What China’s new capital rules mean for banks on risk exposure

New rules for China’s banks to determine their risk exposure and capital requirements are slated to go into effect on Jan. 1, as regulators bring the country’s banking system into line with the latest international standards set by the Basel Committee on Banking Supervision (BCBS).

The final regulations on managing commercial banks’ capital, released on Nov. 1, are the first comprehensive update to bank capital rules since 2012. Some metrics for calculating lenders’ risk-weighted assets (RWAs) have been relaxed from the draft version published in February. But regulators made no changes to rules in the draft setting up a system of differentiated requirements based on a bank’s size to simplify compliance for smaller lenders.

Banks need to retain a certain amount of capital on their balance sheets to cover potential losses on their loans and other assets. This capital requirement depends on the perceived riskiness of the types of assets a bank holds — the more risky an asset, based on the asset classification system imposed by regulators, the higher its risk weighting and the capital requirement.

The guidelines for measuring RWAs are set by the BCBS, and the latest version, Basel III, took effect in January. BCBS member countries use these guidelines as a basis to formulate their own criteria and rules that fit domestic conditions. Thus China’s financial watchdogs have decided that for capital requirements different criteria will be applied to different banks based on a three-tier system that subjects smaller banks to simpler regulations.

Beginning in January, the metrics for calculating banks’ RWAs will be more sensitive to risks associated with loans to the real estate sector, some types of interbank business, bond investments and asset management products.

For residential mortgages, the new regulations have a more detailed methodology for assessing various risks, taking into consideration factors such as whether repayment relies on cash flow generated by the property and the loan-to-value ratio, which compares the size of the outstanding loan on a piece of real estate to its initial market worth.

Certain types of loans to businesses and local governments’ general bonds, whose proceeds mainly fund public welfare projects, will be assigned lower risk weightings than previously.

The new rules lower risk weightings for loans related to the real economy, aimed at encouraging banks to support President Xi Jinping’s long-standing policy that the financial sector should better serve the real economy, some analysts said.

The change to the weightings for personal mortgages will lower the RWA value of such loans for China’s listed banks, excluding six of the largest lenders, by around 2.84 trillion yuan ($400 billion), a 60% drop on the current value, according to estimates by Citic Securities analysts led by chief economist Ming Ming. Lower RWA values mean these banks’ capital adequacy ratios, a measure of their balance sheet strength and ability to absorb losses, will improve.

Banks with a large proportion of personal mortgages, credit card loans and loans to small and midsize enterprises in their total lending are more likely to benefit from the new rules, a Ping An Securities report says.

Impacts vary

China’s regulators don’t expect the new rules to lead to significant changes in banks’ balance sheets overall.

In a Q&A posted on its website on Nov. 1, the National Administration of Financial Regulation said the banking sector’s capital adequacy ratios will remain generally stable under the new rules, even if ratios change for individual banks.

Some major banks, including China Merchants Bank and state-owned Agricultural Bank of China as well as leading city commercial banks such as Bank of Guiyang have all said their capital adequacy ratios will remain stable or improve with the implementation of the new RWA metrics.

But for some smaller banks, especially rural and city commercial banks, the new rules create challenges that might require them to make changes to their asset structure that involve the disposal of more risky assets.

Subordinated debt issued by commercial banks and certain interbank negotiable certificates of deposit — certificates for deposits issued by banks in the interbank market — will carry higher risk weightings under the new rules. These are important financing sources for many small and midsize banks, and other commercial banks are among the biggest buyers of these debt instruments, which sit on their balance sheets as assets.

Commercial banks’ subordinated debt mostly comprises bonds that boost Tier-2 capital, the second layer of capital a bank needs to hold as part of its capital reserves. The new rules will increase the risk weighting of commercial banks’ subordinated debt to 150% from 100% and require them to hold more capital. So banks might become reluctant to buy Tier-2 bonds issued by other lenders, and smaller banks might even sell their existing holdings, according to Ming’s team. Issuers could also find it more difficult to sell new bonds, the team said.

“The adjustment to the risk weighting of Tier-2 bonds will have the greatest impact on small and midsize banks,” a senior executive of a city commercial bank told Caixin.

Some rural and city commercial banks tend to hold a higher proportion of assets whose risk weightings will rise under the new rules. This could lead to a decline in their capital adequacy ratios and require them to issue more Tier-2 bonds to raise capital to strengthen their balance sheets as other commercial lenders will be more reluctant to buy them, according to fixed-income analysts at China Merchants Securities.

The difficulty in issuing subordinated debt may force smaller banks to look for alternative ways to raise capital in already unfavorable market conditions.

“Banks will need to do all they can to expand the channels for capital replenishment,” a source in charge of the interbank business department of a major bank told Caixin.

Caixin Global