PEOPLE BANK OF CHINA LIQUIDITY SUPERVISION MANUAL

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					Attachment 8




          PEOPLE'S BANK OF CHINA
       LIQUIDITY SUPERVISION MANUAL




                 June 2001




                     1
I. Liquidity-General

A bank’s essential role is to intermediate funds between its depositors and other
creditors and its borrowers. To carry out this role, a bank must continuously
maintain adequate liquidity resources that will enable it to respond swiftly and
effectively to demands for funds by its depositors, other creditors and borrowers.
If it does not do so, the consequences can vary from the bank experiencing a
squeeze on earnings, a capital shrinkage, or a dramatic outflow of funds,
generally referred to as a "run" on the bank. In a worse case scenario, these
problems can spread to other institutions in the banking system.

Because liquidity is such an important element to a bank’s financial safety and
performance, it should be a primary concern of its board of directors and senior
management to ensure that it has liquidity resources adequate to meet all
possible situations. A framework to accomplish this end should include:

Ø Oversight by the bank’s board of directors of the liquidity position of the bank,
Ø A written liquidity risk management policy that is approved and periodically
  reviewed by the board.
Ø Designation of senior management and management committees that are to
  be responsible for the ongoing oversight of the bank’s liquidity management
  activities.
Ø Well trained and dedicated employees.
Ø An effective management information and reporting system, including a
  system for tracking indicators of the bank’s financial health to act as an early
  warning mechanism against potential liquidity problems at the bank.
Ø A methodology for projecting the liquidity position of the bank under a variety
  of adverse scenarios and a contingency plan for reacting to those conditions if
  they do occur.
Ø An effective system of Internal Controls

Because the People's Bank of China (PBOC) is the principal supervisory
authority for the Chinese financial system, it is responsible for overseeing the
liquidity and the liquidity risk management practices of banks. The PBOC does
this through promulgation of prudential rules and regulations based on basic
banking and other relevant laws of the People’s Republic of China and acts to
insure that banks and financial organizations comply with these rules and
regulations through on-site examinations and off-site surveillance.

The Chinese financial system is becoming more competitive and complex as
market principles are increasingly introduced. As a result, the regulatory and
supervisory processes will need to be enhanced to respond to these changes.
These evolving conditions will call for the PBOC to take steps to bring its policies




                                           2
and practices into full compatibility with the principals pertaining to liquidity risk
management recommended by the Basle Supervisors Committee.

The purpose of this manual is to give bank management and bank supervisors
guidance on how they should carry out their responsibilities with regard to
liquidity. It also provides a summary review of the laws of China that provide the
PBOC with its authority to regulate and supervise banks and of the regulations
and guidelines issued by the PBOC that pertain to liquidity risk management. In
addition, it discusses the procedures and practices the PBOC carries out in
supervising liquidity developments and the liquidity condition of Chinese banks.
Finally, it discusses procedures the PBOC can follow in dealing with banks with
liquidity and /or structural problems and spells out general guidance on the
provision of that assistance.

II. Bank Liquidity Risk Management

A. Board and Management Oversight

Oversight of the liquidity risk position of a bank requires a multi-tiered program of
strategies, policies and analysis. It includes:
Ø a board of directors that sets out a general strategy and is periodically made
    aware of issues relevant to the liquidity position of the bank.
Ø a senior management team that is responsible for ongoing oversight of staff
    and for keeping the board informed.
Ø staff trained in the basic elements of liquidity issues and informed sufficiently
    regarding what issues should be raised with senior management or the board.

1.Responsibilities of the Board

Each bank should have an agreed strategy for the management of its liquidity
position. The strategy should establish the general approach the bank will have
to liquidity, including various quantitative and qualitative targets. It should
address the bank’s goals of protecting the financial strength of the bank and of
assuring its ability to withstand financial stress in the marketplace. A bank’s
liquidity strategy should cover particular aspects of liquidity management, such
as the composition of assets and liabilities. There should also be agreed
strategies for dealing with both temporary and longer-term liquidity disruptions.

The strategy should be spelled out in a written liquidity risk management policy
that is approved by the Board of Directors and should be communicated
throughout the organization. The formality and sophistication of the liquidity
management process should be appropriate for the overall level of risk incurred
by the bank and for the complexity of its liquidity risk exposure. The written policy
should also designate senior management and management committees, such
as an Asset/ Liability Management Committee (ALMC) that are to be responsible
for the ongoing management of liquidity, define how these management activities



                                             3
are to be coordinated with other asset/ liability activities and specify a
requirement for the bank to have an effective management information system1.
In addition, the policy should require senior management responsible for liquidity
management to prepare a written contingency plan for dealing with serious
liquidity problems. This plan should be reviewed by the board of directors.

Banks should assign ultimate responsibility for carrying out the liquidity risk
management policy and reviewing liquidity decisions to the bank's highest level
of management. The Board should ensure that senior management is hired that
understands the management of liquidity issues and takes the steps necessary to
monitor and control liquidity risk. They and other appropriate personnel should
have a thorough understanding of how other risks, including credit, market and
operational risk, impact the bank’s overall liquidity strategy. The Board should be
informed regularly of the liquidity situation of the bank and immediately if there
are any material changes in the bank’s current or prospective liquidity position.


2. Responsibilities of Senior Managers

Each bank should have a management structure in place to execute the liquidity
strategy. Senior management must ensure that liquidity is effectively managed,
and that procedures are established to control and limit liquidity risk as specified
in the written liquidity policy:
Ø The responsibility for managing the overall liquidity of the bank should be
    placed with a specific, identified group within the bank.
Ø This structure should include the ongoing involvement of members of senior
    management.
Ø Staff should receive on-the-job and formalized training regarding the
    management of the liquidity position of the bank.
Ø A schedule of frequent routine liquidity reviews and less frequent, but more in-
    depth, reviews should be established.
Ø It is critical that there be close links between those individuals responsible for
    liquidity and those monitoring market conditions, as well as other individuals
    with access to critical information, such as credit risk managers.
Ø Banks’ management should set limits, consistent with the liquidity policy, to
    ensure adequate liquidity, such as limits for PBOC liquidity indicators which
    may be set more conservatively than those specified by the PBOC.
Ø As one aspect of their liquidity analysis, banks should utilize, to the extent
    they are able, the cash flow gap methodology recommended by the Basle
    Committee on Banking Supervision


1
   It is intended that the outline of key elements that should be included in a Liquidity Risk
Management policy that is offered in the second part of Attachment 5 to the Final Report will
ultimately be attached to this Manual ( as its Attachment 1) when the Manual serves as a stand-
alone document. The outline, however, is not attached here in order to avoid duplicating
Attachment 5 of the Final Report.



                                              4
Among the key aspects of this recommended methodology is that
a bank should analyze liquidity by considering a set of “what if” scenarios—
normal business conditions, bank specific problem, systemic problem in the
banking or financial system. Under each scenario, a bank should try to account
for any significant positive or negative liquidity swings that could occur. The
following principles should be applied:

Ø Analysis should allow for factors that are both internal (bank-specific) and
  external (market-related).
Ø While liquidity will typically be managed under “normal” circumstances, the
  bank must be prepared to manage liquidity under abnormal conditions.
Ø A bank will need to assign the timing of cash flows for each type of asset and
  liability by assessing the probability of the behavior of those cash flows under
  the scenario being examined.
Ø For each funding source a bank would have to decide whether the liability
  would be paid in full at maturity, reduced to a shorter-term maturity or rolled
  over at the same or a longer maturity. Since all depositors in China have the
  right to withdraw their funds on demand no matter what their contractually
  specified term to maturity, such questions have particular importance when
  considering scenarios in which the bank may be experiencing a crisis
  situation. The bank's historical experience of the pattern of flows and a
  knowledge of market conventions could guide the decisions, but judgement
  often plays a large role, especially in crisis scenarios.
Ø A bank will never have perfect information when choosing between courses of
  action. Hence the timing of cash inflows and outflows on the maturity ladder
  can differ among scenarios and the assumptions may differ quite sharply.
Ø A bank, in formulating projections of its cash flows under such
  circumstances, should refer to the experience other banks have had in a
  liquidity crisis.
Ø A bank should review frequently the assumptions utilized in managing liquidity
  to determine their continued validity.

The recommendation of the Basle Committee is set forth in very general terms,
and there are a number of possible approaches to cash flow gap analysis. For
illustrative purposes, one such approach is set forth in Attachment 6 to the Final
Report2.

It is understood that many banks do not yet have information systems that would
enable their staffs to carry out a full scale cash flow gap analysis. Establishment
of such an information system should be a goal of all banks, particularly those
who are of medium to large size or who intend to enter those ranks in the not
distant future. Moreover, even if a detailed cash flow projection cannot be
developed, use of other elements of the methodology can yield important
benefits, as discussed in the Final Report’s Attachment 6.

2
 It is intended that when this Manual is used as a stand-alone document, Attachment 7 to the
Final Report will become Attachment 2 to the Manual.


                                                5
B. Contingency Liquidity Plan

Bank’s senior management should establish a contingency liquidity plan that will
be submitted to the board of directors for its review. A bank’s ability to withstand
both temporary and longer-term liquidity strains in a timely manner and at a
reasonable cost depends on the adequacy of its formal contingency plans.
Among other matters, the plan should specify a strategy for dealing with a
liquidity problem and outline particular funding sources that would be drawn
upon as part of the overall strategy.

       1. Scenario Analysis

   The methodology of the previously discussed cash flow gap analysis can be
   followed to conduct this analysis

       2. Strategy

   A contingency plan for dealing with liquidity problems should consist of
   several components:

       Ø Managerial coordination to ensure that information flows remain timely
         and uninterrupted in order to be able to make quick decisions.

       Ø A clear division of responsibility must be set out so that all personnel
         understand what is expected of them during a problem situation.

       Ø A strategy for taking certain actions to alter asset and liability holdings.

       Ø Procedures for maintaining customer relationships with liability-holders,
         borrowers, and trading and off-balance-sheet counterparties.

       3. Sources of Funding

       Ø Contingency plans should also include procedures for making up cash
         flow shortfalls in adverse situations.

       Ø Banks have available to them several sources of such funds, including
         previously unused credit facilities. Depending on the severity of the
         liquidity problems, a bank may choose, or be required to use, one or
         more of these sources.

       Ø The plan should set forth as clearly as possible the amount of funds a
         bank has available from these sources, and under what scenarios a
         bank could use them.



                                           6
        Ø Banks must be careful not to rely excessively on back-up lines of
          credit. Indeed, banks should have contingency plans for times when
          their back-up lines become unavailable.

Banks should consider under what circumstances and for what purposes they
would establish committed lines of funding, for which they pay a fee, which will be
available to them under abnormal circumstances if uncommitted facilities fail.

        4. Other features of a good plan

        Ø Maintaining good communication with customers, the media and the
          bank’s staff to keep them accurately informed as to the nature of the
          problem and what the bank is doing to correct it

        Ø Conducting simulated testing of the plan periodically

        Ø Establishing procedures for internal review of the plan
        Ø periodically3.

C. Asset/Liability Management, Domestic Currency

Bank management must respond to increases and decreases in demand for
funds by creditors and borrowers. However, these changes in the structure of
the balance sheet are not so easily isolated solely to either asset or liability
accounts. When confronted with a liquidity squeeze, a management response
may involve increasing liabilities in the form of short-term borrowings or modifying
the structure of assets by converting loans or securities into cash equivalents.

At the same time that they are responding to these changes determined by
decisions of their customers, banks must also ensure that, at the close of the
business day, the balances they have in their reserve/settlement account with the
PBOC meet reserve requirements established by the PBOC. In addition, under
present rules, the balance in this account must be positive throughout the
business day. A bank has a number of options to not only meet reserve balance
requirements, but also to make sure it does not complete the day with excessive
reserve balances. In achieving effective aggregate reserve management, a bank
or the branch of a bank experiencing liquidity problems would generally prefer to
seek funding in the following order (preferred options listed first). Consistent with
the above discussion, these sources of funding can either rely on the asset side
of the balance sheet, the liability side or a combination of the two.



3
  For a sample liquidity contingency plan see the first part of Attachment 5 to the Final Report. It is
intended that that part of the Attachment will serve as Attachment 3 to this Manual when it
becomes a stand-alone document.



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Ø If a branch of a bank, contact Head office or other branches within the bank
  (liability side)
Ø Pledge Treasury securities in the form of a repurchase agreement (liabilities
  side);
Ø Cash out low interest-earning assets, such as reverse repurchase
  agreements (asset side);
Ø Let loans to banks in the interbank market run down as outstanding loans
  mature (asset side)
Ø Borrow funds unsecured in the inter-bank market (liability side);
Ø Sell short term securities (asset side)
Ø Borrow funds from the PBOC (liability side).
Ø Sell longer term securities – depending on the circumstances, a bank may
  choose to sell long term securities first before turning to the PBOC for liquidity
  assistance.


   1.Asset Side Liquidity Management

Liquidity requirements can be met through the sale or liquidation of assets. Banks
have much more discretion over the extent of their asset holdings than liability
holdings. To a large degree the level of deposits is driven more by the
independent decisions of bank customers. With this relationship in mind, the level
of liquid assets required by a bank will depend on how stable the deposit and
funding base is as well as the stability of the demand for funds. If there is stability
in funding and demand for loan funds, a lower level of liquid assets is needed.
Alternatively, if either or both of these potential sources of liquidity pressures
tend to be unstable, a higher level of liquid assets that can be easily and quickly
converted to cash (or cash equivalent) is required.

Thus, the asset side of the balance sheet can be broken down, and is usually
broken down under international accounting standards, by the degree of liquidity
of the asset portfolio. The primary purpose of highly liquid assets that generally
provide lower yields than other assets is to serve as a liquidity resource to meet
the needs of the bank. On the other hand, the primary purpose of less liquid
loans and investments is to provide income to the bank. The following discussion
breaks down the primary assets of the typical Chinese bank from the most liquid
assets to the least liquid assets and offers pertinent comment.


Current Assets

       Deposits with the Central Bank

The PBOC establishes reserve requirements for banks that are largely
maintained in the form of deposit balances with the PBOC; holdings of domestic
currency making up the remainder. Altogether, at present these requirements



                                            8
mandate that a bank must maintain, each day, an amount equal to at least 6 per
cent of its total deposits in its reserve/settlement account at the PBOC. In
addition, since the banks are concerned to assure that they meet these
requirements, they maintain balances above this amount, perhaps in the range of
3 to 5 percentage points of the total deposit base. In the ordinary course of
business, these balances, since they must be maintained to meet PBOC
requirements, are not available to meet short term liquidity needs of the bank.
The PBOC does permit their use, however, if a bank is subject to a serious
liquidity drain.

       Reverse Repurchase Agreements

These assets, securities purchased with an agreement to sell them back at a
later time at a specified price, are generally based on securities issued by the
Chinese Ministry of Finance, They are one of the first line sources of liquidity for
a bank.


       Short term Investments

These investment holdings are mostly composed of securities issued by Chinese
Ministry of Finance and by state policy-related banks but also include securities
issued by business enterprises. The first two are more liquid than the latter, but
there is also an active market for business enterprise securities. In all cases,
however, a bank might find it difficult to sell a large tranch of securities in a short
period of time without a sizable erosion in the price of these securities.

       Medium and Longer Term Investments

These asset holding are made up of the same mix as the short term investment
category discussed immediately above. They are less liquid than the shorter term
investments, but the Ministry of Finance and the state policy-related bank
securities can be sold relatively quickly under most circumstances and also sold
under repurchase agreement. Once again, the sale of a large tranch of these
securities in a short time period would likely result in considerable decline in their
price. There is a market for securities issued by business enterprises but it is less
active. It is even less likely that a large tranch of any of these longer term
securities could be sold without a significant impact on their price.

       Short, Medium, and Long-term Loans

The sale of loans is not yet a common practice in China. While the banks take
part in loan syndications--and, indeed, the PBOC has promulgated guidance on
such activities (see circular, Provisional Measures for Syndicated Loans, that
became effective in October 1997)--the practice of selling whole loans to other
banks or of securitizing loans is not yet occurring. It is to be expected that these



                                            9
practices will begin to occur as the financial upturn continues to evolve. In the
meantime, the loan portfolio can serve as a source of liquidity in two ways: from
interest paid on loans and from the repayment of loans.



       2.Liability Side Liquidity Management

A critical component of managing liquidity is assessing market access and
understanding various funding options and how much funding a bank can expect
to receive from the market, both under normal and adverse circumstances.

1) Each bank should periodically review its efforts to establish and maintain
   relationships with liability holders. Relationships might exist with trading
   counterparties, correspondent banks, corporate customers and payments
   systems. Senior management needs to ensure that market access is being
   actively managed by the appropriate staff within the bank. The frequency of
   contact and the frequency of use of a funding source are two possible
   indicators of the strength of a funding relationship.
2) Concentrations in funding sources increase liquidity risk. In all banks, senior
   management must constantly be aware of the composition, characteristics
   and diversification of its funding sources.
3) Developing markets for asset sales or exploring arrangements under which a
   bank can borrow against assets is another element of managing market
   access.

In China, a primary means for obtaining liquidity is through arranging repurchase
agreements with the PBOC or with other financial institutions.

Another most active market for short-term funding adjustments is via borrowing
on a short-term basis in the inter-bank lending market. Such loans are arranged
on an unsecured basis, under prearranged bilateral agreements between banks.
The maturity of these loans ranges from overnight to 120 days. Under Article 46
of the Commercial Banking Law, the term of inter-bank lending is limited to four
months, and funds borrowed in the market cannot be used to make fixed-asset
loans or to acquire investments. Foreign institutions are allowed to participate in
this market. These inter-bank transactions are carried out under the auspices of
the National Interbank Funding Center, which monitors the transfer of funds
between trading parties and keeps statistics on the volume and number of
transactions, as well as the interest rates at which they occur (China Inter-bank
Offered Rates--CHIBOR). The inter-bank market rate is not subject to regulation
by the PBOC, although it is obviously influenced by other monetary policy actions
of the PBOC.

The PBOC has also established and manages a facility that is designed to assist
banks with deficit reserve/settlement positions at the end of the business day in



                                          10
borrowing from banks with excess positions. Each participating institution signs
an agreement with their PBOC Branch under which they agree that the Credit
Policy Department of the PBOC Branch may eliminate deficit positions in their
settlement accounts by arranging a loan with a participating bank that holds a
surplus of settlement funds. Banks specify the maximum risk exposure they are
willing to accept from each participating bank and update these specifications
periodically in response to changing financial information. Even though this
facility allows banks to avoid ending the day in a shortfall position, they are
generally reluctant to use this option because the rate of interest they must pay
on these loans is 20 per cent higher than the closing overnight rate in the inter-
bank market. Accordingly, banks have an incentive to have their accounts in
balance rather than relying on this facility.

One method that allows the PBOC head office, branches and sub-branches to
extend credit to deposit-money banks is through a short-term “re-lending”
program. Under this program, both secured and unsecured loans are extended
for periods that vary in duration from overnight to up to three months. The PBOC
head office establishes a target volume of short term re-loans that are to be
extended by all lending offices of the bank over a specified period and then
allocates a quota of this total to each of its branches.

Through its branches, the PBOC also changes the volume of base money by
rediscounting short-term negotiable instruments. This primarily involves the
purchase of commercial bills and acceptances that finance transactions for
commercial goods. The PBOC also enters into repurchase agreements with
market participants based on securities issued by the Chinese government,
primarily to supply reserves on a short-term basis. The PBOC head office
establishes a target volume of rediscounts to be extended by all lending offices of
the bank over a specified period, and then allocates a quota of this total to each
of its branches.


D. Foreign Currency Liquidity Management

The Basle Committee has set out guidance on foreign currency liquidity
management4. Taking into account the currency problems encountered in a
number of countries in the 1990’s, the Committee emphasizes that banks that
have an international presence, with asset and liability positions in multiple
currencies, face a much greater degree of complexity in their liquidity
management. Two factors are cited that cause this complexity. First, neither a
bank, nor the domestic financial system in which it operates, may be well known
to foreigners that are providing it funding. Consequently, these sources may be
quick to withdraw their funding at the first sign of perceived trouble. Second,
foreign exchange positions are always subject to the risk of exchange rate

4
  See pages 16 through 18, “Sound Practices for Managing Liquidity in Banking Organizations,”
issued in February, 2000.


                                               11
changes and to the risk that it may be difficult in such market situations to
mobilize foreign currency liquidity to meet foreign currency funding requirements.
Such market developments can arise because of actual problems in a country
whose currency has come under pressure or because of the contagion effects of
developments in other countries

There are two types of situations cited by the Committee that can create special
problems: a) the use of foreign currency obtained from deposits and borrowings
to fund domestic currency assets; b) the funding of foreign currency assets with
domestic currency. ( Note that each situation implicitly involves the bank having
an imbalance between the amount of its foreign currency assets and foreign
currency liabilities.) With respect to the first, it is pointed out that a sharp
depreciation in a bank’s home currency or a sudden drying up of ability to
exchange domestic currency for foreign currencies can set in motion a series of
adverse developments for the bank— an immediate capital loss for the bank and
an impairment of its foreign currency liquidity condition, developments that can
trigger a sharp outflow of funding, particularly perhaps that provided by
foreigners. If domestic interest rates are raised, moreover, to defend the
exchange rate, the bank’s loan customers may not be able to service their loans
and the bank’s domestic funding cost would rise.

With respect to a bank lending in a foreign currency there are similar risks to
consider, from the other side. If the bank is lending to domestic borrowers in
foreign currency, a devaluation of the currency may result in these customers
being unable to service or repay their loans, creating cash flow problems for the
bank. If an overseas branch of a bank extends loans in the domestic currency of
the country in which it is located, it may find that the loans are not being serviced
or repaid and that may create liquidity pressures.

The Committee offers two principles for sound practice to deal with the risks just
described.

     A. Each bank should have a measurement, monitoring and control system
     for its liquidity position in the major currencies in which it is active. In
     addition to assessing its aggregate foreign liquidity needs and the
     acceptable mismatch in combination with its domestic currency
     commitments, a bank should also undertake separate analysis of its
     strategy for each currency.

     B. Subject to the analysis undertaken according to principle A, a bank
     should, where appropriate, set and regularly review limits on the size of its
     cash flow mismatches over particular horizons for foreign currencies in
     aggregate and for each significant currency in which the bank operates.

Two other comments offered by the Committee in its discussion of foreign
currency risk should be mentioned. First, in discussing issues involved in



                                           12
addressing various risks that arise with foreign currency activities, the advice is
offered that… ‘a simple but effective way to deal with these issues is for an
institution to hold foreign currency assets in an amount equal to foreign currency
liabilities.” Second, in discussion of principle B. above regarding cash flow
mismatches, the comment is offered: “A bank would typically have lower
mismatches for foreign currency than those tolerated for the domestic currency.”

E. Management Information and Reporting Systems

As discussed in the previous section, a major element of board and management
oversight of liquidity risk is a strong management information and reporting
system. All banks should have the ability to calculate their liquidity positions, on
a day-to-day basis for the shorter time horizons and over a series of specified
time periods thereafter. Banks should also have an equal ability to provide
relevant information on a bank’s liquidity condition on an accurate, complete and
timely basis to the bank’s board of directors, senior management and other
appropriate personnel.

Reports should be tailored to the needs of specific users. That is to say, reports
prepared for senior management or for the board of directors should contain
much less detail than reports prepared for the use of those responsible for the
day to day management of the bank’s reserve/settlement account or of its
investment portfolio.

A system should, among other things, fulfill the following requirements:

Ø Provide the board of directors, senior management and other appropriate
  personnel with timely, accurate, and complete information on the bank’s
  liquidity position, including indications of potential needs to make payments in
  cash (or cash equivalents) and             the availability of the bank’s liquidity
  resources ( either from reducing liquid assets or increasing liabilities) to meet
  those needs.
Ø Enable management to evaluate trends in the bank’s liquidity risk exposure.
Ø Provide management with information on the bank’s asset and liability
  positions in foreign currencies in the aggregate and in each individual
  currency in which it has a significant position.
Ø Periodically provide a clear indication of plans for how the bank would
  proceed to meet its liquidity needs under different possible types of liquidity
  conditions and circumstances.
Ø Periodically provide a review of the bank’s largest funds suppliers and a
  summary of the bank’s arrangements to obtain backup funding assistance
  from other banks, arrangements that have been both firmly established with
  the payment of a fee and those that are more informal in nature.
Ø Enable the management to check to see that the bank’s personnel are
  complying with the bank’s established policies and procedures and with
  limits established for its various liquidity risk positions.



                                          13
Ø Review periodically to determine that the information being conveyed in
  reports utilizes the most analytically useful information available and is
  presented in a format that facilitates quick understanding by those that are to
  rely on the report.
Ø Periodically insure, by audit, that information contained in reports is accurate
Ø Have the capability of increasing the frequency and content of reports should
  that be needed during a time in which the bank is experiencing liquidity
  difficulties.

Standard Types of Reports
Liquidity resources available to the bank and projected liquidity needs under
different possible conditions
Ø large funds providers;
Ø cash flow or funding gap report;
Ø funding maturity schedule;
Ø a report monitoring and exception report;
Ø asset quality and trends;
Ø earnings projections;


F. Internal Controls

Each bank must have an adequate system of internal controls over its liquidity
risk management process. A fundamental component of the internal control
system involves regular independent reviews and evaluations of the
effectiveness of the system and, where necessary, ensuring that appropriate
revisions or enhancements to internal controls are made. The results of such
reviews should be available to supervisory authorities. The internal controls for
liquidity risk management should be an integral part of the bank’s overall system
of internal control. They should promote effective and efficient operations, reliable
financial and regulatory reporting, and compliance with relevant laws, regulations
and institutional policies. An effective system of internal control for liquidity risk
includes:

Ø a strong control environment
Ø identifying and evaluating the bank’s process for measuring its liquidity risk;
Ø assessing whether the bank has an effective framework for managing
  liquidity risk, such as having appropriate policies and procedures;
Ø insuring that information contained in reports is accurate
Ø determining whether bank personnel continually adhere to the bank’s
  established policies and procedures.

III. PBOC Regulation and Supervision of Bank Liquidity Risk Management

A. PBOC Prudential Rules and Regulations




                                         14
PBOC derives its authority to supervise and regulate Chinese banks and foreign
funded banks operating in China from three Laws of the People’s Republic of
China

Legislative summary


       Articles under                 Relevant Powers Granted to PBOC
       People's Bank
       Law
       Article 4 (3)      examine, approve, supervise and control financial institutions
                          in accordance with regulations.
       Article 4 (4)      supervise and control the financial market in accordance with
                          regulations.
       Article 4 (5)      Promulgate orders and regulations relating to financial
                          supervision and control and to business operations.
       Article 30         Exercise supervision and control over financial institutions and
                          their operations according to law and shall maintain the lawful
                          and sound operation of the financial industry.
       Article 31         Examine and approve the establishment of, changes in,
                          termination of and scope of business of financial institutions.
       Article 32         Audit, inspect, and supervise the deposits, loans, settlement,
                          bad debts, etc. of financial institutions.
       Article 33         Entitled to require financial institutions to submit their balance
                          sheets, profit and loss statements as well as other financial
                          and accounting statements and information in accordance with
                          regulations.
       Article 34         Responsible for centrally preparing nationwide financial
                          statistical data and statements, and for publishing same in
                          accordance with the relevant state regulations.

        Articles under
         Commercial                 Relevant Powers Granted to PBOC
          Bank Law
       Article 10         Commercial banks shall accept the supervision and control of
                          the People’s Bank of China according to law.
       Article 39         In addition to specifying standard ratios for banks pertaining to
                          their capital adequacy (not lower than 8%),loan to deposit ratio
                          ( not greater than 75%), Liquid asset to liquid liability ratio ( not
                          lower than 25%), and loans to a single borrower (no greater
                          than 10% of the bank’s capital), this article also authorizes the
                          PBOC to issue other regulations concerning the control of
                          assets liabilities ratios.


        Articles under
       Foreign-           Relevant Powers Granted to PBOC
       Funded
       Financial
       Institutions
       Law


                                           15
       Article 36           Foreign-Funded Financial Institutions shall submit financial
                            statements and relevant information to the People’s Bank of
                            China and its relevant branches in accordance with
                            regulations.
       Article 37           The People’s Bank of China and its relevant branches shall
                            have the right to examine and audit the operation,
                            management and financial position of Foreign-Funded
                            Financial Institutions

PBOC uses its legal authorities to issue regulations and guidance on which
banks are required to comply. Among the most important of these for matters
pertaining to bank liquidity risk management are:

      Circular of the People’s Bank of China, No. Yinfa(1996)450

      Specifies a set of control and monitor indicators that establishes
      prudential standards for banks in their asset/liability management activities
      and provides PBOC staff with guidance for assessing whether banks are
      operating in a safe and sound manner in their off- site surveillance and
      on-site examination activities.

      Document from People’s Bank of China, NO. Yinfa (2000)127

      Establishes a basic framework of reports that should be prepared to
      present the results of offsite and onsite analysis of a bank’s condition and
      its policies and practices. Tables are specified for presenting information
      on a bank’s balance sheet and income statement, its liquidity condition,
      the quality of its assets, the adequacy of its capital, its financial status and
      the effectiveness of its internal controls. An outline and templates for
      tables is also provided for the preparation of a report on the results of an
      on-site examination of a bank.

      Document from People’s Bank of China, No.Yinfa(1998)49

      Provides guidance for banks and other financial institutions on how to
      prevent and deal with payment risk crisis of financial institution.( For
      further description see emergency financing schemes below.)

      Bank of Shanghai Circular (2001) No. 8

      This provides instruction to commercial banks on how to prevent and/or
      deal with an event in which they are experiencing a currency run by the
      public. It is a kind of contingency plan for currency runs.

      PBC Document Yinfa No.12 (1999)

      Notice on Temporary Management Measures Governing Short-term Re-
      loans Extended by Branches of PBC. These “short term reloans” are loans


                                           16
       for periods of less than 3 months that are extended by branches of the
       PBOC to solve the shortage of funds of commercial banks that fall with
       each branch’s jurisdiction. The Head Office of the PBOC allocates a quota
       of short-term reloans that the branches of the PBOC may extend to banks
       within their jurisdiction.

       People’s Bank of China Yinfa No. (1997)216

       Provides provisional regulations on Acceptances, Discount, and
       Rediscount of commercial bills of exchange

       People’s Bank of China, Shanghai Branch, Shanghai Yinfa No.
       (1999)414

       Temporary measure governing overnight lending of financial institutions in
       Shanghai. This is an end of day interbank lending/ borrowing facility
       managed by the Shanghai branch of the PBOC. The Shanghai branch is
       authorized to arrange a loan between a bank needing funds over night
       with a bank that has excess funds in its reserve/settlement account. The
       lending bank must sign a pre-agreement authorizing the PBOC to make
       such loans and to have submitted documentation specifying the maximum
       amount of credit exposure it is willing to have with each bank it is willing to
       extend a loan to.

       Shanghai Branch’s Document of PBC, Shanghai Yinfa {2000} No.002

       On-site Examination Procedures of Shanghai Branch of PBOC. Guidance
       issued by the PBOC, Shanghai to its sub-branches and the supervision
       departments of Hangzhou and Fuzhou. Its objective is to standardize on-
       site examination procedures, clarify examination responsibilities, and unify
       on-site examination activities within the jurisdiction of the PBOC Shanghai
       branch

B. Off-site surveillance

A primary means for discovering institutions that may be experiencing liquidity
difficulties is through the off-site supervision process. The PBOC has as its goal
to identify developing problem situations as quickly as possible so that it can take
prompt action to address them. On-site examinations are only carried out
periodically, so it is imperative that PBOC have an effective off-site surveillance
program to promote accomplishment of that end. In carrying out this activity, the
PBOC utilizes the following tools:

   Ø Reference to the last on site examination report of an institution
   Ø Analysis of financial data on the condition of a bank. Banks are required
     by the PBOC bank supervision department to submit reports on a
     quarterly basis of their balance sheet and income statements. These


                                           17
       reports also provide calculations of the statistical indicators described
       immediately below. Bank branches are also required to report financial
       data on a monthly basis to the PBOC’s statistics department.
   Ø   Statistical Indicators of the condition of a bank—A PBOC Circular sets
       forth a set of control and monitor indicators the PBOC will track in
       assessing the liquidity position and financial health of a bank. A
       supplemental set of indicators has been recommended for use by the
       PBOC.
   Ø   Payments Systems Data-additionally, PBOC will be able to track payment
       systems data from the current system and planned China National
       Automated Payment System, if it decides to implement a recommendation
       set forth in TA 3098 project.
   Ø   Early Warning System (EWS) Model—a tool the PBOC has developed
       and will have available as a consequence of the TA 3098 project. An EWS
       will enable surveillance to identify banks showing probable signs that their
       financial condition may deteriorate over a period of three, six, or twelve
       months into the future.
   Ø   Another source of surveillance information is that which is reported in the
       financial media or spread through market rumors that may indicate an
       institution is encountering financial problems.


1. PBOC Reporting Requirements

The PBOC requires each bank branch to file a quarterly report to the
Department of Bank Supervision at the PBOC branch office responsible for the
region in which it is located. This report is a hard copy (i.e., paper report) and
includes balance-sheet data, profit-and-loss data, and some financial ratios as
required by PBOC. Each bank branch also files monthly, quarterly, semi-annual,
and annual statistical reports to the Department of Statistics at the PBOC branch
office responsible for the region in which it is located. The report is filed
electronically within three business days after the end of the reporting period, and
is filed by hard copy within five business days after the end of the reporting
period. The quarterly report is identical to the quarterly report filed with the
Department of Supervision, i.e., it includes balance-sheet data, profit-and-loss
data, and some financial ratios. The monthly, quarterly, semi-annual, and annual
reports provide basically the same information. The Department of Statistics
maintains an electronic database that includes all of this branch information going
back to 1994.

Each of the head offices of the state-owned banks and shareholder banks is
required to file a consolidated quarterly financial report with the Department of
Bank Supervision at the PBOC’s head office in Beijing. Each of the head offices
of city banks files a consolidated quarterly financial report with the Department of
Bank Supervision at the PBOC branch responsible for the region in which it is
located. Each of the Foreign-Funded banks designates one branch as a head



                                          18
office and then files a consolidated monthly financial report (for all branches) with
the Department of Statistics at the PBOC branch responsible for the region in
which the designated head-office branch is located. The Department of Statistics
then forwards this information to the Department of Supervision.

2.Liquidity Indicators, Limits and Early Warning Indicators

The PBOC is responsible for monitoring the financial position of banks, including
indicators of their liquidity position. Currently, the PBOC requires commercial
banks to abide by a number of asset-liability ratios that provide a mechanism for
triggering increased scrutiny if the indicators suggest that an institution is
experiencing liquidity difficulties.

In a circular issued during 1996, the PBOC supplemented the ratios noted above
in the table for the Commercial Bank Law with others in an effort to establish
prudential standards in asset/liability and liquidity management, and to provide a
means for monitoring and assessing bank performance. As noted in the table
below, the circular specifies sixteen ratios. Six other ratios are presented without
specified target values. However, the PBOC monitors them as part of its
surveillance activities.

                                      PBOC Liquidity Indicators

Capital Adequacy Ratios:
Net capital to total risk weighted assets                                Greater than or equal to 8%
Kernel capital to total risk weighted assets                             Greater than or equal to 4%
Loan Quality Indicators:
Overdue loans to total loans                                             Less than or equal to 8%
Non-performing loans to total loans                                      Less than or equal to 5%
Bad loans to total loans                                                 Less than or equal to 2%
Individual Loan Indicators:
Loans to single borrower to net capital                                  Less than or equal to 10%
Loans to top ten borrowers to net capital                                Less than or equal to 50%
Deposit Ratios:
Deposits w/PBOC + Cash to total deposits                                 Greater than or equal to 5%
For. Currency deposits + for. Curr. To total for. Curr. Deposits         Greater than or equal to 5%
Placement/Taking Ratio:
Total money market taking to total deposits                              Less than or equal to 4%
Total money market placement to total deposits                           Less than or equal to 8%
Offshore Fund Application Ratio:
Offshore loans + offshore invest. + offshore dep. to for. curr. Assets   Less than or equal to 30%
International Commercial Loans:
Intl. Comm. Loans + offshore bonds to net capital                        Less than or equal to 100%
Deposit Loan Ratio Indicator:
Total loans to total deposits                                            Less than or equal to 75%
Medium to Long-Term Loan Ratio Indicator:
Loans over one year to deposits over one year                            Less than or equal to 120%
Liquidity Ratio Indicator:
Liquid assets to liquid liabilities                                      Greater than or equal to 25%
Other Ratio Indicators:



                                                      19
Additionally, a number of ratios are monitored by PBOC, but do not have a specified range into which they are
to fall. These include:
• a risk-weighted assets ratio;
• shareholder-loan ratio;
• foreign-currency assets ratio;
• interest recovery rate;
• capital-profit rate;
• and asset-profit rate.


PwC has recommended a number of liquidity indicator ratios to supplement those
listed in the table above. These ratios are presented and explained in detail in
Attachment 3 and Attachment 4 to the Final report for TA 3098. In addition to
ratio indicators PwC has also recommended that PBOC adopt Tables for
reporting information pertaining to a bank’s exposure to risks resulting from
activities involving derivatives, These tables were developed by the Basle
Committee on Banking Supervision and the International Organization of Security
Commissioners In addition, PwC has recommended that PBOC begin to use the
data reported monthly to its Statistics Departments to develop ratio measures
that can provide indications of a bank’s liquidity situation on a monthly basis and
also provide indications of changes in categories of loans by type of borrower
and use of funds that are borrowed. Finally, PwC has recommended that the
monthly data on deposits be combined with data obtained by the Operations
departments of the PBOC on total deposit balances every 10 days ( information
used to establish bank reserve requirements for the following 10 days to
construct and monitor short term developments in bank deposits.

If the PBOC decides to adopt some or perhaps all of these recommendations,
they should be integrated into this manual at this point.

3. If the PBOC decides to adopt the recommendation for using payment system
data for liquidity risk analysis, a summary of this analytical tool should be
provided here. Such a summary might say something like the following:

Payments-based indicators of liquidity risk are obtained from the files of the
inter-bank electronic payments transfer system and the PBOC accounting
system. These data are combined to create a transaction-by-transaction
settlement account balance for each bank. A dynamic monitoring of this data is
carried out to identify possible indications that a bank might be experiencing
liquidity problems. The dynamic monitoring system starts with the daily opening
settlement account balance for each bank, and then tracks each debit and credit
in temporal order. Each hour, the system creates a report, showing the hour’s
opening balance, total debits, total credits, number of transactions, and closing
balance. The system compares these hourly statistics against expected values
(based on reference to historical experience) in order to identify outliers, i.e.,
unusual values that warrant further analysis. When the system identifies an
outlier, it automatically generates an exception report and transmit it to an analyst
for further review and action.


                                                    20
In addition, banks now code their electronic payment orders to identify the nature
of the transaction that gave rise to the order, noting particularly when the
transaction is related to the extension or repayment of an interbank loan. This
data is used to identify any unusual inter bank borrowing activity by a bank,
another possible sign of developing liquidity problems.

Finally, the turnover ratio of the reserve/settlement account ( i.e. the total volume
of debits to an account on a day divided by its opening balance on that day) will
be monitored to identify unusual patterns of behavior.

4. PBOC Use of Early Warning Indicators/System

PBOC has developed an Early Warning System (EWS) as one tool for identifying
potential liquidity problems. At the heart of the EWS is a statistical model that
uses advanced econometric techniques to forecast a bank’s future financial
condition based upon the financial information it provides to the PBOC.
The EWS identifies banks showing probable signs of deterioration in financial
condition over a period of three, six, or twelve months into the future, thus
establishing the potential for them to suffer serious liquidity problems.
The measure used in the EWS as an indicator of a bank’s financial condition is
the Non-performing Asset (NPA) Coverage Ratio, which is more formally defined
as: (Capital + Loan-Loss Reserves - Non-performing Assets) / Total Assets, This
ratio measures the capital ratio of a bank under the assumption that its non-
performing assets are written down to zero.

Once the early warning forecast has been produced, it is used to rank order
banks from worst to best. A cutoff value is then set, and all banks with predicted
NPA coverage ratios worse than the cutoff value are flagged for more intensive
off-site analysis.

The focus of the proposed EWS is on the consolidated bank rather than the
regional branch. There are two reasons for this focus. First, senior management
at the bank level typically makes strategic decisions regarding a bank's
investment policy, funding policy, and capital structure. Second, a bank branch
cannot become insolvent unless the consolidated bank is insolvent.

C. Examination Procedures

Consistent with the "On-site Examination Procedures of the Shanghai Branch of
PBOC", the following discussion details the required steps that should be taken
in conducting a specially focused examination that is initiated because PBOC,
Shanghai has basis for concern that a bank may have serious liquidity or
structural problems. It is broken down into the same phases as is set forth in the
On-site Examination Procedures and assumes that the guidance given in that
document will be referred to in executing each phase:



                                           21
Ø Preparation phase--pre on-site preparation for the examination.
Ø Execution phase--on-site review of the bank.
Ø Settlement phase--post on-site activities.

1. Preparation Phase

The preparation for examinations will be risk-focused on two levels:
Ø the selection of institutions for examination will be made on the basis of
   analysis of the above discussed indicators or as a result of information
   reported to the PBOC by the bank itself or a third party
Ø the focus of the examination will be established with reference to the risks
   perceived on the basis of the same information as well as additional
   information obtained off site following the decision to carry out the
   examination.
Ø one source of such information can be the “questionnaire before
   examination,” perhaps supplemented with special questions related to the
   information that has given rise to the PBOC, Shanghai’s concern about the
   bank. Whether there is time to send a questionnaire will largely depend on the
   acuteness of a bank’s perceived problem, as indicated by whether it requires
   liquidity assistance from the PBOC. If the situation is acute, most of the areas
   requiring special attention will be apparent and any remaining areas will be
   identifiable on site
Ø an examination staff suitable for carrying out the planned examination should
   be selected
Ø a scheme for the examination should be established—that is, the major
   areas of liquidity risk to be evaluated should be specified and time to be
   spent in doing so enumerated.

2. Execution Phase –Jean Louis, the bullets below should be the same as above.
Why Vern used different ones is beyond me. Please make them the same.

Ø If a bank has an acute liquidity problem ( is receiving PBOC liquidity
  assistance) an immediate assessment should be made of all areas of the
  bank’s operations that have been identified as the source of its problems, as
  specified in the examination scheme. In addition, an evaluation should be
  made, again in accordance with the examination scheme, of the bank’s
  ongoing value as a business enterprise. This determination is to be made in
  discussion with the bank’s management and board of directors and possibly
  outside parties. ( These latter discussions might be carried out, in part, by
  senior PBOC officials off-site.) Unless this immediate assessment indicates
  that the bank is in such a weak condition that it should be taken over by the
  PBOC with prompt actions then begun to put it into bankruptcy, examiners
  should also evaluate all of the items listed immediately below

Ø If the situation is not acute, once again, the scheme developed for the
  examination should be followed


                                         22
Ø review all areas identified as potential sources for the bank’s liquidity or
  structural problems. In addition, evaluate other areas that these efforts
  indicate may pose problems previously unidentified

Ø In addition, carry out all of the following:

       review all policies and procedures on liquidity and funds management

--     review contingency funding plan and research previous use

--     review any available information from ALCM (meeting minutes, reports)

--     review compliance in practice with PBOC liquidity indicators and board-
       imposed limitations
--     review use of scenario analysis and emphasize need

--     use of off-balance sheet sources of funding

--     review all internal reports with regard to liquidity

--     detailed analysis of asset structure and ability to meet liquidity demands
       on a day-to-day basis.

--     detailed analysis of use of funding sources including stability of deposits
       and current or planned reliance on volatile liabilities

--     discuss overall liquidity policies and methodology (early)

--     discuss overall liquidity position with senior management (late)

all other procedures set forth in the On-site Examination Procedures Manual.

In short, the PBOC's goal in investigating the bank's circumstances, should be to
answer the questions:

What is the condition of the bank?

Ø Identify specific characteristics of the liquidity or structural problem-that
  is, the source of the bank’s problem (or problems) and its (their) severity, and
  whether they are specific to the affected financial institution or to a broader
  systemic phenomenon.

Ø Evaluate the bank’s value as an ongoing business entity-- that is,
  whether the bank has a special position in the market in which it operate,
  such as established close relationships with its loan or deposit customers



                                            23
   that may result in its having value in the market place greater than its book
   value.


3. Settlement Phase

Ø If the examination team decides that the bank has serious problems, it should
  immediately report its findings and its recommendations to PBOC senior
  management by telephone or other means of quick communication.

Ø if the bank’s problems are determined to be serious, senior management of
  the PBOC, Shanghai in consultation with senior staff of PBOC Headquarters,
  should decide on an appropriate course of action. ( See discussion in Section
  IV for detail, if it is determined that the bank has serious liquidity or structural
  problems.)

Ø a suggestion letter of examination should be prepared

Ø an on-site examination report should be prepared

Ø work papers for the examination should be compiled


IV. Rescue Schemes for Institutions with Liquidity Difficulties

A. Legislative and Regulatory Background

The power to take action regarding banks experiencing liquidity difficulties is
granted under the People's Bank Law and the Commercial Bank Law. The
following table summarizes the relevant sections regarding these laws:

       Table x: Legislative summary of Rescue Scheme Powers

        Article under
        People's Bank                  Relevant Powers Granted to PBOC
        Law
        Article 22           Provide loans to commercial banks.
        (PBOC
        Monetary Tools)
        Article 27           With regard to loans to commercial banks, PBOC may
        (Loans to            determine the:
                             • Amount;
        Commercial           • Term (not to exceed one year);
        Banks)               • Interest rate; and
                             • Method.

         Articles under



                                            24
  Commercial                Relevant Powers Granted to PBOC
   Bank Law
Article 64         If the creditworthiness of a bank becomes critical, the PBOC
(Assumption of     may assume control over the Bank.
                   The purpose of assumption of control is to take measures for
control)           the protection of the interests of depositors and resumption of
                   normal business activity.
Article 65         A decision to assume control shall clearly state the following
(Decision to       particulars:
                   • Name of the commercial bank involved.
assume control)    • Reason for assumption of control.
                   • Organization assuming control.
                   • Term of the assumption of control.
                   The decision to assume control must be publicly announced.
Article 66         Powers of operation and management of the bank are
(Assumption of     exercised by the organization assuming control.
control—Powers
& Management)
Article 67         PBOC may extend the term of control upon expiration.
(Extension of      The maximum term of control shall be two years.
and maximum
term of control)




                                   25
       Article 68          Assumption of control shall be terminated:
       (Termination of     • Term specified has expired.
                           • Bank has resumed normal business activities.
       assumption of
                           • Bank is merged or lawfully declared bankrupt.
       control)
       Article 71          If a commercial bank is unable to pay its debts as they fall
       (Declaration of     due, the bank shall be declared bankrupt by a People's Court
                           after PBOC consents.
       bankruptcy)


Additionally, PBOC has issued Circular 49 (1998) on "Procedure and method on
how to prevent and deal with payment risk crisis of financial institutions." The
major articles in this circular are noted below:

      Table 2: Circular on Rescue Scheme Actions


        Articles under
         Circular 49                             Issues Addressed

       Article 5           Every financial institution must set up an organization
       (Organization       structure to deal with a payment crisis.
       Structure)
       Article 9           If payment risk appears, a financial institution should timely
       (Payment Risk)      adjust its structure of assets and liabilities to respond to it.
       Article 10          The bank with payment problems can negotiate with creditors
       (Negotiations       to delay payment or swap its debt for equity.
       with Creditors)
       Article 11          A financial institution with a payment problem must have a
       (Board Meeting)     board meeting or shareholder meeting and involve PBOC.
                           The following methods can be used:
                           • Ask shareholders to put in more capital
                           • Ask shareholders, directors and senior management to
                                repay loans.
                           • Collect funds lent to other banks.

       Article 14          PBOC will issue a "reminder of payment" if banks do not meet
       (Reminder of        PBOC liquidity indicators
       Payment)
       Article 15          PBOC will issue a "warning letter" if a bank meets the
       (Warning Letter)    following circumstances:
                           • Liquid assets to liquid liabilities below 15%.
                           • Reserve/Total deposits below 13%
                           • Non-performing loan/Total loans above 30%
                           • Money market takings/placements ratio greater than 5%

       Article 16          PBOC will conduct an on-site examination for banks with a big
                           gap on payment.
       (On-Site
       Examination)


                                            26
        Article 17           PBOC will ask those banks with severe payment problems to
        (Replacing           have a board meeting to replace management
        Management)
        Article 18           PBOC should welcome complaints from customers and
        (Customer            explain to them the circumstances, but should not make a
                             commitment of repayment of debt.
        Complaints)
        Article 22           The PBOC branch should provide a report to the PBOC head
        (Loan from           office for approval if a bank with payment risk wants to get a
                             loan from the PBOC branch.
        PBOC)
        Article 23           The local government should take responsibility to fund
        (Local               financial institutions with non-performing loans resulting from
                             strong influence from the government.
        Government)

B. PBOC Tools for Initial Discovery of Rescue Candidates.

The PBOC will find out about the distress of an institution with liquidity and
structural problems through use of the supervisory tools discussed above. In
addition, on occasion it will learn of the problem from reports provided by other
banks or participants in the financial markets or in some cases by the distressed
institution requesting assistance and guidance.

C. Follow-Up Investigation

If an institution is identified as having a financial problem, the PBOC should
immediately make several determinations as to its characteristics. These
determinations can be accomplished through reliance on the full range of tools
noted in the previous section. For example, if a liquidity problem is discovered
through the EWS model, underlying financial data available through the off-site
supervision process may first be reviewed. A discussion with the bank to clarify
any question that remains unanswered may be required.

If these procedures do not clear up the matter, an on-site examination is
required. Examiners, in conducting such examinations, should carry out the
procedures discussed in Section III.C.

In short and in order of priority, the PBOC's goal in investigating the bank's
circumstances, should be to answer two questions:

What is the condition of the bank?

Ø Identify specific characteristics of the liquidity or structural problem-that
  is, the source of the bank’s problem (or problems) and its (their) severity, and
  whether they are specific to the affected financial institution or to a broader
  systemic phenomenon.




                                             27
Ø Evaluate the bank’s value as an ongoing business entity-- that is,
  whether the bank has a special position in the market in which it operate,
  such as established close relationships with its loan or deposit customers
  that may result in its having value in the market place greater than its book
  value.

What can be done to restructure the bank's finances?

Ø Identify whether immediate restructuring of financial position is an
  option-the problem may be addressed through a relatively straightforward
  restructuring of the institution's balance sheet; for example, through
  conversion of non-cash assets to cash or a quick sale of one of its business
  units, if one is available that can bring a market price well above its book
  value.

Ø Identify possible sources of additional capital for the bank-sources would
  include current shareholders, new shareholders, local or provincial
  governments, possibly the central government if public policy issues are
  involved, and various other types of potential investors

Ø Identify possible purchasers or merger partners-can be Chinese banks or
  other financial institutions; or consideration should be given to allowing foreign
  banks to undertake such actions


D. PBOC Supervisory Options

Under the current legislative and regulatory framework, PBOC has at its disposal
a variety of options to follow in supervising a bank that has problems of differing
degrees of severity. These options allow PBOC to match the stringency of its
action with the seriousness of the bank's financial difficulties and the perceived
capabilities of its management. To summarize the options:

       Table 3: Summary of Rescue Scheme Options by Severity of Action


           Category           Purpose of Status
        Reminder/         For institutions whose key liquidity indicators fall
        Warning Letter    outside of an accepted range, the PBOC may issue
        (Least Severe)    a reminder or warning letter. This letter is the
                          earliest notification that the bank's activities fall
                          outside what is acceptable to PBOC.

        Close PBOC        Applicable to institutions experiencing serious
        monitoring        structural problems and possibly liquidity difficulties.
        with              There is considerable uncertainty as to whether a



                                          28
        constraints       solution can be found for the bank's capital
        imposed on        deficiency and some basis for concern that the
        activities        bank’s management team may not be able, or will in
                          the end not be willing, to carry out effectively efforts
                          to recapitalize it and to restructure its other problems
        Assumption of     Applicable to institutions with severe structural
        control           difficulties, and unable to put in place a senior
                          management team that is acceptable to the PBOC.
                          The institution must still be considered to have
                          prospects for rehabilitation, sale or merger, but at
                          some point it may become clear that none of these
                          possible solutions will materialize . At which point the
                          institution should be placed in bankruptcy. In the
                          terminology of international best practices, this
                          category is referred to as placement into a
                          conservatorship.

        Bankruptcy        Institutions with liquidity difficulties accompanied by
        (Most Severe)     severe structural problems. The expectation is that
                          the bank cannot be returned to normal operations.
                          In the terminology of international best practices, this
                          category is referred to as placement into
                          receivership.




The next step is to match these options with the particular financial
circumstances and managerial qualities of the institution experiencing structural
difficulties.

In the case of all three of the approaches in which efforts are going to be
made to restore a bank to financial health or to have it sold to or merged
with another bank, one point deserves special emphasis: if the bank has a
capital deficiency, it should be required to provide a detailed plan to the
PBOC that will specify how it intends to proceed to restore its capital
position and to resolve its other problems. Also, the PBOC in all cases
should not accept these plans unless it determines that they are well
designed and have at least a reasonable for success.

1) Reminder/ Warning Letter

The least severe of the options obviously is the first. In Circular 49 (1998) (the
Circular), PBOC has created a good, initial notification to banks that their
structural position does not meet required standards. The circular applies a two-
tiered approach. If the bank does not meet the criteria set forth in the PBOC's



                                          29
liquidity indicators, the bank will receive a reminder that it should bring its
financial position in line with these criteria. If there is further deterioration in the
financial position of the bank and the indicators reach the levels specified in
Article 15 of the Circular, then the bank is issued a warning letter and is required
to submit a payment risk analysis to the PBOC, and as noted above should be
required to provide a plan as to how it intends to eliminate this deficiency

The responses codified in the Circular are a good method for notifying a bank
that its structural/ liquidity position is worthy of attention and that PBOC will
commit its regulatory resources to monitoring the bank's condition and will take
additional action if it is not promptly improved.

Under this option, the PBOC will not generally be closely involved in the day to
day or week-to-week operations of the bank. It should be chosen on the basis
that the assessed degree of capital deficiency of the bank appears to be
relatively manageable, that the capital restoration plan submitted by the bank
seems reasonable and attainable and on the basis that the PBOC has
confidence in the management and board of directors of the bank.


2) Close PBOC Monitoring

A bank warranting this particular stance will have a greater degree of estimated
capital deficiency, one that will increase the likelihood that in order to resolve its
problems, its owners and managers will have to make important concessions
with respect to their claims on the future earnings of the bank and their control
of the bank. In addition, the PBOC will have less confidence in the bank’s
management and in its board of directors. Frequent and detailed written reviews
should be required from the bank’s management discussing the management’s
efforts to strengthen the operations of the bank, deal with its asset quality
problems, and resolve its capital deficiency. Frequent meetings should also be
held between the bank’s senior executives and PBOC senior officials.


3) Assumption of Control

If after a reasonable period of time the management of a bank operating under
close PBOC scrutiny does not seem to be meeting with success in efforts to
restore the bank to health, the PBOC may decide to take control of the bank. Or
in other situations the PBOC may conclude early on that the bank should not be
allowed to operate under its own selected management and will immediately
assume control. Such PBOC actions should be reserved for circumstances
where the liquidity situation is serious, capital is deficient and the PBOC has lost
faith that the current management team is capable of effectively managing the
bank through its present crisis and that the bank’s board of directors will not be
able to assemble another team that can do an acceptable performance.



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To further emphasize the seriousness of this step, it should be noted that under
current law a PBOC decision to take over control of a bank must be publicly
announced. A decision to take control could thus have a number of
consequences. It may trigger a more decided outflow of the bank’s funding,
because it would call public attention to the bank’s problem. It may also
adversely impact the value of the assets in and franchise value of the bank.


4) Bankruptcy

when an illiquid bank has little if any chance of recovering from its serious
structural problems, it will not be extended PBOC liquidity assistance for more
than a short time, just long enough for the PBOC to arrange an orderly takeover
of the bank and for a People’s Court to determine whether it should be declared
bankrupt.This prompt approach is meant to discipline shareholders and poor
bank managers by linking poor performance with exit from the system. Moreover,
it is followed to avoid compounding the losses of a bank that can otherwise result
when a bank, facing severe capital and liquidity difficulties, decides to engage in
highly risky activities in a desperate attempt to make large returns and restore its
financial health.

E. PBOC Liquidity Assistance

Note to PBOC: It is not clear to the PwC team whether the PBOC will want
to include a section on PBOC lending to troubled financial institutions in
this manual whose focus in on regulatory and supervisory matters. We
offer the following in case the PBOC decides to include such a section.

As noted above, Article 22 of the Law of the People’s Republic of China on the
People’s Bank of China authorizes the PBOC to provide loans to commercial
banks, and it does so without placing restrictions on lending to troubled
institutions.

The PBOC’s current policy is that its branches and sub-branches do all of its
lending. These loans are to be made to the branches of the four state-owned
banks and the ten shareholding banks. On the other hand, only the head offices
of the ninety-nine city commercial banks may borrow from the PBOC’s branches
and sub-branches. There is also one city bank in Beijing that may borrow from
the PBOC Beijing operating office rather than from the PBOC head office. The
PBOC’s expects a branch of a bank to first seek assistance from its headquarters
before turning to the PBOC branch or sub branch for a loan (re-loan). If it is late
in the day and there is no time to obtain funds from its head office, a branch of a
bank may borrow from the local PBC branch or sub branch.




                                          31
It takes time to make a careful assessment of a bank’s condition and time to
decide whether or how its problems might be resolved. The PBOC will provide
liquidity assistance to a troubled bank over this period, if the bank does not have
sufficient liquidity and is unable to obtain liquidity assistance from other
reasonable sources, to meet outflows of funding from depositors and creditors.
Whether or for how long the PBOC will continue to provide assistance beyond
the assessment period will depend on the condition of the bank and the nature of
the circumstances prevailing at the time.

PwC advises not being any more specific than what is stated in the above
paragraph in this manual, in order to assure that it has maximum flexibility
and discretion in dealing with each troubled bank case. If the PBOC
decides to implement a policy that would require banks borrowing from the
PBOC, in all cases, to secure their loans with collateral, that policy should
be spelled out here.




PBOC Liquidity Circulars and Regulations
     PBOC Circular 450 (1996)
     PBOC Circular 49 (1998)
     Regulations on the Control of Renminbi Interest Rates (1999)




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