Li Wenhong: Two Important Trends in Banking Supervision after the Global Financial Crisis and Practices in China

2017-03-23 IMI

Li Wenhong, Member of IMI Academic Committee, Director of the Department of Innovation and Regulation, CBRC In the aftermath of the global financial crisis, a comprehensive set of policy recommendations have been initiated by the Financial Stability Board (FSB) and Basel Committee on Banking Supervision to improve the effectiveness of banking supervision and enhance financial stability. Among them, two important trends, from my observation, have been transforming the landscape of banking supervision, which, I believe, will contribute to a more stable financial system at both the international and national levels. This paper is organised as follows: Section I discusses the rethinking of the relationship between banking supervision and banks’ risk management, argued from both microprudential and macroprudential perspective. Section II discusses two important trends in banking supervision after the crisis. One is to reduce the reliance of banking supervision on banks’ internal risk assessments. The other is to reinforce the current regulatory framework with a greater emphasis on macroprudential supervision. Section III discusses, from the bank regulator’s perspective, the macroprudential supervision practices in China. Section IV discusses the challenges faced by authorities to build up an effective macroprudential supervision framework. I. Rethinking of the relationship between banking supervision and banks’ risk management, argued from both microprudential and macroprudential perspectives Before the global financial crisis, it was widely believed that banking supervision should establish an incentive-compatible structure, to encourage banks to improve the effectiveness of their risk management. The more effective banks’ risk management is, the more bank supervisors could rely on their internal risk assessments. This rationale was highly emphasized in Basel II, where using internal models to bring the regulatory capital closer to banks’ economic capital was taken as an important step of improvement before the crisis. Banks, subject to supervisory approval, can choose between standardized approaches and the use of internal models to determine their regulatory capital requirement. For banks using internal models, capital requirement, in most cases, may be lower, sometimes much lower than those using standardized methods. This supervisory approach was regarded as more risk sensitive, more flexible and more aligned with industry best practices. It was also taken as a desirable way to incentivise banks to improve risk management. From microprudential perspective However, after the crisis, bank supervisors started to challenge the inherent drawbacks of banks’ internal model, thereby raising concerns on the rationale of the existing architecture of the regulatory capital framework. First, models may have fundamental errors and produce inaccurate outputs when viewed against its designed objective. Running a model involves complex process, which includes application of theory, choice of samples, selection of inputs and estimation of outputs. Errors can occur at any point from design through implementation. Furthermore, some asset classes are inherently difficult to model. Empirical studies have suggested that simpler metrics are at times more robust than complex ones, and the use of internal models may not always measure and differentiate risk accurately and appropriately for all portfolios and risk types. Second, models may be used or interpreted incorrectly or inappropriately. Models by their nature are simplification of reality. But real-world events may prove those simplifications inappropriate. When assuming things happen in a way of normal distribution, we bear risks to use the past to predict the future. All these can lead to financial losses, as well as poor business and strategic decision making. Third, the use of internal models can provide unintended incentives for banks to underestimate risks and hence capital requirements, as they may have incentives to use models to produce lower risk-weighted assets, and hence higher capital adequacy ratios. Forth, allowing banks to use internal models to calculate capital requirement has substantially increased the complexity of the regulatory framework while reducing the comparability across banks and jurisdictions. The complexity associated with the use of internal models, the degree of discretion provided to banks in modelling risk parameters and the use of national discretions have all contributed to the excessive variability in risk-weighted assets and eroded the comparability of the capital adequacy ratios across banks. To address the above issues, it has been agreed after the crisis that, banking supervision should not overly rely on banks’ internal risk management. Supervisors need to challenge the process and results of banks’ internal risk assessments, not only the design of models, but also the way how models are used. They should not only review whether there is solid model validation process in place, but also review the data quality and assumptions behind models. From macroprudential perspective From macroprudential perspective, three issues have emerged as top agenda of banking supervision. First, procyclicality of the financial system. It has been widely acknowledged that financial system is highly procyclical. The system-wide risks can be amplified by interactions within the financial system and between the financial system and the real economy. Actions that seem reasonable from the perspective of individual institutions may result in undesirable aggregate outcomes if they behave collectively, therefore destabilising the whole system. While each financial crisis is different, a shared feature is that most crises were preceded by an upswing period with the build-up of financial imbalances, characterized by excess liquidity, excessive risk-taking, strong credit growth and asset price increases, and rising leverage and systemic concentrations across the financial system, which often led to further expansion of the economy. During the downturn period, however, banks that experienced substantial losses often faced growing difficulties in replenishing capital. This, in turn, induced them to cut credit and dispose of assets, therefore resulting in further weakening of the economic activities. In addition, the increasing use of banks’ internal models for regulatory capital purposes has been criticized for amplifying the inherent procyclicality of the financial system, and hence being regarded as an important source for the build-up of financial imbalances and vulnerabilities leading up to the global financial crisis. This is because the measures of risk and the assumptions underlying risk measurement tend to be highly procyclical. Near-horizon estimates of quantitative inputs, such as probability of default (PD), loss given default (LGD), short-term volatility, asset and default correlations tend to decrease in the upswing phase and increase in the downturn period, which can lead to decrease or increase in the regulatory capital requirements. Second, externality of too-big-to-fail. The crisis also highlighted the importance of the too-big-to-fail (TBTF) issue. The large and complex financial institutions, termed as systemically important financial institutions (SIFIs), imposed extensive negative externalities on the financial system and real economy during the crisis. In maximizing their private benefits, individual institutions may rationally choose outcomes that, from a system-wide perspective, are suboptimal because they do not take into account the externalities. These negative externalities include the impact of the failure of large and interconnected global financial institutions that can send shocks through the financial system which in turn harm the real economy. In addition, the moral hazard costs associated with explicit or implicit government guarantees encouraged risk-taking, reduced market discipline, created competitive distortions, and further increased the probability of financial instability in the future. Third, shadow banking driven by regulatory arbitrage. Shadow banking has been identified as one of the major sources of financial stability concerns, thereby having attracted a lot of attention after the crisis. Partly driven by regulatory arbitrage, recent years have witnessed the rapid growth of the shadow banking system worldwide. These credit intermediaries, which are mainly outside of the regular banking system, are parallel to the traditional banking system and conduct bank-like activities, thereby involving leverage, liquidity and maturity transformation, and imperfect credit risk transfer. Although the shadow banking system has provided an alternative source of funding to corporates and market participants, it could also become a source of systemic risk, both directly and through interconnectedness with the regular banking system. Now it is widely agreed that, shadow banking entities and activities should be brought into the regulatory scope and subject to appropriate form of regulation and supervision. II. Two important trends in banking supervision after the crisis The above issues identified from either microprudential or macroprudential perspectives can not be adequately addressed by banks’ internal risk management. Therefore, we can see two important trends in banking supervision to deal with the confronted challenges. One is to reduce the reliance of banking supervision on banks’ internal risk assessments. The other is to reinforce the current regulatory framework with a greater emphasis on macroprudential supervision. These two trends, from my observation, have been transforming the landscape of banking supervision, contributing to more effective supervision, and in turn leading to better risk management with broader views and forward-looking approach. (i) Reduce the reliance of banking supervision on banks’ internal risk assessments The crisis experience has precipitated new thinking on the relationship between economic and regulatory capital. It has been realized that banks’ internal models can differ in their objectives from those used to calculate regulatory capital. Banks’ internal models are tools to maximize risk-adjusted return to shareholders, and intended to capture risks consistent with the risk appetite of the bank. In comparison, the regulatory capital requirement seeks to estimate tail risks to creditors and to the system as a whole. A model that is suitable for one purpose may not be entirely so for the other. As a result of this rethinking, initiatives have been made to reduce the over-reliance on internal models. Leverage ratio, which is a simple, non-risk based measure, was introduced in 2010 as an integral component of Basel III. It has been emphasized as an important safeguard against model risks and is intended to be a backstop to the risk-based capital regime. First, it provides a floor to the outcome of risk-based capital requirements guarding against model risks and the reduction of capital requirements via the optimistic use of models; second, it mitigates procylicality of financial system by setting a hard limit over the excessive expansion of banks’ balance sheet; third, it is simple and could serve as a more transparent metric that investors and counterparties can use to make comparisons between banks over time (BCBS 2010a). Meanwhile, the Basel Committee has decided to remove the use of internal models for regulatory capital purposes in certain cases. It issued a consultative document - Standardised Measurement Approach for operational risk - in March 2016, where the option to use an internal model-based approach for measuring operational risk - the advanced measurement approaches (AMA) – was removed, as the Basel Committee believes that modelling of operational risk for regulatory capital purposes is unduly complex, and that the AMA has resulted in excessive variability in risk-weighted assets and insufficient levels of capital for some banks. It also released a consultative document -Reducing Variation in Cedit Risk-weighted Assets - Constraints on the Use of Internal Model Approaches in March 2016, which proposes removing the option to use the advanced IRB approach for certain exposure categories, such as loans to financial institutions, and completely removing the IRB approaches for equity investment, as the Basel Committee views the model inputs required to calculate regulatory capital for such exposures cannot be estimated with sufficient reliability. The use of capital floors will also be increased to prevent capital requirement from falling too low due to over-optimistic model estimation. In addition to the current Basel I output floor and some input floors in the internal ratings-based (IRB) approach, the Basel committee is considering introducing more input floors (constraints on input parameters of internal models such as PDs and LGDs) and/or output floors (a minimum risk weighted assets based on standardized approaches). These floors, which have the same benefits as leverage ratio, are meant to mitigate model risk and measurement error stemming from internal model approaches. They can provide additional comfort that banks’ risks are adequately covered by capital, help reduce excessive variability in risk weighted assets and make capital adequacy ratios more comparable across banks. In December 2014, the Basel Committee issued a consultative document - Capital floors: the design of a framework based on standardised approaches, which outlines its proposals to design a capital floor based on standardised, non-internal modelled approaches to replace the existing transitional capital floor based on the Basel I framework. In the consultative document - Reducing variation in credit risk-weighted assets - constraints on the use of internal model approaches, exposure-level and model-parameter floors are also proposed to ensure a minimum level of conservatism for portfolios where the IRB approaches remain available. Last but not least, the Basel Committee has engaged in a strategic review of the overall architecture of its regulatory capital framework, in order to balance risk sensitivity, simplicity and comparability. This will also mean less reliance on banks’ internal risk assessment for regulatory purposes. As discussed above, reviewing the role of internal models in the capital framework and finalising the design and calibration of the leverage ratio and capital floors are all part of the Basel Committee’s policy package aimed at addressing the concerns on the undue complexity, lack of comparison and excessive variability of its regulatory capital framework. (ii) Reinforce the current regulatory framework with a greater emphasis on macroprudential supervision Macroprudential supervision: concept and rationale With the deepening of the global financial crisis, there has been an increasing consensus that banking supervision, which used to be mainly microprudential oriented, should be enhanced by taking a macroprudential perspective. On one hand, since the 1990s, we have entered a period of low and stable inflation across most of the world. But a number of crises, including this one, still happened. This shows that price stability has not been sufficient to ensure financial stability. On the other hand, these crises, especially the recent one, show that effective supervision at the individual firm level is not sufficient to safeguard the soundness of the financial system as a whole. This points to the need for financial regulators to supplement microprudential supervision with a macroprudential approach to better address the externalities and mitigate the build-up of systemic risks in the banking system, as they can not be adequately addressed by banks’ internal risk management. Building a regulatory framework that effectively combines macroprudential with microprudential polices has been a major trend in the aftermath of the crisis (G20 2009，IMF 2009, BIS 2009，FSA 2009a，De Larosiere et al.2009, Brunnermerier et al. 2009, Borio and Shim 2007, White 2006). As defined by the FSB/IMF/BIS report to the G20 in 2011 (FSB et al. 2011), macroprudential policy is characterized by reference to three defining elements. First, its objective is to limit systemic or system-wide financial risk, thereby limiting the incidence of disruptions in the provision of key financial services that can have serious consequences for the real economy. Second, its focus is on the financial system as a whole, including the interaction between the financial and real sectors, as opposed to individual institutions; Third, it uses primarily prudential tools to target the sources of systemic risk. Any non-prudential tools that are part of the framework need to clearly target systemic risk. In order to better understand macroprudential supervision, we need to clarify its role in the financial stability framework and how it differs from and interacts with the traditional microprudential supervision. Some people regard the macro-prudential supervision framework as equivalent to the overall framework for maintaining financial stability. However, macroprudential Supervision is a key but only one element to safeguard financial stability. Other essential elements include sound and sustainable macroeconomic policies, safe and sound financial institutions, efficient financial markets, sound financial infrastructure, efficient crisis management and effective financial supervision. Macro-prudential supervision is just an added component to the financial supervision element which, however, has traditionally focused too much on the microprudential objective. While it remains highly controversial on whether monetary policy should aim at achieving both price and financial stability by incorporating asset prices and/or credit growth into inflationary targets and how, there has been a clear consensus that macroprudential tools should be developed and used to limit the build-up of systemic vulnerabilities resulted from rapid growth in credit and asset prices. Macroprudential and microprudential supervision differ in terms of objectives and characterisation of risk while working together to improve the effectiveness of banking supervision and enhance financial stability. Microprudential supervision mainly focuses on the safety and soundness of individual institutions, largely taking the rest of the financial system and the economy as given. As for policy toolkit, macroprudential and microprudential supervision often use similar tools, such as capital, provisioning and liquidity requirements. But the motivation and calibration of such policy tools are somewhat different. For example, under a microprudential approach, the regulatory capital requirement mainly concerns the risk profile of an individual institution, whereas under a macroprudential approach, the capital also needs to cover its contribution to system-wide risk and the systemic risks that build up during the economic upswing. Notwithstanding these differences, macroprudential and microprudential supervision should not be segregated as they complement and interact with each other, and work hand-in-hand to improve the effectiveness of banking supervision and enhance financial stability. Many views argue that the difference between these two perspectives is largely semantic as long as existing prudential policy frameworks address explicitly systemic risk, adopt a system-wide analytical perspective and target tools at systemic risk (FSB et al. 2011). It is worth noting that after the crisis, macroprudential issues have been incorporated into the core principles for effective supervision in banking, securities and insurance sectors respectively. The IOSCO Securities Core Principles have been revised to enhance the focus on systemic risk as one of the three objectives of securities regulation, together with investor protection and market integrity. The revised Insurance Core Principles have added a new Principle (ICP24), which is about macroprudential surveillance and insurance supervision. As for the revision to the Core Principles for Effective Banking Supervision (Basel Core Principles), the Basel Committee believes that macro overlay is integral to many of the core principles. So it is preferable not to introduce a single specific principle on macro-prudential supervision, but rather to include the macro focus, directly alongside the micro focus, within each relevant principle, such as the principles on supervisory objectives, supervisory approach, supervisory techniques and tools, capital adequacy and various core principles related to risk management. Meanwhile, it is specified in the Preconditions for Effective Banking Supervision that an overall macro-prudential policy framework should be put in place to mitigate system risk and contribute to financial stability. Along this line, the Basel Core Principles revised in September 2012, for the first time, specifies that the primary objective of banking supervision should be to promote the safety and soundness of banks and the banking system. This emphasizes that banking supervision should not only guard against the risks on an individual institution basis, but also maintain the stability of the banking system as a whole. Therefore, an effective banking supervision framework should comprise of two components: microprudential as well as macroprudential supervision. Key elements in the macroprudential supervision framework The macroprudential supervision framework should have three key elements, ie. macroprudential analysis, macroprudential policy tools and institutional arrangements. Macro-prudential analysis, or systemic risk analysis, is aimed at identifying, assessing and monitoring systemic vulnerabilities so as to inform the macroprudential policy decisions. The IMF, World Bank, BIS and central banks and supervisory agencies in various countries have made lots of efforts in this area before and after the crisis. The macroprudential policy tools can be characterised as consisting of two dimensions: a time dimension and a cross-sectional dimension. As discussed earlier, this is because that experience shows that two externalities are central to systemic risks: one is procyclicality, the other is the externality of the TBTF issue and joint failures of institutions resulting from their common exposures. So the key issue in the time dimension is how to mitigate the procyclicality of the financial system, while the key issue in the cross-sectional dimension is how to address the TBTF problem and deal with common exposures across financial institutions. After the global financial crisis, substantial progress has been made in countercyclical policies, SIFI supervision and policies to address shadow banking risks. Basel III represents a fundamental turning point in the design of financial regulation, with an explicit macroprudential dimension supplementing the microprudential elements of the regulatory framework. It provides a strong macroprudential framework that takes account of both sources of systemic risk. On the time dimension, as an important part of Basel III, banks are required to establish capital conservation and countercyclcial capital buffers above the minimum capital requirement. The introduction of the innovative buffer mechanism is aimed at promoting the build-up of additional capital cushions in good times to further enhance resilience and limit procyclicality. These buffers can be drawn down in times of stress to absorb losses and help maintain credit to the real economy (BCBS 2010a and 2010b). It has also been recommended that more forward-looking provisions, Loan-to-Value (LTV) and loan-to-Income (LTI) limits could be useful tools to address threats to financial stability arising from excessive credit expansion and asset price boom. On the cross-sectional dimension, the supervision of systemically important financial institutions (SIFIs) has been substantially strengthened, which include the higher loss absorbency requirement for SIFIs, enhanced supervision and establishment of effective recovery and resolution framework. The objective of the SIFIs supervision policies is to reduce both the probability and external impact caused by the failure of SIFIs (FSB 2010, BCBS 2010a). More recently in 2015, the FSB introduced an international standard for total loss absorption capacity (TLAC) in resolution, requiring the G-SIBs to have in place a sufficient amount of debt or capital that could be credibly and feasibly exposed to loss, so that the bank in resolution could continue to provide key financial services without exposing taxpayers to losses. It should be emphasized that the primary objective of the countercyclical capital buffer regime is to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth that has often been associated with the build- up of system-wide risks. The countercyclical capital buffer may also help to constrain the excess credit growth in the build-up phase of the cycle, as the capital buffer can raise the cost of credit, and hence dampen its demand. However, this potential moderating effect should be regarded as a positive side benefit, rather than the primary objective of the countercyclical capital buffer regime (BCBS 2010b). Therefore, the countercyclical capital buffer is to protect the banking system rather than managing the economic, credit cycle or asset price booms. This makes the macroprudential policy different from the monetary policy, with different objectives, instruments and analytical framework. With regard to shadow banking, the G20 leaders requested the FSB, in collaboration with other international standard setting bodies, to develop policy measures to strengthen the oversight and regulation of the shadow banking system. To these ends, the FSB has created a monitoring framework to track developments in the shadow banking system in order to identify the build-up of systemic risks and enable corrective actions if necessary. It has also coordinated the development of policies in five areas i.e. banks’ interactions with shadow banking entities, money market funds, securitization, securities financing transactions such as repos and securities lending, as well as other shadow banking entities and activities, and published the Policy Framework for Strengthening Oversight and Regulation of Shadow Banking Entities in August 2013. As for other shadow banking entities and activities, the FSB proposed assessing the sources of financial stability risks based on five economic functions or activities, ie. collective investment vehicles, loan provision, market intermediation activities dependent on short-term funding, facilitation of credit creation through credit insurance and securitization-based credit intermediation and funding of financial entities, and apply appropriate policy measures where necessary to mitigate these risks. III. Macroprudential Supervision practices in China, discussed from the bank regulator’s perspective The Law on Banking Regulation and Supervision promulgated in China in 2003 provides that the objective of banking regulation and supervision is to ensure the safety and soundness of the banking industry, which essentially requires the China Banking regulatory Commission (CBRC) to take a macroprudential approach to banking supervision. This was before the revised Basel Core Principles set out the objective of banking supervision is to ensure the safety and soundness of banks and banking industry. The supervisory measures that the CBRC, along with other relevant authorities, has taken from the macroprudential perspective, are summarized as follows: Systemic risk analysis and assessment The CBRC conducts risk analysis of both individual banks and the banking sector as a whole. It continuously monitors and assesses the build-up of risks, common risk exposures, trends, and concentrations within and across the banking system, analyzing aggregate data, conducting horizontal reviews and producing various macroprudential analysis reports on a regular basis. Great efforts have been made to build a system risk early warning system for the banking sector. Meanwhile, it closely follows the developments and changes in the economic sectors and financial markets, both domestic and overseas, which have had or may have material impact on the banking system, and evaluates this impact. Systemic risk analysis has been communicated to banks on a regular basis, through regular meetings attended by the Chairmen and CEOs of all major banks, as well as monthly, quarterly and annual risk analysis reports discussing the common risks and vulnerabilities across banks. Stress testing has been conducted as part of systemic risk analysis. On one hand, stress test is required to become an integral component of banks’ risk management and internal capital and liquidity adequacy assessment process. On the other hand, the CBRC also carries out stress tests at the macro level and for targeted sectors. For instance, in 2010, it required banks to stress test, using common scenarios, their exposures to the property sector in major cities with relatively rapid increase in housing prices. In 2014, it conducted bottom-up and top-down stress tests of 19 major banks，i.e. stress tests of credit risk, liquidity risk and bank exposures to the property market, to analyze the impact of macroeconomic situations, property market conditions and changes in the financial market on the asset quality, capital adequacy and liquidity conditions of the banking sector (FSB 2015). Macroprudential policy tools, from both time dimension and cross-sectional dimension The Ministry of Finance (MOF), People’s Bank of China (PBC) and CBRC, as members of the FSB and Basel Committee representing China, have actively participated in the international standard-setting on both dimensions of the macroprudential polices, including developing the countercyclical capital framework as well as the policy framework for global systemically important banks (G-SIBs) and domestic systemically important banks (D-SIBs) to address the TBTF issues. In recent years, a series of countercyclical measures have been taken to mitigate systemic risks in the banking system, focusing on the interaction between financial institutions, markets and the wider economy. Actions have also been taken to enhance the regulation and supervision of G-SIBs and D-SIBs, and address the shadow banking risks in China. (i) Countercyclical tools: capital, provisioning, liquidity and LTV requirements Capital and leverage ratio requirements In view of the rapid credit growth starting in late 2008, the CBRC introduced a capital buffer requirement of 2% for all banks and a capital surcharge of 1% for large banks in 2009, even before the Basel Committee finalized its countercyclical buffer and G-SIB and D-SIB policy framework. This means that before the Basel III was issued, the capital buffer requirement and D-SIB capital surcharge had already been implemented in China. In June 2012, the new Capital Rules for Commercial Banks was issued in China to implement both Basel II and III. Banks are required to meet a minimum core tire 1 (CET1 ) capital requirement of 5%, which is higher than the 4.5% Basel III requirement, together with a minimum Tier 1 capital requirement of 6% and total minimum capital requirement of 8%. The New Capital Rules also introduced a capital conservation buffer of 2.5%, a countercyclical capital buffer of 0-2.5% and a 1% capital surcharge for D-SIBs. Therefore, when the countercyclical capital buffer requirement is set at 0%, the total capital requirement for D-SIBs is 11.5% and that for other banks is 10.5%. In 2013, the Basel committee conducted the regulatory compliance assessment program (RCAP) to evaluate the regulatory consistency of the new Capital Rules in China and graded it as ‘compliant’. The Supervisory Rules on Leverage Ratio was issued in June 2011 according to the Basel III leverage ratio standards, and updated in March 2015 according to the revised Basel leverage ratio standards. The minimum standard for leverage ratio is set at 4%, which is 1 percentage point higher than the 3% Basel III requirement. China is the first country in the world to introduce the Basel leverage ratio rules as a minimum regulatory standard. Since 2010, by referring to the Basel Guidance on Operating the Countercyclical Capital Buffer, the CBRC has also conducted empirical analysis of the credit/GDP indicator on a quarterly basis using data starting from 1998, where the credit includes both bank and non-bank credit, in order to evaluate the build-up of systemic risk and the role of the credit/GDP Gap in informing the countercyclical capital buffer decision. The Credit/GDP Gap is calculated as the difference between the Credit/GDP ratio and its long-term trend produced using the hp filter. Currently the CBRC is working together with other relevant authorities to formulate the Supervisory Guidelines for Countercyclical Capital Buffer, which will set out the policy framework for activating and releasing countercyclical buffer. Dynamic provisioning requirement The CBRC requires banks to take a more forward looking approach when making loan loss provisions, thereby promoting the build-up of provisions during the upswing period. In 2009, in order to mitigate risks arising from the rapid credit growth, banks were required to increase their provisioning coverage ratio, which is the ratio of provisions over NPLs, to 150% by the end of 2009. The Supervisory Rules on Loan Loss Provisioning was updated in July 2011, requiring banks to meet both a 150% minimum provisioning coverage ratio requirement and a 2.5% minimumprovisioning/loan ratio requirement. Liquidity risk management requirement The Rules on Liquidity Risk Management was issued by the CBRC in February 2014, which combines both qualitative and quantitative requirements for liquidity risk management. On the qualitative side, the requirements cover liquidity risk management governance, policies, procedures and tools, which are consistent with the Basel Principles for Sound Liquidity Risk Management and Supervision. On the quantitative side, the Liquidity Rules incorporate the liquidity coverage ratio (LCR) and Basel III liquidity monitoring tools while maintaining the traditional liquidity standards such as liquidity ratio in China. The LCR requirement is generally consistent with the Basel III standards but is more stringent as for the definition of high quality liquid assets (HQLA). Neither RMBS nor equities are qualified as Level 2B assets. The liquidity Rules also introduced a macroprudential perspective by requiring banks and supervisors to closely monitor market liquidity conditions, and allowing banks to use their stock of HQLA during periods of financial stress. LTV requirement The LTV requirement for mortgage loans has been a very important macroprudential tool in China. In 2004, the CBRC introduced an 80% LTV limit for mortgage loans, together with a 50% monthly debt service ratio limit. In the past ten years, the LTV limit has been adjusted several times in response to the changing property market situations. In May 2006, given rising housing prices, the LTV limit was lowered from 80% to 70%. In September 2007, in response to continuously rising housing prices, the LTV limit for the second home mortgages was lowered further from 70% to 60%, together with tightened risk management criteria for property lending. In October 2008, with the deepening of the global financial crisis, the LTV limit for the first home mortgages was raised from 70% to 80%. However, housing prices picked up rapidly since late 2009. Therefore, in April 2010, the LTV limit for the first home mortgages was lowered again from 80% to 70% and that for the second home mortgages was lowered from 60% to 50%. In January 2011, the LTV limit for the second home mortgages was lowered further to 40%. Since 2015, given the adjustment of the housing market, the LTV limits have been changed upwards, with the LTV limit for the second home mortgages increased to 60% in March 2015. For cities not subject to restrictions on the purchase of housing, the LTV limit for the second home mortgages was increased further to 70% in February 2016, and the LTV limit for the first home mortgages was increased to 75% in September 2015 and then 80% as decided on a city-by-city basis in February 2016. However, since the first quarter of 2016, the housing prices in the first tire cities experienced rapid increase. Hence, the LTV limit in 16 first tire cities have been reduced since the end of September 2016. (ii) Policy Framework for systemically important banks (SIBs) The Chinese banks have participated in the Basel Committee’s G-SIB quantitative impact study (QIS) exercise since 2009. Four Chinese banks, the Bank of China, Industrial and Commercial Bank of China, Agricultural Bank of China and China Construction Bank, have been identified as G-SIBs consecutively among a total of 30 G-SIBs in the world. The supervision of SIBs has been a priority on the supervisory agenda. In addition to a 1% capital surcharge requirement, the CBRC has also taken a number of measures to enhance and intensify its supervision of D-SIBs. More emphasis has been placed on high quality corporate governance and risk management in large banks. More supervisory resources have been allocated to conduct more frequent and intensified off-site and on-site supervision, focusing on risk governance, consolidated risk management and risk data aggregation capacity, etc. Consolidated supervision of banking groups have also been enhanced from both cross-sector and cross-border perspectives. Meanwhile, higher disclosure requirements have been implemented for large and medium-sized banks in China. In January 2014, the CBRC issued the Guidelines on the Disclosure of G-SIB Assessment Indicators, requiring banks with a leverage ratio exposure measure exceeding RMB 1.6 trillion, or Euro 200 billion, and banks identified as a G-SIB in the previous year, to disclose the 12 indicators used in the G-SIB assessment methodology in five broad categories, ie. size, interconnectedness, substitutability, complexity and cross-jurisdictional activities. Banks should make the disclosure no later than four months after the financial year-end – and, in any case, no later than end-July. A total of 15 Chinese banks disclosed the 12 indicators as required by the Guidelines in 2014 and 2015. The CBRC is, together with other relevant authorities, in the process of formulating a policy framework for D-SIBs, including the methodology for identifying D-SIBs which will consider four categories of systemic importance, i.e. size, interconnectedness, substitutability and complexity. Banks’ systemic importance will be determined according to their systemic importance score, together with supervisory judgment based on additional quantitative and qualitative analysis. This assessment will not only inform higher loss absorbency requirement, but also inform supervisory intensity and resource allocation, which means differentiated regulatory and supervisory measures will be taken according to banks’ systemic importance. Meanwhile, the relevant Chinese authorities have been working together to improve the recovery and resolution regime and tools. The large banks have been required to formulate and submit recovery plans. The Crisis Management Groups (CMGs) for each of the G-SIBs in China have been established with the participation of the MOF, PBC, CBRC and relevant overseas authorities. The CMGs have met on an annual basis, to review the recovery and resolution plans (RRPs), conduct resolvability assessment and discuss other relevant issues to improve the resilience and resolvability of the G-SIBs in China. In addition, structural measures such as activity restrictions and firewalls have been implemented for a long time to reduce the complexity and interconnectedness in the financial sector. In China, banks are prohibited by law to conduct non-banking businesses, such as insurance and capital market activities. Only in the past few years, some banks have been allowed, on a trial basis and with approval by the State Council, to establish or acquire subsidiaries to conduct non-banking financial businesses, such as fund management, financial leasing and insurance. Moreover, in order to reduce risk contagion across different financial sectors, as well as the level of interconnectedness and complexity in the financial system, the activity restrictions are reinforced by supervisory rules, such as the rules prohibiting banks from guaranteeing corporate bonds and those prohibiting bank lending from financing stock trading activities. (iii) Addressing shadow banking risks The MOF, PBC and CBRC, as the FSB members representing China, have actively participated in the discussion of the policy framework to address the shadow banking risks. Meanwhile, non-bank credit intermediation has grown rapidly in China in the past several years. We acknowledge that it’s a result of financial deepening and provides the real economy with an alternative source of finance. However, we also recognize that it poses new challenges to risk management and financial supervision. The non-bank credit intermediation activities are supervised by different regulatory authorities in China. Therefore, in response to its rapid development, the supervisory responsibilities have been further clarified with cooperation and coordination among different regulators enhanced to prevent regulatory arbitrage. Also, to effectively oversee the non-bank credit intermediation, supervisors have focused on the nature and underlying risks in addition to legal forms, to ensure that the activities with similar nature and underlying risks are subject to consistent regulation and supervision. (iv) Cross-sector and cross-border coordination and cooperation There are a number of formal and informal mechanisms among the various authorities relevant for financial stability in China, which play a crucial role in enhancing information sharing and policy coordination. These mechanisms have helped the relevant authorities to better identify, analyze and assess the emerging risks in the financial sector, and ensure measures are taken in a timely manner to address these risks to maintain financial stability in China. The Financial Crisis Response Group (FCRG) led by the State Council has been the highest level of forum for the discussion, coordination and decision of financial stability issues in China. At the second level is the Financial Regulatory Coordination Joint Ministerial Conference (JMC) among the central bank, three financial regulators and State Administration of Foreign Exchange (SAFE) established in 2013. The JMC has met on a quarterly basis and mainly focused on cross-sector cooperation and coordination. At the third level are the supervisory MOUs. On matters related to specific supervisory cooperation and coordination, the three financial regulators operate according to the tripartite MOU on Supervisory Cooperation and Coordination signed in April 2004, as well as subsequent bilateral MOUs sighed in 2008 and onwards (FSB 2015). In practice, the PBC and three regulators jointly issue supervisory rules, guidelines and other policies on issues that need joint efforts from relevant agencies. They also share information and conduct joint on-site examinations on cross-sector activities. The extent and frequency of information sharing and cooperation have been enhanced in emergency situations. With respect to cross-border cooperation in the banking sector, the CBRC has signed MOUs and Exchange of Letters (EOLs) with supervisory authorities in 68 countries and regions. It conducts bilateral consultations regularly with US, UK, Canada, Japan, Korea, Singapore and Hong Kong counterparts, etc. Since 2009, the CBRC has held supervisory colleges for large banks on a regular basis, with the supervisory colleges for the G-SIBs in China taking place once a year. Meanwhile, the CMGs for the G-SIBs in China have and will continue to play an important role in strenghtening both cross-sector and cross-border cooperation and coordination. IV.Challenges faced by authorities to build up an effective macroprudential supervision framework Even though after the crisis, lots of efforts have been made to enhance macroprudential supervision, recent experiences have shown that authorities are facing great challenges to build up an effective macroprudential supervision framework. First, it is difficult to identify systemic vulnerabilities in an accurate and timely way. Recent crisis has defeated our belief that systemic risk could be identified easily beforehand. Although we have a lot of models at hand, we find that none of them is sufficiently robust to predict crisis in advance. My view is that assessment of systemic risk should not be limited to develop and utilize quantitative models and early warning indicators, but needs to involve qualitative discussions even debates among relevant agencies, and making judgments and decisions based on credible knowledge and experiences. It will only work effectively if there is intense joint working by central banks and supervisory agencies to bring together macroeconomic analysis as well as insights from specific institutions, and from sectoral and business model analysis. It is also important to close data gaps that hinder systemic risk assessment, and to enhance data infrastructure to improve the capability of identifying, analyzing and monitoring systemic risks. Second, as for the use of macroprudential tools, the uncertainty of the measurement of systemic risk and the transmission channels of macroprudential tools would support a discretionary use of the toolkit. However, rules have the benefits to overcome the bias for inaction, especially given potentially strong market resistance. In my view, it would be desirable, to the extent possible, to introduce simple, transparent and easy-to-implement rules. This can help relieve market pressures on authorities to take unpopular actions, especially during the upswing period. If carefully designed, rules can serve as built-in stablisers which depend much less on the ex- ante risk assessment. Having said that, we should be fully aware that in the real world, due to practical constraints, we will always have to face the trade-off between rules and discretion, and need to apply expert judgement for policy decisions. Third, as financial stability is harder to measure than the price stability objective of monetary policy, it is difficult to define the macroprudential accountability of agencies. Furthermore, sound macroprudential policies mean that authorities will need to make unpopular decisions. My view is that macroprudential institutional arrangement should balance independence and accountability to encourage authorities to act in a responsible and timely way. In essence, macroprudential supervision is a shared responsibility of central banks and supervisory agencies. They should all strengthen the macroprudential orientation, i.e. take account of financial system stability in carrying out their mandates. In particular, assessment of systemic vulnerabilities need be jointly conducted by the central bank and supervisory agencies, with policy responses coordinated to mitigate the build-up in systemic risks. In this regard, effective cooperation and coordination among the central bank and supervisory agencies will be more important than ever. We notice that the Financial Stability Oversight Council (FSOC) established in the US and the European Systemic Risk Board (ESRB) in the EU are essentially formalized/enhanced coordination mechanisms for assessing systemic vulnerabilities and making policy recommendations. In addition, mechanism should also be put in place to enhance the coordination between macroprudential and other policies such as microprudential and monetary policies. Finally, it remains to be seen how effective the macroprudential policies would be in practice. Since 2009, the FSB, along with national authorities, has taken great efforts to address the TBTF problem. However, the recent IMF analysis shows that this TBTF problem is far from being solved. The implicit subsidies have fallen but are still huge for SIBs, and the expected probability that SIBs will be bailed out remains high in all regions. We should be aware that the TBTF problem remains to be a threat to the global financial stability and more efforts still need to be made in the years to come. References 1. BCBS (Basel Committee on Banking Supervision), 2010a. Basel III： A Global Regulatory Framework for More Resilient Banks and Banking Systems. Available from Basel Committee website: http://www.bis.org/publ/bcbs189.htm. 2. 2010b. Guidance for National Authorities Operating the Countercyclical Capital Buffer. Available from Basel Committee website: http://www.bis.org/publ/bcbs187.htm. 3. 2014. Capital Floors: the design of a framework based on standardized approaches - Consultative Document. Available from Basel Committee website: http: //www.bis.org/bcbs/publ/d306.htm. 4. 2016a. Standardized Measurement Approaches for Calculating Operational Risk – Consultative Document. Available from Basel Committee website: http://www.bis.org/bcbs/publ/d355.htm. 5. 2016b. Reducing Variation in Cedit Risk-weighted Assets - Constraints on the Use of Internal Model Approaches– Consultative Document. Available from Basel Committee website: http://www.bis.org/bcbs/publ/d362.htm. 6. BIS (Bank for International Settlement), 2009. BIS 79th Annual Report. 29 June. Bank for International Settlement, Basel, Switzerland. 7. Borio and Shim, I., 2007. What Can (Macro-) prudential Policy Do to Support Monetary Policy? BIS Working Papers No. 242, Bank for International Settlement, Basel, Switzerland. 8. Brunnermeier, M., Crockett, A., Goodhart, C., Persaud A.D. and Shin, H., 2009. The Fundamental Principles of Financial Regulation. International Center for Monetary and Banking Studies, Geneva, Switzerland. 9. De Larosière, J., Balcerowicz, L., Issing, O., Masera, R., Mc Carthy, C., Nyberg, L., Pérez Onno Ruding, J., 2009. The High-level Group on Financial Supervision in the EU, Brussels. Available on the Website of the European Commission: http://ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf 10. FSA (Financial Services Authority), 2009a. The Turner Review: A regulatory response to the global banking crisis. Available from: http://www.gov.uk/pubs/other/turner_review.pdf. 11. FSB (Financial Stability Board), 2010. Reducing the Moral Hazard Posed by systemically Important Financial Institutions: FSB recommendations and time lines. Available from the FSB website: http://www.financialstabilityboard.org/publications/r_101111a.pdf. 12. IMF and BIS, 2011. Macroprudential Policy Tools and Frameworks Progress Report to G20. Available from the FSB website: http://www.imf.org/external/np/g20/pdf/102711.pdf. 13. 2015. Peer Review of China. Available from the FSB website：www.fsb.org/wp-content/uploads/China-peer-review-report.pdf. 14. IMF, 2009. Lessons of the Financial Crisis for Future Regulation of Financial Institutions and Markets and for Liquidity Management, Prepared by the Monetary and Capital Markets Department. International Monetary Fund, Washington, D.C.. 15. G20 (Group of Twenty), 2009. Enhancing Sound Regulation and Strengthening Transparency. Group of Twenty, 2009. 16. White, W.R., 2006. Procyclicality in the Financial System: Do We Need a New Macro-financial Stabilisation Framework? BIS Working Paper No.193, Bank for International Settlement, Basel, Switzerland.

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Li Wenhong: Two Important Trends in Banking Supervision after the Global Financial Crisis and Practices in China

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