Chapter 4 Does Financial Regulation Affect the Profit Efficiency and Risk of Banks? Evidence
2. Basel III and the China Banking Regulation
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risks increase. A higher loan-to-deposit ratio implies lower efficiency. However, these three ratios did not significantly affect the risks of large banks. Similarly, the CBRC regulates the loan-to-deposit ratio, capital adequacy ratio, and leverage ratio, which seems relevant to small banks.
The CBRC regulates the current ratio to reduce the risks of banks. Based on our empirical results, the current ratio did not affect the risks and led to different efficiency results between large and small banks. In an environment with asymmetric information, a bank decision-making is unobservable. The characteristics of financial regulation provide market clues if a bank is operating at the most efficiency and risk condition.
The remainder of this paper is as follows. Section 2 introduce Basel III and the China banking regulation, Section 3 provides a review of the related literature, Section 4 discusses the methodology, data used in the study and hypothesis, section 5 elaborates the empirical analysis, and section 6 summarizes our findings.
2. Basel III and the China Banking Regulation 2.1 China’s Own Version of Basel III
The CBRC issued 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. It is called China's Own Version of Basel III.
Higher Capital Requirements
The guidelines introduce a three-tier regulation standard in terms of the capital adequacy ratio of commercial banks. Three minimum capital adequacy ratios -- the "core capital adequacy ratio," the "tier-one capital adequacy ratio" and the "capital adequacy ratio"-- applicable to commercial banks of different sizes will be set at 5 percent, 6 percent and 8 percent, respectively. We are requiring much higher levels of capital to absorb the types of losses associated with crises. This includes an increase in the minimum common equity requirement from 2% to 4.5% and a capital conservation buffer of 2.5%, bringing the total common equity requirement to 7% under Basel III.
The new domestic regulatory standards and structural arrangements regarding capital adequacy ratio are largely consistent with Basel III, except for two differences. First, the domestic minimum requirement on core tier-1 (common stock) CAR is 5%, 0.5 percentages higher than that prescribed in Basel III. Second, the supplementary capital requirement for systematically important banks (SIBs) is temporarily set at 1%, while the Basel Committee and FSB have yet not reached consensus in this regard. In addition, a regulatory requirement for two capital buffers has also been introduced by the CBRC Guidelines: a 2.5 percent
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reserve excess capital conservation buffer and a 0-2.5 per cent countercyclical capital buffer.
Last but not least, an additional capital requirement of 1 percent is imposed on systemically important banks.
Leverage Ratio
As a supplement to capital adequacy ratios, a leverage ratio is introduced. In order to facilitate banks to transform the development mode of relying on rapid expansion, strengthen self-discipline and improve the quality of development, it is necessary and viable to set the minimum leverage ratio at 4%. If the ratio is set too low, it will not effectively constrain the banks’ rapid expansion. The New Standards adopt a new leverage ratio of at least 4% of Tier 1 capital to total (including off-balance sheet) assets, 1 percentage point more than the Basel III requirement of at least 3%.
Stricter Loan-loss Provision Rules
The loan-loss reserve requirement reflect 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. The 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. 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. Under the New Standards banks will be expected to have a loan provision ratio (i.e., a general loan provision ratio) of at least 2.5%
and a provision coverage ratio (i.e., a ratio of provisions for specific nonperforming loans) of at least 150%.
Better Liquidity Rules
Generally speaking, as China banks still follow the conventional business model. CBRC aims to establish a multi-dimensionally liquidity risk control standards and will set out various ratios for supervisory purposes. These include a current ratio, a loan to deposit ratio, a core debt ratio, a liquidity gap ratio, deposit concentration, and an interbank funding ratio. In addition to the liquidity coverage ratio (LCR) and net stable finance ratio (NSFR) prescribed by Basel III, the New Standards contain rules intended to monitor liquidity risks. The CBRC Guidelines provide that the liquidity coverage ratio and the net stable finance ratio must not be lower than 100 percent.
2.2 CBRC’s Regulation of China's Banking Industry
We organized description into Table 1. By Table 1, we can clearly understand the financial supervision indicators for measures already implemented in accordance with the provisions of the CBRC and expected to be implemented under the new Basel III regulations.
Therefore, the study will choose the financial supervision indicator according to the Table 4-1.
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Table 4-1 The CBRC’s supervision of China's banking industry
Supervision indicator Definition Required ratio
1. Asset Quality
Non-performing loan ratio non-performing loans to loan outstandings
less than 5%
Provision coverage ratio loan-loss reserves to non-performing loans
shall be no lower than 150%
Loan loss provision ratio loan-loss reserves to loan outstandings
shall be no lower than 2.5%
2. Liquidity
Loan to deposit ratio loans to deposits less than 75%
Current ratio current assets to current liabilities
shall be no lower than 25%
Liquidity coverage ratio stock of high quality liquid assets to net cash outflows over a 30-day time period
shall be no lower than 100%
Net stable funding ratio available amount of stable funding to required amount of stable funding
shall be no lower than 100%
3. Benefit and Efficiency
Cost to income ratio operating costs to operating income less than 45%
4. Capital Adequate Capital adequacy ratio (CAR)
net capital to risk weighted assets shall be no lower than 8%
Tier 1 (core) CAR tier 1 capital to risk weighted assets Basel III requirement of at least 6%
Core tier 1 CAR common equity to risk weighted assets
no lower than 5%, 0.5% more than the Basel III requirement of at least 4.5%
Leverage ratio tier 1 capital to the adjusted on-and off-balance sheet assets of the relevant bank.
drawing lessons from the crisis that banks were distributing earnings even during periods of stress
Basel III prescribes
protect banking sector from periods of excess aggregate credit growth.
Credit/GDP as the reference guide
countercyclical important banks (SIBs)
set at 1% for the time being
Source: CBRC website and constructed by the authors in accordance to related articles.