China's major banks are coming to recognize the importance of implementing the global accord on bank capital standards, known as Basel II.
And although the nation's banking regulators realize how difficult it will be for Chinese banks to comply with the new capital requirements, they are eager to make this happen.
China Banking Regulatory Commission Vice-Chairman Tang Shuangning said at the end of last month that the commission is "actively encouraging" the nation's major lenders to intensify their efforts to build an internal-ratings-based (IRB) approach in accordance with Basel II requirements and improve their risk management capabilities.
The only way that domestic banks will be able to weather the storm of increased competition, especially with the opening of the sector to foreign lenders in line with China's World Trade Organization commitments, is to establish a sound risk management system, based on the new Basel Accord requirements.
Issued by the Basel Committee on Banking Supervision, the Basel capital accord determines what capital levels should be deemed safe for commercial banks. The accord, which will replace the 1988-issued Basel I capital accords, is expected to come into force by the end of 2006, providing new impetus for banks to strengthen risk management.
Once Chinese banks' services are on a par with those of their foreign rivals, the next step in competition would be on how well they manage risks and find business opportunities, based on their knowledge of historic data, said Chen Zhongyang, a professor from Renmin University of China.
But the commission has delayed the implementation of Basel II, given the current situation in China's banking industry.
Despite this, the nation's big banks have actually started preparing to implement Basel II.
According to Li Yunqing, an official from the Industrial and Commercial Bank of China (ICBC), the nation's largest lenders started to study the implications of Basel II about two years ago. The ICBC has already opened a Basel II office, an IRB report has been completed and it is constructing an integrated infrastructure in order to fully implement the Basel II principles.
Given the industry regulator's enthusiasm to get Basel II implemented in China, all of the nation's big banks have drawn up plans to put the standards into practice, but have yet to draw up timetables for this, said an industry insider.
All the "Big Four" State-owned banks have reached an consensus on heavy investment in the infrastructure construction to meet the Basel II requirements. And they may even take a short-cut in utilizing IT services such as installing new systems that could be easier than replacing old systems, a common practice for many banks in developed countries.
The "Big Four" refers to the ICBC, the Bank of China, the Agricultural Bank of China and the China Construction Bank.
What is encouraging is that the nation's lenders are increasingly complying with international standards to remodel their risk management systems ahead of the industry's complete opening, but this will take a long time.
Commission officials also stressed that it is by no means an easy task for local banks to comply with the Basel II requirements. Rulings made in China on the banks' capital will fully take into account the specific situation of the country's lenders, which are continuing to struggle to meet existing capital requirements.
Basel I established guidelines for calculating banks' capital with a minimum requirement of 8 per cent.
It is widely recognized that Basel II's objective goes beyond merely requiring a better matching of capital requirements. It aims to encourage the use of modern risk management techniques and systems in order to better manage risks.
Therefore, Basel II is highly complex and technical, far more than Basel I. A sign of this is that while Basel I was only 40 pages long, Basel II runs to over 200 pages.
To implement modern risk management systems, and utilize the more advanced approaches required by Basel II, banks are going to have to commit significant resources by investing in IT infrastructure and reviewing corporate governance structure.
But a recent survey by Ernst & Young finds that most financial institutions in the Asia-Pacific region remain at the early stage of their implementation plans to meet requirements of Basel II. And Chinese banks are no exception.
Phillip Straley, a partner with Ernst & Young's Financial Services Risk Management, who masterminded the survey, said that data collection is one of the weak links in Chinese banks' implementation of Basel II as it is a very complicated process.
A report by US law firm White & Case, said that on the IT infrastructure front, banks will have to collect and process a significant amount of historical-loss data. These databases have to be built and integrated with the banks' processes so that data can be made available to the banks and their subsidiaries, including across geographical locations.
To take advantage of Basel II's advanced approaches, banks will have to be able to use advanced analytical models to assess and predict risks based on such data.
Such banks must collect and store data on rating decisions, the rating history of borrowers, and the probabilities of defaults associated with rating grades and ratings migration in order to track the predictive power of the rating system.
The IT system must support banks' ability to meet the minimum requirements, including exposure aggregation, data collection and use and management reporting. Finally, the banks must be able to demonstrate the integrity and strength of their systems.
Straley said it could be very difficult, - sometimes even impossible - to complete the whole requirements since many Chinese banks operate systems that were designed many years ago to process transactions, which do not collect the kind of data that Basel II requires. Needless to say, such systems as they are now set up, would not be adequate for the demands of the risk modelling and analysis required by Basel II.
In addition, the huge sprawling network of Chinese banks makes it even harder to integrate all the data, he said.
Replacing core banking systems or trying to adapt existing systems is difficult, time-consuming and costly, according to experts.
Implementation of Basel II is not just a data and information systems exercise, but involves focusing on risk measurement, risk allocation and the return on risks.
Basel II is intended to stimulate the evaluation of a bank's choice of core businesses and also the development of better corporate governance practices.
Basel II's risk-sensitive approach allows banks to determine capital adequacy based on the level of risk posed by each transaction. Banks will develop and use various models to allocate capital to transactions based on how much risk an individual transaction contributes to the bank's portfolio of risks. These models would help determine how much capital is required to support the various risks taken by the bank.
The huge cost for local banks was once seen as a major obstacle which could hamper their efforts in implementing Basel II as some experts estimate that it will take no less than US$50 million for each bank in China to attain Basel II compliance.
But, according to the source, there is a strong belief among China's banks that implementing Basel II requirements will be worthwhile in view of future benefits, meaning that this cost does not concern them.
"All the big Chinese banks are gearing up for listing in the near future. Implementing Basel II would help them gain a good reputation in the stock market and also build up investor confidence," said Straley.
Although Chinese banks could go public if they failed to implement Basel, complying with the capital requirements is also in line with local banks' strategic considerations, said experts.
Major Chinese banks also find it increasingly necessary to set up overseas subsidiaries. If their subsidiaries are required to comply with Basel II requirements by the local authorities, Chinese banks will feel additional pressure to accelerate their implementation of Basel II, they said.