Questions remain about China banks' TLAC exemption

China is one of only two Asian countries with G-Sibs – but unlike Japan its banks can sidestep TLAC

ICBC: one of China's G-Sibs

With the Financial Services Board (FSB) due to come out with a new set of capital requirements in November, industry observers are expressing doubts over whether China's banks should retain their carve-out from the impending total loss-absorbing capacity (TLAC) framework.

The issue concerns the minimum amount of capital and unsecured debt that the world's most systemically important banks will have to hold to support a resolution in case of failure, without relying on taxpayer money or undermining the stability of the financial system.

The TLAC framework, expected to come into force in 2019, will initially only apply to global systemically important banks (G-Sibs), although it could later be extended to other large domestic institutions, and is intended to address the too-big-to-fail issue following the collapse of Lehman Brothers in 2008.

Under the FSB's proposals, the basic TLAC requirement will be between 16–20% of a bank's risk-weighted assets (the exact calibration is yet to be calculated), with at least a third of this made up of debt instruments that can be easily converted to equity – or bailed in – in the event of failure.

Only two countries in Asia are home to G-Sibs: Japan and China. While the new rules will apply to Japanese banks, the FSB has proposed giving China an exemption for its three largest banks by market capitalisation – Agricultural Bank of China, Bank of China and ICBC.

 G-Sibs in China and Japan 
 China  Japan
 Agricultural Bank of China  Mizuho FG
 Bank of China  Sumitomo Mitsui
 ICBC  Mitsubishi UFJ FG


"G-Sibs that are headquartered in emerging markets will not, initially, be subject to the Common Pillar 1 Minimum TLAC requirement," says the FSB's consultative paper – a sentiment that many expect to make it into the final rules.

Case for the defence

Submissions made by the three large Chinese banks to the FSB's consultation include several defences in favour of an exemption. One of the central arguments is that Chinese banks are financed mostly through deposits and do not have as much debt in their funding models as their European or American counterparts.

Having to suddenly issue new debt instruments under TLAC would necessitate a "comprehensive and costly restructuring", says Bank of China.

Another argument is that Chinese markets are not deep enough to allow for issuance of TLAC-style instruments. "China's domestic bond market could hardly absorb the funding demand if all three PRC-incorporated G-Sibs raise TLAC-eligible debts simultaneously," says Bank of China.

Given the size of Chinese banks' balance sheets, potential TLAC liabilities could be significant. According to the latest quarterly reports, the combined assets of China's three G-Sibs amount to $8.7 trillion.

The proportion that would be subject to TLAC requirements depends on how the risk weighting of these assets is eventually calculated, but if the full amount was used then the additional capital needed would be between $1.4 trillion and $1.7 trillion, depending on the final calibration of the TLAC rules. At least a third of this would have to be TLAC-eligible debt.

According to recent data from Asian Bonds Online, the size of the local currency corporate bond market in China is $1.9 trillion and growing fast.


However, capital experts question the validity of both these arguments.

"Many commercial banks have been complaining that TLAC seems to be more favourable for investment banks, but this isn't particular to the Chinese market," says Tsuyoshi Oyama, head of the centre for risk management strategy at Deloitte in Tokyo. "Other banks – including those on the Japanese market – have a very traditional commercial bank structure with their liabilities also funded from deposits."

Some G-Sibs headquartered in the US and Europe – such as Wells Fargo – are also principally deposit-funded.

Qiang Liao, a Beijing-based analyst from credit rating agency Standard & Poor's (S&P), points out that large volumes of Tier 1 and Tier 2 instruments are already being issued by Chinese banks under the Basel III framework – and these could be converted to TLAC securities with little difficulty.

One head of capital solutions for a major bank, based in London, says: "A lot of TLAC is not new capacity that you need – it's a rolling of old-style instruments into new-style ones. If you look at the size of the senior debt market, it is in the hundreds of billions if not trillions. Obviously not every investor who is invested in senior debt will readily migrate to a bail-inable instrument overnight, but this is a process that will take place over the next five years."

State support

There is a third reason for the exemption, which is not mentioned in the submissions – that the Chinese government is the majority shareholder in each of the three major banks and therefore the ultimate guarantor should they run into difficulty.

At the end of April, S&P adjusted the criteria it uses to evaluate banks to include what they term additional loss-adjusting capital (ALAC), which broadly follows the principals of TLAC. The rating agency says this will principally affect banks in western Europe, since banks elsewhere – including in Asia – are more likely to have government backing.

"The whole idea behind TLAC is that the instrument will be bailed in before senior creditors take any loss, but if you believe that the government will step in, then the whole purpose of this type of instrument will not be as effective as it is meant to be," says S&P's Qiang.

Mark Young, Singapore-based head of Asia-Pacific financial institutions at Fitch Ratings, says this goes to the heart of the rationale that stands behind TLAC.

"It all comes back to trying to address the too-big-to-fail issue: next time there's a problem it will be the private sector, and not the government, that has to step in and bail out the banks," he says. "But China's banks have the government standing by them and their actions are not necessarily commercially driven, so you can see their argument against the need to go down this route of TLAC-type instruments."

Sabine Bauer, a Hong Kong-based senior director within Fitch Ratings, says there are advantages for G-Sibs that will not be subject to the new requirements, which might not sit easily with their competitors.

"The requirement to issue TLAC securities will increase banks' funding cost and it could affect how fast a bank can expand into high-yielding products, since this would change the risk profile of the institution," she says.

But Qiang from S&P points out that there could be a clear business case for Chinese banks to issue TLAC securities, regardless of whether they have an exemption.

"These kinds of securities are part of the regulatory capital which will help boost the bank's capital ratio and peer pressure may eventually lead to a similar size of hybrid capital instruments being issued by major Chinese banks, particularly when they go abroad and compete with global banks that have higher capital ratios," he says; though he also accepts that not being forced to issue them from day one gives "a little bit more operational flexibility".

There may be another reason for Chinese banks to issue TLAC securities, too: that eventually the TLAC rules are going to catch up with them.

"It's difficult to know how long the China exemption will last," says Qiang. "Sooner or later you can expect the Chinese regulator to present their own version of a resolution regime and, with that clarity, you may start to see the government put regulatory pressure on banks to issue these bail-inable instruments. But for now China is at the very early stage of resolution regime development."

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