China’s Proposed Capital Rules to Align with Final Basel III

Vivian Xue and Grace Wu at Fitch Ratings estimate the four Chinese G-SIBs will need to issue at least CNY 1.3 trillion in capital instruments by January 2025.

Proposed capital rules stemming from the implementation of the final Basel III standards will not immediately affect the ratings of Chinese banks. This is because Fitch Ratings estimates that the impact on their capital requirements is neutral. The banks’ Issuer Default Ratings, which are driven by our expectations of government support, will be unaffected.

In the medium term, the rules may improve the comparability of reported capital ratios by bringing the calculation of risk-weighted assets (RWA) closer to international norms, which will strengthen banks’ risk sensitivity and address potential RWA understatement. These, if successfully implemented over time, will improve sector transparency and may benefit our assessment of China’s bank operating environment (bbb-/stable) over time, and raise headroom for Viability Ratings.

Final Basel III Rules Implementation in China

Chinese regulators launched a draft consultation on new capital rules for commercial banks on 18 February 2023. Once approved, these are targeted to take effect on 1 January 2024, and will classify banks into three Buckets based on the scale of their adjusted on- and off-balance sheet as well as cross-border exposures.

The proposed rules will bring Bucket 1 banks, which we estimate together contribute to about 80% of sector assets, under a regulatory framework that is closely aligned with the final Basel III framework, while those for Bucket 2 banks are largely unchanged from existing capital requirements. Bucket 3 banks will be subject to the most simplified capital and disclosure standards. The rules will not reduce banks’ capital requirements, but may affect their RWA calculations. All the Fitch-rated Chinese commercial banks (excluding subsidiaries of foreign banks) are in Bucket 1.

The proposed rules will enhance the risk sensitivity under the standardised approach by applying more granular RWA calculation for most banks. They will also constrain the use of the internal model approach, by removing the use of the advanced internal-ratings-based (A-IRB) approach for certain asset classes. The revised output floor to 72.5% from 80% should have a limited impact, as most Chinese banks have reported RWAs under internal models which already exceed 80% of their RWAs calculated under the standardised approach at end-2022.

Limited Impact on Bank Capitalisation

Only the five big state banks and China Merchants Bank Co., Ltd. (CMB, A-/Stable) are permitted by regulators to adopt internal model approaches in China. They use IRB for credit risk and internal models for market risk. The standardised approach is used for operational risk. They all use the foundation IRB (F-IRB) approach to calculate their non-retail RWAs. As a result, they will be minimally affected by the removal of the A-IRB approach for exposures to large and mid-sized corporates, as well as to banks and other financial institutions.

This differs from developed market peers, which more commonly use the A-IRB approach when calculating RWAs for non-retail exposures, meaning those banks will generally report lower capital ratios when they migrate to final Basel III rules.

For banks that do not use internal model approaches, the revisions will generally lead to modest improvements in reported capitalisation ratios. The modest capital uplift is mainly driven by lower risk-weights for specific exposures relating to sectors that the regulator considers as supporting the real economy or having lower credit risks. For example, there will be a reduction in risk-weights for SMEs, general local government bonds, investment-grade corporates and residential mortgage loans with low loan-to-value ratios, while risk weights for exposures to senior and subordinated debts issued by other banks, including total loss-absorbing capacity (TLAC) debt issued by global systemically-important banks (G-SIBs), will increase in order to limit contagion risks.

The increase in risk-weights for bank debt and capital instruments will spur capital consumption for these assets. We expect bank refinancing costs to rise as a result, especially for smaller banks with weaker financial profiles and shareholder support. For large state banks, however, we believe the government will remain supportive of these banks in meeting their TLAC requirements, given their systemic importance, state ownership and quasi-policy roles.

Potential TLAC Gaps

The four Chinese G-SIBs are required to meet minimum TLAC requirements set at 16% and 18% of their RWAs by January 2025 and January 2028 respectively. This is on top of their G-SIB buffer requirements (1.5% for Industrial and Commercial Bank of China Limited (ICBC; A/Stable); and Bank of China Limited (BOC; A/Stable), and 1% for China Construction Bank Corporation (CCB; A/Stable) and Agricultural Bank of China Limited (ABC; A/Stable)), 2.5% capital conservation buffer and a countercyclical buffer, which is set at zero in China at the moment.

Fitch estimates the four Chinese G-SIBs will need to issue at least an aggregate of CNY1.3 trillion (USD190 billion) and CNY5.4 trillion (USD775 billion) worth of capital and other TLAC-eligible instruments by January 2025 and January 2028, respectively, based on their capital positions at end-2022. This assumes RWA and net profit growth of 8% and 5% per annum as well as a dividend payout ratio of 30%, and excludes potential offsets (up to 2.5% of RWAs by January 2025 and 3.5% by January 2028) from the deposit insurance fund in meeting their TLAC requirements. The authorities have not clarified whether the offset is on an actual paid-in basis or in full; Chinese banks contributed around CNY55 billion to the deposit insurance fund at end-2022, equivalent to 0.03% of sector RWAs.

The four Chinese G-SIBs have collectively issued around CNY1 trillion per annum in capital instruments and senior unsecured debts since 2018, and most of these are tier-2 and additional tier-1 instruments. Only around 1% of outstanding capital instruments in China are issued offshore at end-2022. Fitch expects that the Chinese G-SIBs will continue to rely on onshore issuances initially, especially in light of weaker investor confidence in global bank capital instruments following the turmoil in the banking sector in recent months.

This article was contributed by Vivian Xue, Director, Financial Institutions – Banks, Fitch Ratings; and Grace Wu, Head of Greater China Bank Ratings, Fitch Ratings.

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