What can we expect from China's amended reserve regulation?

China's Ministry of Finance recently revised its general banking risk reserve norm to at least 1.5% from the current 1% - will this be a boon or a bane?

According to previous reports, Chinese financial institutions will be required to keep 1.5% of their gross loans as general provisions beginning this July 1, 2012. The revised general banking risk reserve norm requires financial institutions to distribute more profits into the general banking risk reserve under shareholders' equity, notes Standard & Poor's.

ABF: How can this new rule help improve Chinese banks' risk prevention and control? What can we expect?

Oliver Wyman: Jason Ekberg, Consultant
From a pure risk perspective, by taking capital out of the system and reallocating this towards a ‘credit cushion’ for NPLs, the system should inherently become less risk prone, though at the same time, it also means less liquidity in the market, which is also a key concern of the PBOC, i.e., inflation. A more nuanced point is that Chinese incentives encourage lending with less emphasis on risk/economic metrics, e.g., return on RWA, return on risk capital, EVA, etc.

Thus, taking capital out of the systems is a quick fix, but it needs to be supported by more structural changes to ensure lending decisions consider the right balance of economic and risk measures with the goal to reduce potential agency risks, e.g., excessive lending to SOEs. On the flip side, less capital in the system, could encourage lenders to be more innovative in how they approach lending decisions, e.g., less capital to deploy so ensure maximize the potential return and lead to some form of new balance sheet management strategies, e.g., CLO funds. 

Standard & Poor's: Ryan Tsang, Primary Credit Analyst
China's amended reserve regulation would push Chinese banks to further shore up their credit cushions. Such a move would benefit the country's banking sector over the long term.

The revised regulation indicates the government's entrenched concern about a possible deterioration in Chinese banks' asset quality during an economic slowdown in China. Loan
loss provision norms in China are already stringent. We believe this rule would further enhance Chinese banks' credit buffers.

The MOF rule could also largely offset possible negative effects from the sector's transition into BASEL II on credit risk buffers. Major Chinese banks are likely to adopt an advanced internal-rating-based approach for credit risk measurement in the second half of 2012. This may lead to a release of surplus in loan loss reserves. By hiking the threshold for the general banking risk reserve, the rule would make it harder for banks to pay out the released reserves as dividends.