Overhauling China's banking system: the regulatory issues

Baker and McKenzie partners discuss why China is in the middle of a difficult transition to a commercially based banking system.

China is in the midst of a difficult transition from a banking system that supported a planned economy by providing easy credit to state-owned enterprises to a commercially based banking system. A key element of China's reforms is the creation of a more effective regulatory system. To this end China established the China Banking Regulatory Commission (the "CBRC") in April 2003 and enacted fundamental banking legislation in December 2003. This article covers recent legislative and regulatory developments, and briefly addresses China's attempts to cope with nonperforming loans and its plans to list two of the wholly state-owned banks. (For a discussion of foreign investment in China's banking sector, see article: Banking on foreign Investment: Recent Developments.)

Improved legal basis for CBRC

In December 2003, China promulgated the new Law of the People's Republic of China on the Regulation of the Banking Sector (the "Banking Regulation Law") and amended the Law of the People's Republic of China on the People's Bank of China (the "People's Bank of China Law") and the Law of the People's Republic of China on Commercial Banks (the "Commercial Banks Law") (collectively, the "December legislation").

The primary purpose of this legislative activity was to provide a firmer legal basis for the new CBRC. On March 10, 2003, the National People's Congress approved a State Council proposal for a reorganization of the administrative bodies under the State Council. One of the proposed changes was establishment of the CBRC. The CBRC came into existence in April 2003.

Before creation of the CBRC, the authority to regulate financial institutions had been vested by law in the People's Bank of China ("PBOC"). The CBRC's lack of legal authority to carry out its duties was solved by a decision issued by the Standing Committee of the National People's Congress on April 26, 2003. The decision simply authorized the State Council to decide that the CBRC would exercise "the functions of examination, approval, supervision and administration of banks, financial asset management companies, trust and investment companies and other deposit-taking types of financial institution, etc., and related functions" which were originally exercised by the PBOC.

The Standing Committee decision served as the legal basis for the CBRC's regulatory authority until December when the CBRC obtained, in effect, its own law - the Banking Regulation Law - and the People's Bank of China Law and the Commercial Banks Law were amended in order to shift regulatory functions from the PBOC to the CBRC.

The PBOC and the CBRC

In 1983 the State Council decided to make the PBOC the central bank of China. The PBOC regulated the entire financial sector including the banking, securities, insurance and trust industries and was also in charge of monetary policy. In 1992 and 1998 respectively, China established the China Securities Regulatory Commission and the China Insurance Regulatory Commission to take over the regulatory functions for the securities and insurance industries. But the PBOC still controlled banking regulation and monetary policy. Now its banking regulation functions have been transferred to the CBRC.

Under the rough division of labor created by the December legislation, the PBOC is to exercise a role somewhat similar to that of the US Federal Reserve. The PBOC is responsible for monetary policy and macroeconomic issues, while the CBRC is responsible for regulation of financial institutions.

This separation of powers is intended to achieve the following objectives:

  • to prevent the tightening up or loosening of banking regulation by the PBOC in order to achieve monetary policy objectives;
  • to prevent the use of monetary policy tools, such as increasing the supply of money, by the PBOC to solve banking regulation problems;
  • to improve specialization and professionalism in the two distinct areas of banking regulation and monetary policy; and
  • to establish a regulatory system more able to cope with the overwhelming problem of non-performing loans at state banks.

However, some overlap of powers remains. Though the CBRC is vested with sweeping regulatory powers over financial institutions, the PBOC retains certain powers such as the power to carry out inspections of, and supervise, financial institutions, other units and individuals with regard to implementation of regulations for the administration of deposit reserves, Renminbi and foreign currency regulations, interbank lending regulations, interbank bond market regulations, liquidation regulations and antilaundering regulations. The PBOC also has the power, upon approval from the State Council , to inspect and supervise high-risk financial institutions that are encountering difficulty in making their payments. In some of these areas the PBOC's regulatory authority overlaps with that of the CBRC. These areas of overlap are accepted for the present but the State Council Legislative Affairs Office, the PBOC, the CBRC and other authorities are to conduct further study concerning this overlap of regulatory authority.

Institutions subject to regulation

Though the provisions of the Banking Regulation Law consistently refer to "banking financial institutions," the law also applies to asset management companies, trust and investment companies, financial companies and finance-leasing companies established in China as well as other financial institutions the establishment of which is approved by the CBRC.

"Banking financial institutions" are defined to mean commercial banks, city cooperatives, rural cooperatives, other financial institutions that take deposits from the public and the policy banks.

However, if laws or administrative regulations have special rules for policy banks or asset management companies established in China, those rules shall apply.

Likewise, special rules in laws or administrative regulations for foreign-funded banking financial institutions, Sino-foreign equity joint venture banking financial institutions and branches of foreign banking financial institutions shall prevail over the general provisions in the Banking Regulation Law.

China's Banks (Other than the Foreign-Funded Financial Institutions)*

The Policy Banks

  • China Development Bank
  • Agricultural Development Bank of China
  • Export-Import Bank of China

The "Big Four" Wholly State-Owned Commercial Banks

  • Industrial and Commercial Bank of China
  • Agricultural Bank of China
  • Bank of China
  • China Construction Bank

The Joint Stock Commercial Banks

  • Bank of Communications
  • Citic Industrial Bank
  • China Everbright Bank
  • Guangdong Development Bank
  • Shenzhen Development Bank
  • Shanghai Pudong Development Bank
  • Industrial Bank Co., Ltd.
  • Hua Xia Bank
  • China Minsheng Banking Corp., Ltd.
  • China Merchants Bank

Additionally, it has been reported that the Zhejiang Commercial Bank is in the process of being reorganized as a joint stock commercial bank and that a joint stock commercial bank, tentatively named the Bohai Bank, is in the in the process of being established in Tianjin.

The City Commercial Banks

112 city commercial banks

The Rural Banks

At the time of writing no rural banks have been established, but it is reported that 30 rural commercial banks and rural cooperative banks are to be created in the trial areas of Jilin, Shandong, Zhejiang, Guizhou, Jiangxi, Shaanxi, Jiangsu and Chongqing in 2004.

* If foreign investors hold 25 percent or more of an unlisted bank's equity, the bank will be treated as a foreign funded financial institution (Article 9 of the Measures for the Administration of Investment and Acquisition of Equity in Chinese-Funded Financial Institutions by Foreign Financial Institutions).

Implementation of the Basel Committee "Core Principles"

Another major reason for the December legislation was to create a strong regulatory system based largely on the Basel Committee's 1997 Core Principles for Effective Banking Supervision (the "Core Principles"). As the Director of the CBRC informed the Standing Committee of the National People's Congress:

...drawing from and absorbing the Core Principles for Effective Banking Supervision formulated by the Basel Committee on Banking Supervision, [the draft of the Banking Regulation Law] changes the previous solely compliance-based regulatory system into a system of combined compliance/risk regulation and emphasizes the inclusion of provisions for perfecting the regulatory system and strengthening regulatory methods.

The Basel Committee on Banking Supervision is a committee of banking supervisory authorities established by the central bank governors of the Group of Ten countries in 1975. The Core Principles are an attempt to set forth minimum requirements that must be met in order for a banking supervisory system to be effective. The Core Principles were prepared in a group that included representatives from China.

While China has partially implemented some of the Core Principles previously by means of notices, regulations and standards issued by the PBOC, the introduction of the Banking Regulation Law goes further towards establishment of a cohesive legal framework for a system of banking supervision consistent with the Core Principles.

Power to impose prudential operating requirements

Article 21 of the Banking Regulation Law gives the CBRC power to impose prudential operating requirements, such as risk management requirements, internal control requirements, capital adequacy requirements, asset quality requirements, loss reserve requirements, risk concentration requirements, connected transaction requirements and asset liquidity requirements. The power of a banking regulator to impose such prudential operating requirements on financial institutions is a key element of the Core Principles.

The following statutory requirements for commercial banks have been retained by the Commercial Banks Law:

  • The capital adequacy ratio may not be lower than 8 percent.
  • The loan to deposit ratio may not be more than 75 percent.
  • The ratio of liquid assets to liquid liabilities may not be less than 25 percent.
  • Loans to one borrower may not exceed 10 percent of the bank's capital.

Power to examine shareholders' financial condition

When an application is made to establish a financial institution, the CBRC will examine the shareholders' source of funds, their financial condition, their ability to replenish capital and their integrity. This implements the Core Principles rule that the licensing process should include an assessment of the ownership structure. This assessment should include a determination of the "suitability of major shareholders, transparency of ownership structure and source of initial capital."

Information sharing between regulators

The Banking Regulation Law requires exchanges of regulation management information between the CBRC and the People's Bank, and other financial regulators under the State Council. The CBRC may establish cooperation systems with financial regulators of other countries or districts. Arrangements must be made to keep such information confidential. This is consistent with the Core Principles requirement that supervisors share information and make arrangements to keep such information confidential.

Power to review equity transfer proposals

Approval must be obtained from the CBRC when there is a change of shareholders that hold more than a prescribed minimum percentage of a financial institution's capital. This is consistent with Principle 4 of the Core Principles. In the case of commercial banks, the December amendments to the Commercial Banks Law have reduced the prescribed percentage from 10 percent to 5 percent.

The CBRC shall conduct both onsite inspection and offsite supervision (through management information systems) to review a financial institution's business activities and risk conditions. This is consistent with Principle 16 of the Core Principles.

Power to take corrective action

Principle 22 of the Core Principles provides that:

Banking supervisors must have at their disposal adequate supervisory measures to bring about timely corrective action when banks fail to meet prudential requirements (such as minimum capital adequacy ratios), when there are regulatory violations, or where depositors are threatened in any other way. In extreme circumstances, this should include the ability to revoke the banking license or commend its revocation.

The Banking Regulation Law accordingly gives the CBRC a number of specific powers to use when dealing with non-compliant financial institutions. When a financial institution violates prudential operating rules, the CBRC or its provincial-level counterpart may order the rectification of such matters and depending on the seriousness of the case may:

  • order a suspension of part of the financial institution's business;
  • refuse to approve the commencement of new types of business;
  • restrict the distribution of profits or other income;
  • order the controlling shareholders to transfer their equity or restrict the rights of relevant shareholders;
  • order changes in directors or senior management or restrict their rights; and
  • refuse approval of new branches.

If a financial institution experiences a credit crisis and the rights and interests of depositors or other customers would be seriously affected, the CBRC may take over management of the financial institution or organize its restructuring.

If a financial institution engages in illegal operations or it has poor business management, the CBRC may close down the financial institution to avoid serious harm to the financial order and the public interest.

Better regulation only a partial answer

Of course, mere implementation of sound banking supervision arrangements cannot ensure stability in financial markets. The Basel Committee has pointed out some preconditions for financial stability that are much broader than just effective supervision, such as (i) sound and sustainable macro-economic policies, (ii) a well developed public infrastructure, (iii) effective market discipline, (iv) procedures for efficient resolutions of problems in banks and (v) mechanisms for providing an appropriate level of systemic protection (or public safety net).

Nonperforming loans and listing of two state-owned banks

Nonperforming loans are the most serious threat fac ed by China's banking industry. They have been the biggest obstacle to China's attempts to convert the banking system from a financial mechanism to support state-owned enterprises into a purely commercial banking system. But the Chinese government recognizes the seriousness of the problem and has continued to make real efforts to address the problem.

In 1999 China created four asset management corporations to take over and deal in nonperforming assets of the Big Four wholly state-owned commercial banks. According to CBRC Director Liu Mingkang, between 1999 and 2000 the asset management corporations helped the Big Four reduce their rate of nonperforming loans by ten percentage points.

Official statistics show a continuing drop in the rate of nonperforming loans. The CBRC reported that at the end of 2003, the wholly state-owned commercial banks had a nonperforming loan rate of 16.86 percent (down 4.71 percentage points from the beginning of 2003), the joint stock commercial banks had a nonperforming loan rate of 6.50 percent (down 3.03 percentage points from the beginning of 2003), the city commercial banks had a nonperforming loan rate of 12.65 percent (down 4.87 percentage points from the beginning of 2003) and the rural cooperatives had a nonperforming loan rate of 29.72 percent (down 7.5 percentage points from the beginning of 2003). The CBRC believes that part of the reason for this drop in the rate of nonperforming loans is more effective banking regulation in the form of increased onsite inspections, more guidance to bank directors and management and new regulations such as the Notice on Strictly Controlling Connected Transaction Risk and the Notice on Promoting and Perfecting the Classification of Loan Risk.

The above figures are based on the old four-category loan classification system (pass, past due, idle and loss) and are widely believed to be understated. The five-category loan classification system (pass, special mention, substandard, doubtful and loss) was introduced in 1998, but the wholly state-owned commercial banks and the joint stock commercial banks were using both the four-category and five-category systems until the end of 2003. Beginning in 2004, they were to use only the five-category system. The Standard and Poor's rating agency considers this to be a "commendable" change because the five-category system aims to define nonperforming loans based on international norms but considers that implementation of the system will pose difficulties because it is based on subjective judgments rather than quantitative measures.

Listing of Bank of China and China Construction Bank

Two of the Big Four - the Bank of China and the China Construction Bank - have been selected to undergo restructuring as joint stock limited banks and list on a stock exchange. To further those goals, the CBRC has issued the Guidelines on Corporate Governance Reform for, and Supervision of, the Bank of China and the China Construction Bank (the "Guidelines") which came into force on March 11, 2004.

The Guidelines state that the objective of the reform is to convert the two banks into internationally competitive modernized joint stock commercial banks with adequate capital, strict commercial controls, secure operations and good services and results in around three years' time. The Guidelines state that the banks will seek strategic foreign investors to help them modernize. The Guidelines provide various financial indicator targets and timeframes for meeting targets. However, no timeframe for listing is specified. The Guidelines also provide that beginning from 2004 the nonperforming asset ratio of the two banks should be kept between 3 percent and 5 percent.

At the beginning of this year, China announced that US$ 45 billion capital had been injected into the two banks. The banks were permitted to use this capital to cancel nonperforming loans. According to CBRC Director Liu Mingkang, after the injection and completion of the restructuring, the banks' rate of nonperforming loans will be around 4 percent based on the five-category loan classification system.


The creation of a special banking regulator and enactment of better legislation for the regulation of banking are encouraging signs. Of course such actions are not in themselves enough. Whether or not the CBRC has the will, the power and necessary government support to make financial institutions follow the rules are key questions. The vast amounts of nonperforming loans are a serious concern and challenge to China's banking authorities, but it appears that some progress is being made in controlling the growth of this problem. China's commitment to financial reform has been further evidenced by the recent injection of capital into the Bank of China and the Construction Bank. Huge strides have been made. China's commitment is clear, but the inherent, systemic problem that financial institutions face very great pressure to extend credit for reasons that are not entirely commercial still exists. It remains to be seen whether China can successfully overcome this problem.


Law Committee of the National People's Congress, "Report on the Status of Amendments with Respect to the Law of the People's Republic of China on the Regulation of the Banking Sector (Draft) and the Bill to Amend the Law of the People's Republic of China on the People's Bank of China (Draft)," submitted at the 5th Session of the Standing Committee of the 10th National People's Congress on October 23, 2003.

Liu Mingkang, "Explanations Concerning the Law of the People's Republic of China on the Regulation of the Banking Sector (Draft)," submitted at the 4th Session of the Standing Committee of the 10th National People's Congress on August 22, 2003.

See Basel Committee on Banking Supervision, Core Principles Methodology (1999), "Additional Criteria" to Principle 3 on p. 16 (available at http://www.bis.org/publ/bcbs61.htm).

Basel Committee on Banking Supervision, Core Principles for Effective Banking Supervision (1997), p. 11 (available at http://www.bis.org/publ/bcbs30a.htm).

Terry Chan, "Recapitalization Still Necessary Despite Lower Impaired Asset Ratio," in Standard and Poor's China Financial Services Outlook 2004 (November 2003), 11.

"Record of a Press Conference Concerning 'Financial System Reform and Financial Regulation' at the Second Session of the 10th National People's Congress (March 11, 2004) (available at http://www.cbrc.gov.cn/yaowen/detail.asp?id=315).