China prefers its own Basel II

Basel II would cripple China''s inefficient banks, so they are trying a folk remedy.

The Basel capital accords were a consensus arrived at by the Group of Ten nations on what capital levels should be deemed safe for commercial banks. The consensus arrived at the somewhat arbitrary figure that banks would do well to have 8 cents in capital for every dollar of loans they made. Over 100 countries have since signed up to the deal, which also includes a range of rigid risk weightings on different classes of loans.

Recently, proposed new regulations (Basel II) came out, allowing for a three pillar approach involving stricter forms of internal and external controls, and higher levels of transparency. The new capital accord tries to match the much greater array of businesses that banks do with a risk based apporach to capital levels.

The new Basel regulations essentially empower banks to release capital by fine-tuning (reducing) the risk weighting of certain creditor categories. However, the bank must prove it has the powerful IT systems and necessary historical data that can help it build up a credit profile of its customers. It therefore overwhelmingly favours powerful, global banks. It's possible that, in Hong Kong, only HSBC could live up to the standards required.

Consequently, the head of China's newly set up China Banking Regulatory Commission, Liu Mingkang, had already announced that at least until 2006, the date at which those countries amenable are to implement the new accords, Chinese banks would not be attempting to match the these standards.

Last Thursday, a CBRC official told reporters that it would be more realistic, in the medium term, to focus on implementing the existing accords. Analysts say that makes sense, since Chinese banks don't yet comply with the Basel I capital levels because they are dragged down by bad debt levels amounting to 35% of China's GDP. They are also hamstrung by the way capital levels are calculated.

For example, under the Basel I accords, the risk weighting used for loans to SOEs by Chinese banks would be 100%, as it would for all commercial loans, compared to the 20%-70% levels that are used in China. That low risk weighting artificially inflates China's banks' capital adequacy ratios, but even then, ratings agency Fitch estimates that only Bank of China matches the central bank's (un-enforced) goal of 8%.

The CBRC official also announced that in the second half of this year new regulations would appear on the appropriate capital levels for domestic banks which would draw many lessons from the Basel II capital accords and which would reduce the gap between the international banks and the Chinese banks.

The regulations will make it clear that the CBRC will be responsible for overseeing the banks' adherence to the regulations and that it would take 'appropriate measures' against banks which failed to have the required capital levels, said the official. The CBRC will also require the banks to provide the information from which to calculate the capital ratios.

However, the proposed rules do not for the time being explicitly include 'operational risk' within the inspection remit.

Operational risk is the risk that something goes wrong with the systems or the integrity of the bank. Even Basel II has not yet agreed on how an advanced banking environment should be risk weighted, let alone one such as China.

"Obviously, it would have to be much higher than London, for example, for which a risk weighting of 10%-20% has been calculated. But how much higher is hard to calculate, given the lack of available data. But in any case it would impose a huge burden on the mainland banks," says China banking sector analyst Arthur Lau at Fitch Ratings, Hong Kong.

It's clear, say analysts, that given the tendency of banks in China to be plundered by staff and local government officials, let alone run-of-the-mill mistakes, that China would be off the chart as regards its score for operational risk.

As to China's own standards it wants to introduce, Lau points out it makes it impossible for Chinese banks to grow beyond their existing international branches - assuming these aren't closed down for not conforming to agreed international banking criteria.

At any rate, these developments have shifted the floodlight onto the CBRC, set up in April, and from which great things are expected.

While the CBRC's apparent decision to back off from Basel II and even the analysis of operational risk under its own proposed set of rules, is understandable, it puts into question the CBRC's determination, or perhaps only its capability, to purge China's dangerously overloaded banking system..

The CBRC is new, and as such, is still fighting turf battles. Crucially, the necessary empowering legislation has still not been passed by the State Council.

Given the lack of legislation, since it was set up four months ago, it is not clear whether the CBRC has been allowed to inspect the capital adequacy ratios of Chinese banks - an important part of its remit, and snatched away from the previous regulator, the PBOC. The latter now concentrates on interest rates and currency issues.