions and investment firms on the day-to-day basis and the National Credit and Securities Council (Conseil national du crédit et du titre) with a Advisory Committee (Comité consultatif), both of which provide advisory services. The Autorité de contrôle prudential (ACP) within Banque de France takes special tasks in the authorization of foreign branches, representative offices and supervising financial holding companies. The market conduct and investor’s protection are in charge of the Financial Market Authority (Autorité des Marchés Financiers). The insurance sector is licensed by Insurance Companies Committee (Comité de Entreprises d’Assurance CEA) and supervised by Insurance, Mutual Insurance and Contingency Insurance Providers Control Commission (Commission de contrôle des assurances, des mutuelles et institutions de prévoyance). The French regulatory and supervisory structure is characterized with the separation of sectoral supervision of banking, securities and insurance and the separation of rule-making and day-to-day oversight both in banking and insurance sectors. Within the EU financial markets integration,

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consolidation and unification trend is first seen in the consolidation of rule-making for banking, securities and insurance within one single agency CCLRF and the implementation of the EU Single Market Directive and the EU Financial Conglomerate Directive.

Figure 3. Supervisory Structure in Germany Source: BaFin, Bundesbank, own illustration In Germany, financial supervision tasks are shared between the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, BaFin) and the central bank Bundesbank. BaFin was founded in 2002 as a single financial regulator integrating former sectoral regulators for banking, insurance and securities services. The Bundesbank is responsible for the continuous oversight of the solvency, liquidity and risk management systems of credit institutions. It is also involved on a national and international level in the ongoing development of prudential regulations.

Figure 4. Supervisory Structure in the UK Source: Bank of England, FSA, own illustration

In the UK, fundamental changes were carried out after the assessment of financial services regulatory structure in 1997, when the Financial Services Authority (FSA) was founded through the merger of banking and investment services regulation. Banking regulatory tasks formerly conducted through Bank of England were transformed to FSA. Over the time, regulation for other financial services such as for securities and futures, mortgages (since November 2004), insurance (since January 2005) were all integrated into the FSA.

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Figure 5. Supervisory Structure in the USA

Source: CFTC, FDIC, Fed, FFIEC, NAIC, OCC, OTC, SEC, own illustration The salient features of the US regulatory system include the dual supervision system of federal and state supervision of banking shared by the Office of the Comptroller of Currency (OCC), the Federal Reserve Board (Fed) and the Federal Deposit Insurance Cooperation (FDIC) as well as the functionally segregated supervision for banking, securities and insurance through the above mentioned banking regulators, Securities and Exchange Commission (SEC) and National Association of Insurance Commissioners (NAIC). Both insurance and mortgage institutions are mainly subject to state supervision, which is unequal and sometimes without full coverage of all institutions. State-chartered banks with federal deposit insurance are in contrast covered by both state and federal supervisors. To enhance the coordination among banking supervisors and cross-sectoral supervision, the Federal Financial Institutions Examination Council (FFIEC) and President’s Working Group on Financial Markets (PWG) were created in 1979 and 1988 respectively, which however only amended the existing patch-work structure instead of creating integrated supervisory structure. Till now, the Office of Thrift Supervision (OTS) is for instance still not covered in the coordination system. The post-crisis reform enforced by the Dodd-Frank Wall Street Reform and Consumer Protection Act keeps the current structure, however further strengthens the coordination system through the founding of the Financial Stability Oversight Council (FSOC) with members from OCC, FDIC, Fed, SEC, CFTC etc. to better oversight systemic risk. Dysfunctional agencies such as the Office of Thrift Supervision, which was founded in 1831 to supervise the national thrift industry, should be shut down with functions transferred to OCC. The reform creates for the first time in history a unified insurance supervisor the Federal Insurance Office within the Treasury.

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Figure 6. Supervisory Structure in China

Source: CBRC, CIRC, CSRC, PBC, own illustration The Chinese regulatory structure is characterized with segregation in line with the current segregation of banking from securities and insurance services. Regulation and supervision of banking, securities and insurance are carried out by three sectoral supervisors, supplemented through coordination meetings with the State Council as the final decision maker. However, with the expansion of business scope of banking in pilot trials with bank’s equity participation in asset management companies since 2005 and in insurance companies since 2009 and the emergence of financial conglomerates through the holding structure, the coordination task has become more challenging. Currently, the proposal of the set-up of a Financial Supervision Coordination Commission is in discussion for a more active role of supervisory coordination, to better supervise financial holding companies and to promote financial innovation of cross-sectoral products.8 Summarizing the above comparison, we observe the overall reform effort to strengthen macro-oversight with the establishment of new financial stability agencies or the assignment of the task to existing agencies especially to central banks. The lesson is learned that the pure micro-level supervision and the pure focus on price stability can not automatically guarantee financial system stability. Another focus is put on the unification of sectoral supervision in banking, securities and insurance to better close loopholes in regulatory arbitrage and better supervise large sized and complex financial conglomerates. Another question regarding regulatory structure refers to the level where the regulation should be set, on the national, the international or even the global level. The financial industry has developed far across national boarders, but the regulatory and supervisory ends mainly at national boarders, in spite of bilateral cooperation based on memorandums of understanding for foreign banks. The EU takes the leading role in transferring more rule-setting and supervisory power from the EU national states to the EU Commission in the new reform package. The Basel Committee aims to achieve a global level playing field for internationally operating financial institutions, struggles with difficulties with unbalanced development 8 See Ouyang and Tian (2010), Economic Observer , May 3rd, 2010, http://www.eeo.com.cn/finance/banking/2010/05/02/169087.shtml

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stages of financial markets in member countries. Despite those difficulties, we observe the global consensus of strengthened cooperation between regulatory authorities across boarders. An archetype is the Financial Stability Board (FSB) which was established in September 2009 as the global coordinator among national regulatory authorities, finance ministers, central banks and international institutions with the goal to achieve a global level playing field for financial institutions and to safeguard global financial markets stability. 9 The active participation in the international decision processes belongs to the inevitable tasks of national supervisors. III.4. Regulatory scope: regulating the value chain (rating agencies etc.) and systemic players (hedge-funds, private equity etc.) Closely related to the question dealt above that who is in charge of the regulation is the question that who is to be regulated. The scope can be derived from the regulatory goal. To protect depositors and to ensure financial system stability, deposit taking institutions are at the front of the regulatory terrain and any financial and non-financial institutions with the ability to put the system stability in danger should therefore be covered. The finance industry has developed in last years to a complex system of value-chain with sub-systems covering many non-bank financial institutions such as hedge funds, private equity and non-financial institutions such as rating agencies and accounting advisors. The legal structure does not always reflect the economic reality and the risk bearing responsibility. Especially the fast spread of the reputational risk can quickly undermine the trust foundation of a financial group far beyond the legal accountability. Based on such consideration, accounting and audit services companies are already included in the UK FSA supervisory scope. Also in China, securities rating agencies are closely supervised by the CSRC. Extended regulatory coverage to major players of the finance industry beyond banking institutions is the general consensus reached after the crisis. The registration of such institutions should bring more market transparency and better monitoring. In the US, the reform Act expanded the regulatory coverage to non-bank financial institutions if systemically relevant, which are supervised by the Fed. Rating agencies, hedge funds and private equity firms should be registered with SEC and disclose information to SEC. A new Office of Credit Ratings is set up within the SEC. In the EU, a European Securities and Markets Authority (ESMA) is proposed by the EU Commission in June 2010 to supervise the functioning of private credit rating agencies, which are essential in risk pricing and capital charge of credit risks. Regarding structured financial instruments, issuers are obligated to disclose information to all external rating agencies if requested both in the EU and in the US, with the aim to increase market transparency and competition between rating agencies. To better understand and monitor the complex system of the finance industry, more transparency is required with the renaissance of central clearing trading. The European Commission proposed an OTC transactions registration system. The system test is already under way operated by the Spain stock market operator BME and the German trading service provider Clearstream with the aim to bring more transparency into the European OTC derivatives market. In the US reform Act, SEC and CFTC are granted authority to oversight OTC derivatives markets, and central clearing and exchange trading are required for derivatives that can be centrally cleared. The Basel III framework also encourages more centrally cleared trades through central clearing center or on exchanges by measures charging higher capital for counterparty credit risks of OTC trading. However, the obligation of central 9 See FSB Charter http://www.financialstabilityboard.org/publications/r_090925d.pdf.

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clearing of standardized products can be circumvented by creating more complex derivatives which can not be traded in a standardized way. It is also questioned if standardized products can meet all individual clients’ needs in risk, pricing, transactions size etc. Higher capital charge for intransparency and complexity seems to be the balanced solution. For China, the capital markets are still in the infant development stage with little exposure beyond traditional securities products like bonds, common stocks, funds and the sophistication and innovation in derivatives products is limited. For instance, stock index future was just introduced to Chinese markets in April 2010. Obligation for exchange trading has been long installed for money market mainly through China Foreign Exchange Trading System & National Interbank Funding Center (established in 1994 by the central bank PBC) and for government bonds markets through China Government Securities Depository Trust & Clearing Company Ltd. (established in 1996 jointly by the PBC, Ministry of Finance and nine financial institutions, from 2000 on owned solely by the PBC and Ministry of Finance). Money markets transactions not centrally traded should be registered at the PBC and non-member bond traders should execute deals only through entrusted member traders. Derivatives products are currently mainly traded through the OTC markets. The current move of derivatives trading from OTC to exchanges in Western countries can provide China valuable template to develop its own trading platform along with the development of derivatives products. The potential move of derivatives trading from highly regulated Western markets to non-regulated markets especially to Hong Kong further urges Chinese regulators to adopt international standards to prevent high risk relocation of derivatives trading to China. III.5. Macro-prudential regulation and pro-cyclicality One of the fundamental changes in regulatory philosophy is the abandonment of the blind believe that ensuring the health of individual financial institutions would automatically lead to the soundness of the whole system. Understanding the interconnection between financial institutions, between key macroeconomic key determinants and the stability of financial institutions as well as the interplay between financial markets and the real economy plays a crucial role for a stable, sound financial sector best supportive for real economic growth. BIS defines macro-prudential policy as “the use of prudential tools with the explicit objective of promoting the stability system as a whole, not necessarily of the individual institutions within it”. As intermediaries to channel funds to the real economy and active players in the open market with the central bank and traders of government bonds, banks are at the front to be influenced through fiscal and monetary policy. The economic policy and the development of national economy indirectly determine the overall loan quality both for private and corporate sectors. Thus, the soundness of the finance industry is the result of the interplay of many macro-economic decisions, not limited to decisions of the banking supervisor. As consequence of the above knowledge, new macro-prudential supervisors were set up in the reform package of many countries. On the EU level, a new European Systemic Risk Board (ESPB) will be founded; the responsibility of macro-prudential oversight is clarified in Germany within the BaFin and in the UK within the FSA; the Financial Stability Oversight Council will be set up in the US within the Treasury to bundle broadly expertise from OCC, FDIC, Fed, SEC, CFTC, Federal Housing Finance Agency (FHFA), National Credit Union Administration (NCUA), Consumer Financial Protection Bureau and insurance for macro-prudential oversight. Caruana (2010), General Manager at BIS, points out that Asian central banks have advanced experiences in using macro-prudential regulatory rules such as direct control in lending in

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specific sectors to ensure that financial sector development is in line with macroeconomic policy. For instance, China usually uses “credit volume guidance” to control the total credit volume as anti-cyclical measures. Each bank gets quarterly credit quota to be controlled. Total credit volume is determined jointly by the central bank which controls macroeconomic stability, CBRC which has best overview of the soundness of the banking sector, National Development and Reform Commission (NDRC) which determines measures promoting economic growth and structure reform, all within the State Council. This coordination mechanism is established in the course of past years reform with the strong emphasis on the unified goal of all authorities to promote financial sector development to ensure national economic growth. Decision making is a joint process of the central bank PBC, sectoral supervisors CBRC, CSRC and CIRC, if engaged even Ministry of Finance in case treasury, taxation, accounting standard are engaged, Ministry of Commerce if industrial and trade policies are involved, National Development and Reform Commission (NDRC) in decisions of mid- and long-term economic and social development plan. This mechanism enables a holistic approach in rules-setting and monitoring. Regarding the direction of financial system reform, the twelfth five-years-plan to be launched in 2011 in China explicitly stressed the “set-up of anti-cyclical macro-prudential supervisory structure framework”. Regarding the pro-cyclical issue, both the calculation scheme of the CAR in the Basel II framework and the mark-to-market valuation method within existing accounting standards IFRS and US GAAP are blamed to enhance the cyclicality of the banking sector. A contra-cyclical capital buffer and other capital conservation measures are introduced in the Basel III framework. Increase the capability of quick adaption in regulations to macroeconomic changes provides basic tools for anti-cyclical supervision. Dynamic CAR and ad-hoc issuance of contra-cyclical rules could increase the uncertainty of regulatory environment in the financial industry, provides however most effective tool to ensure system stability. The flexible toolkit could include high capital buffer in upwards cycle as reserve for downwards cycle. The dynamic up- and down move of key regulatory ratios should be binding on the global scope coordinated e.g. by the Basel Committee to avoid regulatory arbitrage. CBRC is already in the process of developing dynamic capital adequacy ratio and provisioning rules. For instance, CBRC raised the CAR for systemically importance large banks to 11%, for small- and medium-sized banks to 10% in the crisis above the Basel minimum ratio of 8% and required a rise of provisioning coverage ratio from 100% to 130% and further to 150%. Summarizing the above observations, Chinese regulators demonstrate strong capability in macroeconomic oversight and anti-cyclical regulation, which indeed contributed to the stability and soundness of the whole banking sector through the crisis. III.6. Too-big-to-fail and too-interconnected-to-fail: business model matters How is the systemic relevance defined? Blundell-Wignall, Wehinger and Slovik (2009) emphasize that not only the size but the structure of a bank matters much for systemic relevance, since “credit culture” banks with high reliance on traditional commercial banking and with broad deposits as financing source have much better resilience in sheltering capital market turbulences than “equity culture” banks of similar size with large exposure in derivatives and proprietary trading. Loechel and Li (2010) confirm empirically that non-interest income has higher volatility than interest income, although non-interest income consistently contributes to higher asset return. Moreover, banks with high reliance on capital market operation tend to be more inter-connected through globally integrated capital markets and are more prone to contagion risk.

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The Financial Stability Board (FSB) published in November 2009 a list of thirty systemic risk financial institutions which are subject to potential higher capital requirement.

24 banks 6 insurance groups

Canada Netherlands1 Royal Bank of Canada 25 Aegon

France Germany2 BNP Paribas 26 Allianz3 Société Générale

UK Germany 27 Aviva4 Deutsche Bank

FranceItaly 28 Axa5 Banca Intesa6 UniCredit Switzerland

29 Swiss ReJapan7 Mitsubishi UFJ Switzerland8 Mizuho 30 Zurich9 Nomura 10 Sumitomo Mitsui

Netherlands11 ING Group

Spain12 BBVA13 Santander

Switzerland14 Credit Suisse 15 UBS

UK 16 Barclays 17 HSBC18 Royal Bank of Scotland19 Standard Chartered

USA20 Bank of America Merrill Lynch 21 Citigroup 22 Goldman Sachs 23 JPMorgan Chase24 Morgan Stanley Source: FSB

Table 2. FSB Thirty Systemic Risk Institutions

The list is not free of discussion. BBVA, HSBC, Royal Bank of Canada and Standard

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Chartered, for instance performed much better compared to peers due the commercial banking based business model. Chinese banks also provide contra examples for the determination of systemic relevance solely based on size. According to total assets, Chinese four state-owned commercial banks ICBC, CCB, BOC and ABC were ranked as the 11th, 18th, 21st and 25th largest banks over the world.10 However, the simple commercial banking business model with over 80% of revenues coming from lending business, sufficient deposits as financing source with the mandatory loan-to-deposit ratio of 75% and the prohibition of proprietary trading in stocks jointly ensure in large extent the stability of the whole sector. In China, Wang Zhaoxing, Vice Chairman of the CBRC, mentioned at the Chairmen’s meeting of joint-stock commercial banks in October 2010 that CBRC was in the process of the determination of systemically important banks in China with the international advice. The list could include the “big five” banks ICBC, CCB, BOC, ABC and BoCom and other two joint-stock commercial banks China Merchants Bank and CITIC Bank.11 The CBRC revised however on November 26th 2010 that the two aforementioned joint-stock commercial banks were not included in the list due to the small asset size compared to the “big five” banks.12 The final decision was not made yet. Summarizing the above findings, we address that not only the size, but also the business model matters in respect of the probability to fail and the vulnerability to contagion risk. Therefore, more transparency and standardized disclosure requirements regarding non-interest income business especially capital market services and off-balance sheet activities should be necessarily encouraged for systemic risk assessment. III.7. Activities restriction The decision on activities restriction of banking can not be satisfactorily answered until the functions of banking in the economy is clarified. Major tasks of banking include settlement and clearing, delegated monitoring of credit risk and intermediation of financial transactions. The debate on segregated and universal banking has been lasted over decades since the first appearance of the segregated banking model in the US after the 1930s crisis. However, neither theoretical considerations nor empirical results have reached conclusive consensus on the superiority of one system over another.13 Allen and Jagtiani (2000) identify the risk reduction in combining banking with securities and insurance. Schmid and Walter (2008) however show that financial conglomerates are traded with significant discount. Stiroh (2004) finds evidence that non-interest income is more volatile than interest income, which reduces the diversification benefits. Two cross-boarder studies of Barth, Caprio and Levine (2001) and Barth, Caprio and Levine (2008) provide consistent evidence that activities restriction increases the fragility of the banking system, resulting higher probability of banking crisis. The scope of permissible activities in banking can only be satisfactorily answered in light of the role of banks in modern economy. Some of the regulatory failures in the pre-crisis time originate from regulator’s insufficient caution in bank’s changed role from the pure “financial intermediator” to the actual “financial risk taker”14 with high level of proprietary trading in complex products.

10 See The Banker July 2010. 11 See 21 Century Business News, November 1st 2010, p. 9. 12 See Xinhua News, available at: http://news.xinhuanet.com/fortune/2010-11/26/c_12820926.htm. 13 For an overview of the studies, see Loechel, Brost and Li (2008). For current discussions on business model, see for instance De Jonghe (2009). 14 See BCG (2009) and Lund and Roxburgh (2009).

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The concept of segregated banking system with the prohibition of commercial bank’s engagement in investment banking business was first introduced by the Banking Act of 1933 in the US, also known as the Glass-Steagall Act after the financial crisis in the 1930s. The US model of segregation of commercial and investment banking was adopted also in the UK, Canada and Japan. In contrast, Continental Europe has long tradition of the universal banking system with the allowance of bank’s engagement in almost all financial services including investment banking, investment in industrial firms and real estate and event affiliation with insurance companies. During the global deregulation trend in the late 1980s and early 1990s, the segregation was lifted in many countries and in the US through the Gramm-Leach-Bliley Act of 1999. The Dodd-Frank Act marks the reversed trend to more activities restriction. The Volcker rule was introduced in the reform act to limit bank’s activities in proprietary trading, in hedge funds and in private equity up to 3% of the total tier-1 capital. The so called “Glass-Steagall 2” forced leading investment banks like Goldman Sachs, Citigroup, Morgan Stanley to separate their engagement in proprietary trading, private equity and hedge funds from corporate and private banking. In contrast, the universal banking model dominates in continental Europe. The EU is in the lead position in the regulation and supervision of financial conglomerates. Already in 2002, the EU Conglomerate Directive set the foundation of financial conglomerates regulation. The Conglomerate Directive is currently under revision with the goal of stricter regulation of conglomerates with engagement in both banking and insurance, covering a scope of EUR 25 billion financial assets which makes about half of the assets in the EU financial sector.15 In the early years of the reform in China from the 1980s to the 1990s, bank’s engagement in securities services was not restricted by law. Large flows of bank deposits into stock markets and real estate speculations put two Trust and Investment Companies in Hainan and in Shenzhen into bankruptcy. This triggered the issuance of the first Commercial Bank Law in China in 1995, which separated commercial and investment banking. 16 Securities departments of large banks were mandatorily carved out to form separate securities companies such as China Merchants Securities Co., Ltd. Today, China still belongs to countries with the strictest regulation of business scope in banking. 17 In 2005, the Administrative Rules for Pilot Incorporation of Fund Management Companies by Commercial Banks 2005 marked the first trial of moving toward the integrating of other financial services like asset management with banking. In the development of cross-sector financial services, China follows the bank holding company structure with equity participation, first on a trial basis for selected large state-owned commercial banks, then roll out to other strong joint-stock commercial banks. With the issuance of the Pilot Administrative Measures for Commercial Banks to Make Equity Investment in Insurance Companies in 2009, banks were further allowed to hold stocks in insurance, trust, financial leasing or consumer finance companies. The performance measured by ROA and ROE of a bank’s cross-sector services should reach the average level of the corresponding industry. In case of poor performance, the license for cross-sector services can be revoked. Summarizing the above observations, we see a global convergence of Western banking moving toward the downscaling of capital markets activities in banking and the Chinese move to more liberalized cross-sectoral activities regulation. However, how to align the segregation in supervisory structure with the integration of financial services remains challenging for

15 See Berschens (2010). 16 For reasons of the choice for the introduction of the segregated financial system in China, see for instance CASS (2001). For an overview of the development of financial conglomerates in China, see for instance Lin (2003). 17 See IIB (2009).

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Chinese regulators. In his speech at IIF Spring meeting in June 2010, Shen Liantao, the former President of Hong Kong Securities and Futures Commission and Chief Advisor of CBRC, stressed the backlog of the regulatory architecture in Asia with the dominance of separation of sectoral-supervision.18

18 See Caijing Magazin: http://multimedia.caijing.com.cn/2009-07-06/110193565.html

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IV. Conclusion: joint-tasks ahead The overall assessment shows many differences in the regulatory goals, principles and practices between China and Western countries mainly due to unbalanced development stage of financial markets. Shen Liantao points out that the tasks for Asian supervisors are more challenging in the post-crisis supervisory reform since Asian supervisors bear the conflicting goals of stability and development of financial markets.19 As a result of the Asian financial crisis, Asian supervisors followed conservative and stricter regulatory framework whereas deregulation, liberalization dominated the pre-crisis regulatory philosophy in the pre-crisis Western world. The financial crisis provides the unique momentum to achieve a global consensus for a more balanced global framework between stability and vitality goal and between principle-based and rule-based regulation. More emphasis will be put on macro-stability oversight, strengthened cross-sectoral and cross-national supervision and broader supervisory scope both for products and players. In the last thirty years, China took great effort and made much advance in building up a regulatory and supervisory framework up to international level. While integrating international best practices and Basel Accords, China always followed its own stricter and more holistic way in regulating the finance sector. The regulatory and supervisory framework in China is highly praised in stabilizing the emerging Chinese financial markets in the crisis. The gradual release of high entry burden as the result of China’s commitment to the WTO accession and the narrowing lending spread due to shrinking mandatory interest margin in course of the internationalization of the Chinese currency will undermine the current profitability fundamentals of Chinese banks if efficiency is not gradually built up to international comparative level. Since China’s capital markets are still in a pre-mature state, an increased variation in products and players urges Chinese supervisors to develop more sophistication in tools and be more integrated in the international regulatory architecture. The financial crisis and the consequent implementation of Basel III have already changed or will further shape the future of the global banking landscape with some banks disappeared, some downscaled, and also some strengthened including the emerging players. Learning lessons from the crisis, regulators and supervisors have realized the urgency to overhaul their backlog behind the global financial industry best in a coordinated way. After thirty years of reform, China has successfully built up regulatory and supervisory capacities suitable for the current development stage of China’s banking sector and is well prepared to accelerate the catch-up process in the global reforms. For both Chinese and Western regulators, the joint tasks still lie ahead.

19 See Shen’s speech at the IIF Spring Meeting in June 2010. Caijing Magazine http://multimedia.caijing.com.cn/2009-07-06/110193565.html

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