Chinese banks brace for effects of Basel III rules

Banking | Liu Jun

The Basel Capital Accords are global regulatory standards for financial supervision. The recent issuance of Basel III in the wake of the global financial crisis several years ago reflects strengthened international supervisory cooperation and coordination.

Financial regulators of major economies have set timetables for Basel III implementation. The Chinese banking regulators have been quick to act, and the banks under their supervision have braced themselves for the effects, to whatever extent, on their operations.

Basel III, in substance, provides a "circle" and two puzzling "balloons" in terms of capital and liquidity regulations. Given the three characteristics of the Western financial system - namely, a mature financial market, a dominant role for direct finance and accelerated liquid asset accumulations in commercial banks - Basel III fully reflects the idea of encouraging the convertibility of assets.

The bulk of the marketable assets defined by Basel III refer to those of a high-quality and high-liquidity nature - that is, all the non-cash assets that can be easily and immediately converted into cash at little or no loss of value, such as savings and government-issued securities.

The purpose is to generate money without incurring large discounts to cover cash outflow in times of stress. This essentially imposes a restrictive "circle".

In Basel III, commercial loans and corporate bonds are excluded, given the de facto devaluation of European government bonds against the backdrop of this round of pandemic crises, which gives US Treasuries the superb status as almost the only qualified marketable asset. As a consequence, Basel III apparently facilitates the great expansion of the investor base of US Treasury bills and bonds.

An assumption of a "conspiracy theory" is a bit far-fetched. This is a tough challenge for China, with its financial system mainly based on indirect finance. Whether intentional or otherwise, Basel III puts China, with its special financial structure, at a serious disadvantage to the US.

Failing to recognize this issue, we are either fooling ourselves or burying our heads in the sand.

What's more, in the case of US defaults, a possibility not that remote, what would China do when falling into the "US Treasuries trap"?

In addition to the "circle", Basel III has introduced two new liquidity risk standards, which can be branded as "two puzzling balloons".

One is the liquidity coverage ratio, or LCR, and the other is the net stable funding ratio, or NSFR. The LCR is defined as the ratio of the stock of high-quality liquid assets to net cash outflows over the next 30 days. The NSFR is defined as the ratio of available stable funding to required stable funding.

Both the LCR and the NSFR in Basel III require banks to hold a considerable amount of cash. However, cash sitting in the central bank's account cannot flow into the real economy and can be used only to buy so-called high-quality liquid assets, which are understood to be none other than US Treasury bonds.

Therefore, a bigger proportion of cash can circulate only within the financial system rather than being injected into the real economy, inflating financial bubbles and contributing less to productivity and economic growth.

The consequence is obviously the sharp contrast between the abundance of liquidity in the financial system and the shortage of liquidity in the real economy. It would come as no surprise if this is followed by a hollowing-out effect in the real economy, especially in industrial sectors.

The way Basel III makes rules has the tendency to favor developed economies. It will lead to the buildup of liquidity in the financial system, which will then breed bubbles.

In contrast, the real economy will be squeezed of liquidity, due to its spiral exits from manufacturing industries, etc. Therefore, the implementation of the new rules should be done with prudence. Otherwise, they will be counterproductive.

Furthermore, if China's monetary policy is based on Basel III's liquidity assumptions regardless of the Chinese situation, the economy will end up with excess money in the banking system, whereas the real sector will suffer serious liquidity deprivation.

The conclusion is self-explanatory.

First, the economy's level of leverage, measured by total financial assets compared with GDP, varies from country to country. Thus the liquidity regulation should differentiate toward different settings.

China's economy is relatively low in leverage in regards to both the banking system and the real economy. It goes without saying that the Chinese authority is fully committed to implementing Basel III, but an approach to applying overly stringent capital and liquidity standards obviously do not fit in the macro financial structure characterized by indirect financing. At this stage, it is not advisable to attach so much significance to the two "balloons".

Second, we should implement Basel III step by step and according to our capability, instead of joining a race against time.

The implementation timetable should be tailored to the market infrastructure, the available resources and the special system. China is still making reforms, and the banking sector is playing a dominant role in funding economic development.

Our commitment to Basel III notwithstanding, we have to make sure that the strength of the financial system and the momentum of the GDP growth will not be compromised.

Third, more China factors are needed to be customized in Basel III implementation in order to avoid the problem caused by the mismatch between strict standards and restricted resources. This includes, but is not limited to, a moderate level of capital adequacy ratio, a comprehensive inclusiveness of the marketable assets, and a reasonable definition of the LCR and the NSFR.

China should participate in and be prepared to play a leading role in formulating international standards, including those in the financial sector. Let's begin with Basel III implementation.

The author is executive vice-president of China Everbright Bank.

(China Daily 01/09/2013 page16)