Adapting to Change: Wolters Kluwer Examines China’s Risk Landscape

The continuous innovation in China’s financial services industry has created a complex and challenging operating environment. Here Spark Wang, senior banking regulatory intelligence expert at Wolters Kluwer, examines the country’s risk management environment, arguing that bank’s risk technology systems will need to consider multiple factors.

Experts at the risk and regulatory technology division of information services firm Wolters Kluwer have long said that banks will become ever more dependent on integrated data sets, with further integration between risk and finance. In fact, banks are best advised to leverage new technologies in response to ongoing regulatory trends and market dynamics. And that’s on a global scale. It’s all part of the convergence of Governance, Finance, Risk and Compliance (GFRC).

Certainly, banks in China are no exception to the rule and those that wish to remain competitive are now urged to break down traditional silos, and adopt a flexible, forward-looking approach to counter new regulatory threats. And this can clearly be seen in reference to the multitude of developments banks in the country have to contend with when it comes to risk management.

As readers of FinTech Finance know, following on from Basel III, which was initially published in 2010, the Basel Committee on Banking Supervision (BCBS) has released a series of updates on the banking regulatory framework, loosely defined as Basel IV. Banks should now keep their eyes on the new trends in the calculation and management of capital, risk weighted assets, and liquidity, ensuring systems are in place that can handle all areas.

TLAC Capital

Total Loss Absorbing Capacity (TLAC), consisting of Basel minimum mandatory capital requirements and TLAC debt instruments, should be no less than 16 percent and 18 percent of total Risk Weighted Assets (RWA) for China’s Big Four banks (ICBC, China Construction Bank Corp., Agricultural Bank of China Ltd. and Bank of China Ltd.) as at 2025 and 2028 respectively. The TLAC bond instrument cannot be secured by the issuing bank with remaining maturity more than 1 year and must be no less than 33 percent of total TLAC.

On the positive side, TLAC together with the Basel buffer capital will provide stronger protection to the whole financial market and the deposits of clients of major banks. In addition, the TLAC bond instrument will help bring about a more diversified financial product portfolio.

However, the return on equity will be lower for TLAC eligible banks. How to price these bonds and manage the long-term asset liability structure are two emerging issues.

Risk Weighted Assets (RWA): Market, Credit, and Operational Risks

In addition to the TLAC, there are also changes on the RWA side, such as market risk, credit risk, and operational risk. It is expected that the China Banking Regulatory Commission (CBRC) will follow the main parts of these modifications and request that domestic banks implement once the BCBS versions are finalized.

In January 2016, the BCBS instruction for the market risk capital regime for the trading book was released, while the credit risk and operational risk parts are still under discussion. The new market risk framework introduces a number of changes compared to earlier draft versions, some of which include lowering requirements offset by higher capital requirements in other areas.

For market risk, the boundary between banking book and trading book, and calculation methodology for both the standard approach and the internal model approach are changed.

Now, the new BCBS guideline is more workable to clearly distinguish the banking book and trading book by listing specific product types and the features of the management procedures for each separate book type. The market risk calculation methods are also changed to flexibly capture a wider scope of risk components. The standardized approach is divided into three components, with the ultimate capital requirements being the simple sum of the capital charges for all three components. First, the BCBS introduces the sensitivity based method, with pre-defined risk factor definitions for each market risk class and a step-by-step approach to calculate the capital requirements through the sensitivities of each risk factor, aggregated up to risk classes. Secondly, the new framework aims to capture default risk more in line with the credit exposure treatment in the banking book. And finally, an additional residual risk component is introduced to account for residual risks of certain instruments. The application of the residual risk charge has now been lowered to apply 1 percent on the notional of exotic instruments, and 0.1 percent for other residual risks. This is a change compared to the previous draft where a lot of concerns were raised on the broad application of the 1 percent charge, resulting in huge capital increases.

For the internal model approach, the current Value at Risk (VaR) indicator will be replaced by the Expected Shortfall (ES), where the latter better captures tail risks associated with diversified stress scenarios caused by liquidity and the market panic while the former deems the market values static position. Perhaps of even greater importance to the financial institutions is the increase of the capital multiplier from 1 to 1.5 to calculate the ultimate capital requirements for banks using the internal model approach.

Regarding  credit risk, a proposed big change in the BCBS Draft to determine the credit risk weight and the risk weighted assets for loan, bonds, interbank and other credit assets under the standard approach is up to the CBRC, whether to abolish the external rating and establish an internal rating system for external bank and corporate counterparties. The latest guidelines for the credit risk revision took a step back in the original attempt to reduce the dependence on external ratings for risk weight assignment. This was done after industry feedback pointing to the impractical, and in many cases unwanted, consequences to alternative proposed methods. Most of the risk weights will also be changed upwards under the proposed revisions of the standard approach.

The standard approach of operational risk assets will also be revised to respond to the Quantitative Impact Survey (QIS), which suggests that operational risk is positively correlated to the size of the income and expense of the banks. So, both the basis and coefficient to calculate the operational risk assets are updated, where existing Gross Income (GI) will be replaced by the Business Indicator (BI) and the conversion coefficient will be set in a lookup table according to the total BI from 10 percent to 30 percent according to the bucket of total BI. Currently, all the GI is net amount by business line and the coefficient is always the constant.

Liquidity Risk: LCR and NSFR

In addition to the updates in the Basel Pillar I for capital or TLAC and RWA, there are additional modifications in the liquidity part of Pillar II. Following the BCBS’ latest guideline, CBRC recently changed the requirement for the Net Stable Funding Ratio (NSFR) from 2016 by using the effective remaining maturity, instead of the residual contract maturity, to calculate the Required Stable Funding (RSF). This means that banks must revise their calculation mechanism and will have significant influence on long-term asset liability management.


Author: Jason Williams

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