for bank regulatory rules to rein in the excessive credit expansion of the commercial banks. the result was that bank rules were not fully implemented and capital ratio was notably inadequate. in fact, the basel accord is a comprehensive regulatory and internal assessment system. its essential indicator, capital adequacy ratio embraces earning objective while effectively containing the excessive expansion of the bank. the numerator of car indicates the capital adequacy of the bank and robustness of the buffer against shocks. the more capital, the more resilient a bank is against risks. meanwhile, dynamics of capital depends on retained profit. when a bank calls for additional capital, the investors look at the earnings of the bank. an unprofitable bank can hardly attract external finance. in addition, expansion through merger and acquisition is also subject to capital constraint. the denominator of car assigns different risk weights to assets so as to drive banks towards less risky business and away from high risk business. risky business must be supported by more capital. this effectively contains the excessive growth of risky assets. the basel ii initiated the so - called “ internal rating base ” ( irb ), encouraging banks to identify asset risks through internal rating system. the risk weighting system encourages non - asset business, or commission - based business. the accord will also boost asset securitization since securitization lowers risk level of assets thus lowers capital requirements. in a way, it encourages banks to shift, sterilize and lower risks by all means. in this sense, such an indicator is a combination of incentive and control mechanisms, while encouraging technical innovations to improve credit asset quality. nevertheless, a principal problem in applying car to chinese banking institutions is that different banks bear different historical legacy, which is difficult to measure by a unified standard. this historical problem should be solved by more aggressive reforms before more stringent regulations could be applied and serve as the core objective to improve their corporate governance and business operation. in this spirit, in 2003, the china banking regulatory commission initiated the 3 - year plan for banks to comply with basel ii. some technical issues deserve attention, which, if not properly dealt with, may dampen the effectiveness of the policy. for instance, for banks with inadequate capital, the so - called “ shadow calculation ” may leave a lot of leeway. for banks with lower than 4 percent of capital adequacy ratio, strict regulatory measures have been taken. however, for banks with capital ratio sliding down

a market economy. some financial institutions, especially large ones, have not shed the bureaucracy - oriented mentality, a legacy of the centralized economy. in their business objectives, personal promotion is usually prioritized over profit indicators, which will definitely affect the transmission of price instruments of monetary policy. in order to enhance the micro foundation, china has been strengthening financial supervision over the years. it should be noted that the choice of regulatory intensity and indicators has direct impact on monetary policy effectiveness. for instance, with increasing concern on the rise of non - performing loans ( npl ), the regulatory authority required that npl ratio be reduced to a certain level. this regulatory indicator played its role to the extent that commercial banks did reduce npl ratios. however, in order to comply with the regulatory requirement of lower npl ratio, some financial institutions increased lending in an attempt to inflate the denominator and grow out of the npl problem. this exacerbated the excessive credit growth problem. at this point, some people started to realize that we should worry not only about the npl ratios, but also the quantity of npls. again, this was also an over - simplified perception. it was only after some time of market development, much experience and years of discussion, that consensus was finally reached in 2003 on the importance of capital adequacy. only when agencies at the micro level put in place risk control and capital constraint, could monetary policy transmission mechanism work. the chinese financial community has always watched the evolution of the basel accord closely. as early as in 1994, the pbc initiated the regulatory indicators on commercial bank ’ s capital in its circular 38 entitled “ notification on balance sheet management of commercial banks ”, and required that the ratio of monthly average capital of commercial banks to monthly average risk - weighted assets be no less than 8 percent, while the ratio of average core capital of commercial banks to monthly average risk - weighted assets be no less than 4 percent. the commercial banking act of 1995 also stipulated that capital adequacy ratio ( car ) of commercial banks be no less than 8 percent. however, for an extended period of time, no regulatory actions were ever taken against banks with inadequate capital. concession was even allowed in the calculation of car. compromise was made in the loan asset classification and bad debt provisioning rules in 1997. in the absence of realistic classification and sufficient risk provisioning, car can hardly indicate the risk of the bank. these problems made it impossible