New loan-loss reserve requirement under Basel III set to crimp profits at Chinese banks

A new 2.5% minimum loan-loss reserve requirement to be implemented in China under Basel III is likely to reduce the ability of banks to distribute profits to shareholders

The profitability of Chinese banks is likely to come under increasing pressure following the introduction of a new 2.5% minimum loan-loss reserve requirement on the mainland, according to senior risk management executives.

The new rules come as part of the China Banking Regulatory Commission's (CBRC) efforts to implement more dynamic, contagion-proof measures aimed at upholding the health of the banking system. The CBRC earlier this month issued guidance on a slew of new regulatory requirements for banks on various benchmarks they have to hit related to capital, liquidity and reserve requirements against loan losses, among others, as part of China's planned implementation of the Basel III capital Accord.

Chinese regulators also say they are embracing a central concept under Basel III by dividing financial institutions into groups that are systematically important financial institutions (sifis) and those that are not. The CBRC says sifis in China will need to satisfy new Basel III requirements by the end of 2013; while non-sifis will have a longer transition period but still need to meet the rules by 2018.

The CBRC says it is currently devising an evaluation framework to determine which banks will be deemed as sifis. It says the methodology will be based on their size, interconnectedness, complexity and substitutability - short of one additional factor, that of global activity, as recently proposed by the Basel Committee on Banking Supervision. The Financial Stability Board is due to come up with the criteria for selecting sifis in July, and make formal recommendations on additional capital surcharges they will be required to hold in addition to meeting the Basel III rules at the G-20 Summit in Paris in November.

The CBRC has not detailed its rationale behind the new loan-loss reserve requirement - which is calculated by dividing the total amount of loan-loss reserves a bank provides for by the bank's total loans for that year. But bankers say the new provisioning requirement reflects how the regulator wants Chinese banks to set aside a precautionary amount of reserves ahead of the likelihood that an increasing proportion of their loans should turn bad.

"This new requirement reflects the fact that, amid the high rate of loan growth in recent years, the CBRC is worried that even for loans that haven't turned bad just yet, some of these loans might turn into non-performing loans over the next few years, and thus the regulator wants to add an additional requirement to guard against such likelihood," says a banker at Shenzhen-based China Merchants Bank, who had been briefed by the CBRC on an ongoing basis before the regulator announced its guidance officially.

Top policy-makers and regulators in China have been clamping down on credit expansion from banks during the past two years, after banks lent out a record 9.6 trillion yuan ($1.5 trillion) in new lending in 2009. Such rapid lending growth came after banks in China were told by their state shareholders to lend more to local governments to support Beijing's fiscal stimulus policy and spur the economy during the global financial crisis. But it has since fuelled concern about asset bubbles and inflation among policy-makers.

Rapid increases in lending to local government financing vehicles (LGFVs) raised concern among policy-makers and supervisors that some of these loans will become non-performing loans. Last year, a nation-wide auditing exercise conducted by the government reportedly found that up to 23% of the 7.66 trillion yuan extended to LGFVs faced high repayment risks. Moody's Investors Service has estimated that this could equate to nearly 5% of all bank loans in the system last year.

Traditionally, listed commercial banks in China have reported a coverage ratio against non-performing loans in their financial results as an indicator to shareholders and analysts of their asset quality. For example, China Minsheng Bank's ‘provision coverage ratio' for 2010 increased by 64.4 percentage points from a year ago to 270.45%. The CBRC says in its latest guidance that Chinese banks should be required to maintain such a coverage ratio at a 150% minimum.

While bankers generally do not consider hitting that 150% minimum provision coverage ratio a challenge, a banker at Bank of Communications (Bocom) in Shanghai tells Asia Risk the new 2.5% loan loss reserve requirement represents the single biggest source of uncertainty for Chinese banks; adding that not many commercial banks in China could attain the 2.5% requirement at present.

The challenge facing banks - even for banks that traditionally have had good quality assets in their loan book and a lower level of non-performing loans - is that they are now compelled to also set aside an additional amount in reserves related to the size of their entire lending business volume, bankers say.

As loan provision is an amount taken directly out of a bank's profit, so increased regulatory provisioning will mean banks will have to set aside more funds for such a loan-loss reserve, which could directly squeeze dividend payouts to shareholders. Moreover, if a bank does not want to see its capital adequacy ratio (CAR) lagging regulatory requirements, it will need to sustain the growth rate of its capital (which is included in the nominator of the CAR) by at least the same growth rate as its assets (denominator in CAR, which includes both on-balance-sheet and off-balance-sheet risk-weighted assets).

One way to keep up capital growth is to ensure retained earnings - after paying out dividends to shareholders and a component of tier 1 capital - would be commensurate with the growth of a bank's assets (denominator in CAR). This, however, could be a tough decision for management, especially during an economic down cycle, the Bocom official says.

"The bottom line is that to keep CAR unchanged, our profitability growth must be aligned with our asset growth," the Bocom official says. "The pay-out ratio is something we can control and decide according to our own policy, but profitability is more dependent on the overall market operating and competition environment - something we do not have as good a handle over."

The Chinese bank official says his worst fear is if the economic growth momentum of the Chinese economy seen during the past two years proved unsustainable in the coming years. This would result in bank non-performing loan levels rising, profitability falling and banks still needing more provisions.

Moody's analyst Katie Chen estimates in a recent report that as at the end of March 2010, only China Construction Bank, Agricultural Bank of China and China Guangfa Bank met the 2.5% loan-loss requirements. "Among commercial banks we rate, the requirement will have the most severe effect on China Citic Bank and Shenzhen Development Bank, given their low loan reserve levels."

Under current Basel III proposals, sifis are required to reach a total CAR of 11.5%; while non-sifis are required to reach a total CAR of 10.5%.

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