China's Own Version of Basel III and
Its Likely Impact on China's Banking Sector
Eiichi Sekine
Senior Analyst,
Nomura Institute of Capital Markets Research

I.

China's announcement of its own version of Basel III

On 3 May 2011 the China Banking Regulatory Commission (CBRC) published its
Guidelines for Implementing New Regulatory Standards in the PRC Banking Industry("the New Standards"), which had been enacted on 27 April1. The New Standards are
China's equivalent of the Basel III Accord announced by the Basel Committee on
Banking Supervision (BCBS) on 16 December 2010 and are sometimes referred to as"China's Basel III."The Guidelines comprise five sections, covering their overall aims and principles,
the need to improve the banking industry's prudential regulatory standards, the need to
improve the regulation of systemically important banks, the need to do more to
implement Basel II, and future policy (Figure 1).
The New Standards, which will come into force on 1 January 2012, show how
keen the CBRC is to incorporate Basel III in its own regulatory standards, be it, forexample, by adopting new rules for systemically important Chinese financial
institutions or by adopting capital adequacy rules and leverage ratios that are evenmore stringent than those of Basel III.
We can think of a number of possible reasons for this. First, the Chinese authorities
may see Basel III as a way of using "external pressure," in addition to lending
restrictions, to stem the surge in bank lending that has occurred as a result of thepolicy of stimulating domestic demand following the global financial crisis of 2008.
Second, they may see setting a good example to other G20 members at a time when
China and other emerging economies are having an increasing say in international
finance following the global financial crisis as a way of having an even bigger say.
Third, they may see adopting a positive stance towards Basel III as a way of obtaining
the consent of foreign governments to the establishment by Chinese banks of overseas
branches (including the acquisition of local banks) more easily.

1

See http://www.cbrc.gov.cn/chinese/home/jsp/docView.jsp?docID=20110503615014F8D9
DBF4F4FFE45843249ABE00.

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Nomura Journal of Capital Markets Autumn 2011 Vol.3 No.2

Figure 1: Analysis of Guidelines for Implementing New Regulatory Standards
in the PRC Banking Industry
Main items

Secondary items

OutlineOverall aims

(Omitted)
Improve the prudential regulatory standards in the light of domestic current
situation and international financial regulatory reform

Overall aims andprinciples

Combine macro- and microprudential supervisionPrinciples

Combine consistency and flexible implementation of supervisory standards
Give due consideration to both supporting sustainable economic growth andmaintaining a sound banking system
Revise methods of calculating capital adequacy ratios

Improving supervision

Strengthen supervision of capital adequacy ratiosof capital adequacy

Adopt regulatory standards for leverage ratios
Allow a reasonable grace period

Enhancement ofprudential regulatory

Improving supervision

standardsof liquidity risks

Adopt standards for supervising and monitoring various liquidity risks
Guide banks to improve liquidity risk management
Set a reasonable grace period

Improving supervision

Adopt supervisory standards on loan provision ratios and loan coverage ratios

of loan-loss

Build a system of dynamic provisioning

provisioning

Allow a reasonable grace period
Define SIBs
Retain firewalls and improve ex ante entry regulations

Effective supervisionof systemically－important banks

Strengthen macroprudential supervision
Strengthen supervision on an ongoing basis
Strengthen regulatory cooperation

Implementation ofBasel Accords－

Implement Basel II and Basel III in parallel
Enact related legislation
Supervise banks more closely
Banks formulate feasible implementation plans

Future policy－

Make strategic and serious efforts to modify focus of businessContinue to improve risk management
Improve inspection and regular assessment of how New Standards are being
implemented

Note:
Source:Based on Guidelines for Implementing New Regulatory Standards in the PRC Banking
Industry (27 April 2011).
Nomura Institute of Capital Markets Research, from CBRC data

We think the adoption of the New Standards is likely to put pressure on Chinesebanks, which have been protected by regulated interest and exchange rates as well as
restrictions on the entry of foreign companies, to increase their regulatory capital andchange their business models. Reports in the Chinese media on the adoption of the
New Standards have been largely in line with the CBRC's announcement and deny
any need for large amounts of additional capital. While, on the other hand, US andEuropean media have had very little to say about the adoption of the New Standards,
there have been some quotes from Chinese academics that the measures will require
some RMB4 trillion of additional capital over the next four years2.

2

See “China Bank Regulator Wants Leverage Ratio At 4%; Medium-Term Issues May
Arise”, Dow Jones Newswires, May 23, 2011.

China's Own Version of Basel III and Its Likely Impact on China's Banking Sector

2While it remains to be seen how individual banks will react to the New Standards,
we need, first of all, to understand what the CBRC hopes to achieve. In the following
chapters we will therefore outline the New Standards, the current capital adequacy
requirements and the extent to which they have been met, and the direction in which
the CBRC is likely to go.

II. Outline of the New Standards
As well as its Guidelines the CBRC has published a press release3 and a Q&A
document4 on the New Standards. We conclude from these that the CBRC's response
to Basel III is to try to impose the following regulatory standards on Chinese banks
and then improve those standards.

1. Distinction between SIBs and other banks
The New Standards distinguish between systemically important banks (SIBs) andother banks. SIBs can be identified largely in terms of four criteria: (1) size, (2)interconnectedness, (3) complexity, and (4) substitutability.

2. Improving methods of calculating capital adequacy ratios
Under the New Standards banks' regulatory capital will consist of three tiers (coreTier 1, Tier 1 and Tier 2) rather than two (Tier 1 and Tier 2) as at present. In addition,
the exceptions to core Tier 1 will be applied strictly, and a wider range of methods ofcalculating risk assets will be adopted.
Furthermore, the CBRC intends to optimize the methods the banks use to calculate
risk assets and widen the range of risks covered by regulatory capital. As a result, theweight of risks such as operational risk and those presented by dealing, securitizationand complicated OTC derivatives will be added.

3. Tightening capital adequacy rules
Once they are introduced, the three tiers will have capital adequacy requirements
of 5% (core Tier 1), 6% (Tier 1), and 8% (Tier 2, including Tier 1) (Figure 2). Added
to this will be a reserve excess capital conservation buffer of 2.5% and acountercyclical capital buffer of 0–2.5%. In addition, SIBs will be subject to a 1%
additional capital surcharge for the time being. As a result, they will have an overall

34

See http://www.cbrc.gov.cn/chinese/home/jsp/docView.jsp?docID=2011050361A1A6D30
A626FD7FFC4A1780E59B300.
See http://www.cbrc.gov.cn/chinese/home/jsp/docView.jsp?docID=2011050313449537EC
BC567BFF46D54C7B5D1600.

3

Nomura Journal of Capital Markets Autumn 2011 Vol.3 No.2

Figure 2: New regulatory standards on capital adequacy rules and leverage ratios

5％
6％
8％
2.5％
0～2.5％
1％
11.5％
End-2013

All banks excl. those in thepreceding column
5％
6％
8％
2.5％
0～2.5％―
10.5％
End-2016

10.5％
End-2018

4％

4％

3％

SIBs
Core Tier 1
Tier 1
Tier 2
Capital buffers
Countercyclical capital buffers
Capital surcharge (for the time being)
Capital adequacy ratios
Deadline
Leverage ratios

Basel III
4.5％
6％
8％
2.5％
0～2.5％

Note:

1. Based on Guidelines for Implementing New Regulatory Standards in the PRC
Banking Industry (27 April 2011).
2. Tier 2 requirements include Tier 1.
Source: Nomura Institute of Capital Markets Research, from CBRC data

capital adequacy requirement of 11.5% 5 , while other types of bank will have arequirement of 10.5%.
According to the above-mentioned Q&A document, the 11.5% requirement for
SIBs is the same as the current requirement for major banks (namely, according to the
CBRC's statistical classification, Industrial and Commercial Bank of China (ICBC),
Agricultural Bank of China (ABC), Bank of China (BOC), China Construction Bank
(CCB), and Bank of Communications (BoCom)), while the 10.5% requirement forother banks is basically the same as the current requirement for small and mediumsized banks. In this connection it is perhaps worth mentioning that in February 2007
the CBRC issued Guidelines on the Implementation of the Basel II Capital Adequacy
Framework by China's Banking Sector, which formed the basis of a number of related
pieces of legislation. According to these, the CBRC will regard a number of majorbanks as subject to Basel II after a four-year adjustment period (i.e., from 2011).
Banks will have a period of grace before they are expected to comply with the newcapital adequacy requirements. In the case of the SIBs, this will be until the end of
2013; in the case of other banks, it will be until the end of 2016. In both cases,
however, it will be sooner than Basel III's own deadline for full compliance (the endof 2018).
The New Standards adopt a new leverage ratio of at least 4% of Tier 1 capital tototal (including off-balance sheet) assets (Figure 2), 1 percentage point more than the
Basel III requirement of at least 3%.

5

Assuming no countercyclical capital buffer.

China's Own Version of Basel III and Its Likely Impact on China's Banking Sector

44. Better liquidity rules
In addition to the liquidity coverage ratio (LCR) and net stable finance ratio(NSFR) prescribed by Basel III, the New Standards contain rules intended to monitor
liquidity risks. These include a liquidity ratio, a loan/deposit ratio, a core debt ratio, aliquidity gap ratio, deposit concentration, and an interbank funding ratio. As in thecase of the new capital adequacy rules, the banks will have a period of grace before
they are expected to comply with the new liquidity rules. In the case of the SIBs, thiswill be until the end of 2013; in the case of other banks, it will be until the end of
2016.

5. Stricter loan provision rules
Under the New Standards banks will be expected to have a loan provision ratio (i.e.,a general loan provision ratio) of at least 2.5% and a provision coverage ratio (i.e., aratio of provisions for specific nonperforming loans) of at least 150%.
Furthermore, the CBRC will adjust its provision requirements by means ofdynamic provisioning and differentiation. In other words, it will require banks tomake correspondingly greater provision during cyclical uptrends but moderate this inline with the extent to which they drawn down those provisions during cyclical
downtrends. China has therefore taken a lead in adopting dynamic provisioning,which has been seen as a means of dealing with procyclicality, one of the issues thatreform of the international financial system needs to address. The CBRC will also
adjust its classification of the different grades of provision in line with the quality andprofitability of banks' receivables.
As in the case of the two sets of rules mentioned above, the banks will have aperiod of grace before they are expected to comply with the new provisioning rules. In
the case of the SIBs, this will be until the end of 2013. In the case of the other banks,
those that are profitable and whose underprovisioning is moderate will have until theend of 2016, while those that are unprofitable and need to make considerably more
provisioning will have until the end of 2018.
In this connection it is perhaps worth mentioning that, according to the CBRC,
China's banks have an average loan provision ratio of nearly 2.5% and an average
provision coverage ratio of 230%, with more than 50% of its banks already incompliance with the new loan provision requirement and more than 80% incompliance with the new provision coverage requirement.

6. Regulation of SIBs
The New Standards set out regulatory policies for SIBs from four different
perspectives (Figure 1). These are in line with the policy of the Financial Stability
Board (FSB) and the BCBS to tighten the rules for systemically important financial
institutions (SIFIs).

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Nomura Journal of Capital Markets Autumn 2011 Vol.3 No.2

1) Retaining firewalls and improving ex ante entry regulationsFirst, the firewalls that currently exist between the banking system and capital
markets, between the banks and their controlling shareholders, and between the banks
and their subsidiaries will be retained to stop crises from spreading.
Second, banks' freedom to engage in highly-leveraged activities with complicatedstructures will be strictly limited to prevent them from taking excessive risks.
Third, banks will be required to exercise caution when they conduct pilot programsin universal banking. If a bank's profits from universal banking are below the sector
average, it will be required to discontinue its universal banking operations.

2) Improving macroprudential supervisionFirst, SIBs will be required to issue bail-in bonds to increase their ability to absorb
losses.
Second, the CBRC will supervise the banks' liquidity more strictly.
Third, the banks will be subject to stricter rules on commercial lending andrequired to reduce their lending to particular borrowers or groups to a reasonable
percentage of their net capital.
Fourth, the CBRC will tighten its supervision of risks at group (consolidated) level.

3) Improving supervision on an ongoing basis
First, the CBRC will focus its resources on SIBs, give its inspectors wide-ranging
powers, and strengthen its supervision of banks' decision-making and implementation
processes in order to identify risks as early as possible and take the necessary action.
Second, it will improve and extend its off-site supervisory system, create a systemfor evaluating its monitoring of the risks posed by SIBs, give advance warning ofrisks, identify risks accurately, and deal with them as rapidly as possible.
Third, it will improve its capacity to inspect SIBs on site, persuade them toimprove their governance and risk management, and try to prevent and reverse risky
and unsound management decisions.
Fourth, it will ensure that it has the supervisory tools (in the form, for example, of
product analyses, model tests and stress tests) to deal with the SIBs' increasingly
complex operations and structures.
Fifth, the CBRC will supervise the SIBs in drawing up recovery, resolution andcontingency plans in order to help them increase their powers of self-preservation.

China's Own Version of Basel III and Its Likely Impact on China's Banking Sector

64) Increasing regulatory cooperation
The CBRC will seek to increase cooperation with other regulators, both at home
and abroad. As part of its cooperation with overseas regulators, it will develop
mechanisms for evaluating their regulatory competence and seek to improve themechanisms for discussing with them how to supervise SIBs with cross-border
operations.

III. Current capital adequacy rules and their degree ofattainment
1. Legal basis of China's capital adequacy rules
We now take a closer look at the capital adequacy rules governing China's
commercial banks. First, according to Article 39 of the Commercial Bank Law of thePeople's Republic of China (amended and promulgated on 27 December 2003, andeffective since 1 February 2004), which contains four requirements on the ratios ofassets and liabilities that commercial banks must comply with, "the capital adequacy
rate shall not fall short of 8%."6 Similarly, the Guidance to Corporate Governance ofState-owned Commercial Banks and the Relevant Supervision thereof (enacted on 18
April 2006 and effective since 24 April 2006) stipulates that "the capital adequacy
ratio after financial reorganization shall be kept more than 8%."
Second, the CBRC's Provisional Risk Assessment System for Joint-Stock
Commercial Banks (promulgated on 22 February 2004), which sets out rating
standards for capital adequacy, asset safety, and the performance of commercial banks,
adopts an approach to supervision whereby inspectors are allowed to apply lessstringent criteria to banks with a high rating but are required to apply more stringent
criteria to those with a low rating. In the case of capital adequacy, banks with a capital
adequacy ratio of 10% or more are awarded full marks, while those with a ratio of 2%or less are awarded zero marks. Similarly, those with a core capital adequacy ratio of
6% or more are awarded full marks, while those with a ratio of 1% or less areawarded zero marks.

2. Capital adequacy rules in detailOn this legal basis the CBRC issued (initially with effect from 1 March 2004 andsubsequently, as amended, with effect from 3 July 2007) its Regulation Governing
Capital Adequacy of Commercial Banks. Its definitions of and methods of calculating
regulatory capital can be found in Figure 3.

6

In this connection it is perhaps worth mentioning that the article also sets requirements forthe ratio of loans to deposits (maximum of 75%), the liquidity ratio (minimum of 25%), andthe ratio of outstanding loans to one borrower to that of a bank's capital (maximum of
10%).

7

Nomura Journal of Capital Markets Autumn 2011 Vol.3 No.2

Figure 3: Definition of and method of calculating capital adequacy ratios
of Chinese commercial banks
Capital adequacy ratioCore capital adequacy ratio

Definition

Ratio of capital to risk-weighted assets

Ratio of core capital to risk-weighted assets

Minimum

At least 8%

At least 4%(Capital – deductions)/risk-weighted assets + 12.5 ×(Core capital – deductions from core capital)/risk-

market risk capital charge

weighted assets + 12.5 × market risk capital charge

requirement
Method of calculation

Capital = core capital + additional capitalCore capital: includes paid-up capital, common stock, capital surplus reserve, retained surplus reserves,
Definition of capitalundistributed profits, and minority interests.
Additional capital: includes revaluation reserves, general reserves, preferred stock, convertible bonds, mixed
capital bonds, and long-term subordinated debt.

Deductions from

(1) Goodwill, (2) equity stakes and investments in unconsolidated financial institutions, and (3) real estate

capitalinvestments by commercial banks (not for own use) and equity stakes in nonfinancial companies

Deductions from core (1) Goodwill, (2) 50% of equity stakes and investments in unconsolidated financial institutions, and (3) 50% of
real estate investments by commercial banks (not for own use) and equity stakes in nonfinancial companies
capitalAdditional capital

Additional capital may not exceed 100% of core capital.

ratio
Subordinated debt

Long-term subordinated debt included in additional capital may not exceed 50% of core capital.

ratio

Note:
Source:Based on Regulation Governing Capital Adequacy of Commercial Banks (effective from 3
July 2007).
Nomura Institute of Capital Markets Research, from CBRC data

3. Degree of attainment of capital adequacy requirements
As of the end of 2010, the capital adequacy ratio of Chinese commercial banks as awhole was 12.2%, while the core ratio was 10.1% (Figure 4). As of the end of March
2011, the capital adequacy ratio of Chinese commercial banks as a whole was 11.8%,
while the core ratio was 9.8%. Under the New Standards, the core Tier 1 capital
adequacy requirement is set at 5% (0.5 percentage point higher than Basel III's 4.5%
requirement). This is because Chinese banks have already attained this level of capital
adequacy and an additional 0.5 percentage point was considered unlikely to have anegative impact on their operations. This is also why the deadline for implementing
the new capital adequacy rules is sooner than the Basel III deadline of the end of 2018.
The capital adequacy ratios of Chinese commercial banks (as of the end of 2010)
whose shares are listed on Chinese stock exchanges (A-shares) can be found in Figure
5. All 16 have a capital adequacy ratio of at least 8%. The bank with the highest
capital adequacy ratio is Ningbo Bank (Zhejiang Province) with a ratio of 16.2%,
while the bank with the highest core ratio is Nanjing Bank (Jiangsu Province) with aratio of 13.75%. The five banks classified by the CBRC as "major banks" (ICBC,
ABC, BOC, CCB and BoCom) all have a capital adequacy ratio of at least 11.5% as
required of SIBs by both China's existing rules and the New Standards.

China's Own Version of Basel III and Its Likely Impact on China's Banking Sector8Figure 4: Capital adequacy ratios of Chinese commercial banks
End-2010

End-March 2011

Core capital

RMB4,298.5bn

RMB4,553.4bn

Additional capital

RMB1,029.5bn

RMB1,078.1bn

Capital deductions

RMB319.6bn

RMB323.8bn

RMB35,537.1bn

RMB38,702.9bn

RMB5,323.4bn

RMB5,799.0bn

RMB27.3bn

RMB27.4bn

Capital adequacy ratio

12.2％

11.8％

Core capital adequacy ratio

10.1％

9.8％

(On-balance sheet) risk-weighted
assets(Off-balance sheet) risk-weighted
assetsMarket risk capital charge

Source:Nomura Institute of Capital Markets Research, from CBRC data

Figure 5: Capital adequacy ratios of Chinese commercial banks with shares
listed on Chinese stock exchanges (A shares) (end-2010)
Industrial and Commercial Bank of China
China Construction Bank
Bank of China
Agricultural Bank of China
Bank of Communications
China Citic Bank
China Everbright Bank
China Merchants Bank
China Minsheng Banking Corp.
Industrial Bank Co., Ltd.
Shenzhen Development Bank
Shanghai Pudong Development Bank
Hua Xia Bank
Bank of Beijing
Bank of Nanjing
Bank of Ningbo

0.00
Capital adequacy ratio (%)

Source:

9

5.00
10.00
15.00
Core capital adequacy ratio (%)

20.00

Nomura Institute of Capital Markets Research, based on data from banks
concerned

Nomura Journal of Capital Markets Autumn 2011 Vol.3 No.2

IV. CBRC's future stance
1. CBRC's policies on implementing the New Standards
The CBRC plans to implement the following policies in order to ensure that the
New Standards are implemented (Figure 1).

1) Enactment of related legislation
First, the CBRC has been working on amendments to its Regulation Governing
Capital Adequacy of Commercial Banks in order to ensure that the New Standards are
implemented in time.
Second, it has been carrying out extensive training programs and publicity
campaigns in order to familiarize both regulators and bankers at all levels with the
New Standards.

2) Closer supervision of the bank
First, the CBRC takes the view that each bank should appoint someone to form ateam to implement the New Standards.
Second, it takes the view that each bank's board of directors should discuss andapprove key policies and plans for implementing the New Standards, and require
management to update it regularly and to monitor progress.
Third, it takes the view that the banks should formulate plans for implementing the
New Standards and take responsibility for putting them into practice.

3) Formulation of feasible implementation plans by the banks
When formulating feasible implementation plans, banks are required to include, atthe very least, an asset growth plan, an asset composition adjustment plan, aprofitability plan, an explanation of how they calculate their risk assets, a capital
replenishment plan, the sources of their liquidity, an explanation of how they intend to
replenish their loan-loss provisions, and a timetable (with interim targets) forcomplying with the new regulatory requirements.
Each bank will have to finalize its implementation plan by the end of 2011 andhave it approved by the CBRC.

4) Strategic and serious efforts to modify focus of business
The CBRC wants banks seeking to change their business model to move from anextensive model of development that seeks to increase the size of a business to an
intensive model of development that seeks to improve its quality. Furthermore, theChina's Own Version of Basel III and Its Likely Impact on China's Banking Sector

10CBRC has issued the following guidelines to encourage banks to both deepen andbroaden their lending operations in order to provide a more efficient service andbetter-quality loans on the assumption that they will stick to a traditional businessmodel.
First, banks should restructure their business in order to develop a medium- tolong-term strategy for their lending operations. Furthermore, they should seek torestructure the customers, sectors and regions they lend to in order to ensure thesustainability of these operations.
Second, banks should manage their risk management tools better and constantly
seek to improve them. They should also have risk management policies and risk
management flow charts, and seek to improve their risk control mechanisms.
Third, they should offer their customers new services. They should expand theirbusinesses by offering new services such as Internet banking, telephone banking, andcredit cards, extend the coverage of their financial services, offer their asset
management customers low-risk products, reduce management costs, and increase
their sources of revenue.

2. Distinctive features of Chinese risk management
The CBRC's policies on implementing the New Standards include, in addition to
the above, sustained improvement of risk management and improving inspections andregular assessments related to implementing the New Standards (Figure 1 above). In
particular, the former ("sustained improvement of risk management") contains
proposals to modify the way Chinese banks manage risk.
Reflecting concern about the sharp increase in local government financing vehicles(LGFVs) and property loans produced by the government's efforts to boost domestic
demand from the autumn of 2008 onwards, the CBRC wants the banks to improvestaff incentives and assessment, devise performance assessment and compensation
schemes that strike a better balance between risk and reward, and seriously consider arisk management model that combines both systemic and specific risks. The CBRC's
aim is to create a foundation on which to build and improve a capital assessment
process, and ensure that the banks' capital is capable of withstanding any risk.
It hopes that performance assessment and compensation schemes that strike abalance between risk and reward will also be able to deal with the major credit risks
posed by the economic adjustment process entailed by the 12th Five-Year Program,which starts in 2011 and is aimed at increasing the rate of change of the country's
economic development model.

3. Conclusion
As was mentioned above, the Chinese government has been implementing Basel II
and Basel III in parallel, and hopes that, by adopting the aforementioned rules for

11 Nomura Journal of Capital Markets Autumn 2011 Vol.3 No.2

SIBs, China's banking system will catch up with global financial regulations at asingle stroke. In addition, the CBRC's desire to promote a healthy banking sector andto give China a greater say at international financial forums such as the G20 is evident
from (1) the fact that the New Standards' capital adequacy requirements and leverage
ratio are more stringent than those of Basel III, (2) the fact that, if it introduced
dynamic provisioning, China would be only the second country to do so (the firstbeing Spain), and (3) the fact that China is planning to adopt Basel III before theofficial deadline.
On the other hand, a number of issues remain unresolved, including the fact that,
although the CBRC has been trying to induce the banks to change their businessmodel, it wants to preserve traditional banking. This raises the question how banks aretrying to, or should be trying to, generate revenue while still subject to restrictions on
interest rates and exchange rates. At the same time, the CBRC's citing of Internet
banking, telephone banking, and credit cards as possible new sources of revenue may
give overseas financial institutions either operating in, or thinking of expanding into,
China an incentive to market the latest financial technology and products. However,even if that proves to be the case, we would expect the CBRC to make compliancewith the new standards a requirement for licenses to engage in these new areas andthereby avoid excessive competition.
It will therefore be interesting to see what becomes of China's moves to adopt
Basel III.

China's Own Version of Basel III and Its Likely Impact on China's Banking Sector

12