China’s Proposal to Revise Banks’ Off-Balance-Sheet Exposure Regulations

Moody’s says on 23 November, the China Banking Regulatory Commission (CBRC) published a consultation paper that aims to tighten regulations for commercial banks’ off-balance-sheet activities, which have grown rapidly in recent years. If implemented, these measures would be credit positive because they would reduce risks in the banking system and curtail incentives to engage in the regulatory arbitrage that has accelerated the growth of China’s shadow banking activities.

moodys-chinaThe proposed guidelines provide a more comprehensive set of definitions for off-balance-sheet exposures to better capture the latest innovations. When the CBRC formulated the current regulations in 2011, they mainly addressed the guarantee and commitment businesses. The new rule will expand to include entrusted services (which includes entrusted loans and investment, non-guaranteed wealth-management products, agency transactions, agency issues and bond underwriting) and intermediary services (including agency collection and payments, financial advisory and asset custody). These new services have grown rapidly in recent years, raising concerns about the expansion of China’s shadow banking system.

We estimate that the shadow banking sector grew by an annualized rate of 19% in the first half of 2016 to RMB58.3 trillion, or 80% of GDP, fueled predominately by the issuance of wealth management products. A China Banking Wealth Management Registration System report showed that RMB20.18 trillion of the RMB26.28 trillion of outstanding wealth management products at the end of June 2016 were non-guaranteed products usually kept off the balance sheet of the originating or distributing bank. By remaining off balance sheet, banks have been able to circumvent regulations on loan quotas and limits and dodge capital and provision requirements.

The proposed new guidelines require banks to set provisions on impairment losses on off-balance-sheet assets and retain risk-based capital on such assets. Although many wealth management products are off balance sheet, customers perceive banks as having provided an implicit guarantee for these products. The new rule would increase regulatory capital requirements that better capture banks’ actual credit risk.

The revised guidelines also ask for more detailed disclosure and more robust risk management of off-balance-sheet exposures, and banks would have to establish risk limits for off-balance-sheet exposures. Although the People’s Bank of China plans to include off-balance-sheet items in its macro-prudential assessment and the CBRC in July issued new draft rules on banks’ wealth management products, the new proposal offers a more comprehensive regulatory framework and complements other measures already in effect. The tighter rules will help contain off-balance-sheet risks and improve financial system transparency.

Banks with higher off-balance-sheet exposures will be most affected by the new regulation. Small and midsize banks will likely be most affected by the revised measures because they have been the more active issuers of wealth management products, which at some banks have become a key revenue source.

Although the revised rules focus on general risk-management principles, they fall short in providing details on actual execution, and leave a few key questions unanswered. For example, it remains unclear which off-balance-sheet assets’ credit risks are deemed retained by the banks themselves. Also lacking are specifics about the supervision for the risk conversion factor of off-balance-sheet assets or any details on the level of capital and reserves required. Additionally, a lack of uniformity across banks remains because banks’ boards of directors are responsible for approving off-balance-sheet business, risk management and imposing risk limits. Consequently, implementation by each bank will vary.

Author: Martin North

Martin North is the Principal of Digital Finance Analytics

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