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The Counter-Cyclical Imperative in China

You’ve read from my colleague, David Molyneaux, on how the long-awaited publication of capital guidelines from the Basel Committee on Banking Supervision should help the financial industry emerge from the financial crisis stronger and better capitalized.

Here’s some perspective on how that’s playing out in Asia Pacific. Many banks in Asia already exceed Basel III thresholds for capital reserves, including stricter requirements for Tier 1 capital (or “Required Reserve Ratio” (RRR) by the commercial banks in China). Banks in Indonesia and Singapore are in very strong positions, with average core Tier 1 ratios of around 12.5% and 12%, respectively. In China the RRR is now at 18.5%, the highest capital ratio in Asia Pacific.

So what does this mean for China, the country that seems to be occupying so many people’s thoughts of late? An important question, and one Cliff Wu, head of our China team, addresses in a recent article he wrote for China’s Economic Observer.

Can’t read Mandarin? No problem. Allow me to provide some context and share the key takeaways from Cliff’s article.

Quick background: The PBOC – China’s central bank – has set a high RRR for all banks in China as a way to mop up excess liquidity, which is feared to be a conduit to more lending, which could then lead to a property bubble. Through FICO’s work with 11 of the top banks in China, including China CITIC Bank, China Construction Bank and China Everbright Bank, the company has seen the evidence of a possible rise in defaults on home lending. This is clear from the data that was analyzed on bad debt and predictive analytics showing a potential increase in defaults.

As David wrote in his white paper, FICO believes the most valuable aspect of Basel III is the counter-cyclical capital buffer (CCB).  Banks could tap into their CCBs to cover losses rather than be forced to raise new capital in the midst of financial hardship.

Cliff references China’s 12th Five-Year plan, in which the government outlined guidelines on counter-cyclical administration in China. China's banking sector will shift its focus to a counter-cyclical, macro-prudential financial management system over the next five years. In September, the Chinese banking regulator released a draft of four new major regulatory guidelines and then carried out quantitative measurement in 78 banks. Capital requirement was one of the four major areas, and it has been designed in accordance with Basel III, which includes the requirement on counter-cyclical capital. In fact, since the regulator has already required Chinese banks keep a total capital level at 7%; it is not difficult for the banks to meet the requirements.

Cliff agrees with David in saying the buffer is welcome because it addresses one of the main weaknesses of Basel II — that it exacerbated cyclicality in economies. At a regulatory level, there is now a mechanism to counter natural pro-cyclicality in the lending system. The buffer is an important first step in addressing the pro-cyclicality.

What are needed are initiatives at an individual bank level to drive the process bottom-up. Implementing tools that can act as automatic stabilizers on each bank would complement the regulatory CCB approach, and ingrain counter-cyclical methodology into the system right down from the macro-prudential level to credit policy decisions at an individual customer level. It would ultimately make the banking system safer, more efficient and potentially more profitable.

FICO already has started working with our Chinese clients on their probability of default, exposure at default and loss given default scores. These scores are essential in how the bank estimates the optimum capital allocation for each lending line, while making sure that it complies with the central bank compliance requirements. 

Bottom line: Proper capital allocation is essential. Over-allocation is a cost as the funds can be used in a lending line, and under-allocation will cause severe penalties from the central bank.

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