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Supervising too big to fail

As regulators pursue financial integration, establishing firewalls ensures against risk contagion from systematically important financial institutions.

March 29, 2011 | Liu Mingkang

The issue of systemically important financial institutions (SIFIs) requires more careful consideration than a simple set of new rules and indicators. The issue of wrong business models, coupled with an over-reliance on wholesale market funding, is one of the major factors contributing to the complexity and connectedness of financial institutions we are having today.

Ever since the current crisis, the issues of business and funding models haven’t drawn enough attention. While it may be difficult for banks in some countries to go back to deposit funding, banks will in the mid- to long-run need to return to health and stick to their core businesses, and the issue of regulating SIFIs can’t be addressed separately without touching upon the issue of business models.

Capital adequacy, as well as its quality, is at the centre. Currently, the capital adequacy ratio requirement of Chinese banks is 10%, with 20% being a capital buffer to mitigate risks out of rapid loan growth this year. Capital surcharges should match the risks banks take on under Pillar 2, rather than Pillar 1 of Basel II. Strict filters concerning the quality of capital are key, and cross holding of subordinated debt among banks must be fully deducted from Tier 2 capital. Nowadays, more than 80% of the capital of the Chinese banks is Tier 1 capital, so most capital is common stocks and retained earnings, which can absorb losses.

The enforcement of key limits and constraints should also be strictly followed, and the CBRC sets the provisioning coverage ratio at 130%, drawing from historical data on loan migration and deviation. We have large exposure limits: 10% of the net worth of the bank for a single borrower and 15% for connected party transactions, higher than most other countries, so we monitor all the top 10 borrowers of each bank and the risks attached in the portfolios continuously and we scrutinize connected party transactions.

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Regulation, Risk And Regulation Working Group

Keywords:Regulation