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SNAI Symposium

Risk Management Commercial Banks in China

Observations, Issues, and Approaches

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Central Bank

• State Commercial Bank• National Commercial Banks• Regional Commercial Banks• City Commercial Bank• Foreign Bank• Joint-Venture Banks• Foreign Bank Branches

State Commercial Banks National Joint-Stock Commercial Banks Other Commercial Banks

• Industrial & Commercial Bank of China

• Agricultural Bank of China• Bank of China• China Construction Bank

• Bank of Communications• China Everbright Bank• China Merchants Bank• China Minsheng Banking

Corporation• CITIC Industrial Bank• Guangdong Development Bank• Hua Xia Bank• Industrial Bank• Shanghai Pudong Development

Bank• Shenzhen Development Bank

• 100+ city commercial banks

• 1,000+ urban cooperatives• 38,0000+ rural

cooperatives

Foreign Banks• 190 + foreign banks

Other Institutions• trust & investment

companies• financial companies• lease companies

• China Development Bank• Export/Import Bank• Agricultural Development

Bank

Commercial BanksPolicy Banks

Overall China Banking System

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Macro Backdrop

GNP Annual Growth (%)

0%1%2%3%4%5%6%7%8%9%

10%

2000 2001 2002 2003 2004

Banking Sector Annual Loan Growth (%)

0%

5%

10%

15%

20%

25%

30%

2000 2001 2002 2003 2004

% NPLTotal Banking Sector 12.4%State Owned Banks 15.0%Joint Stock Banks 4.9%City Commercial Banks 11.5%Agricultural Banks 6.1%Foreign Banks 1.2%

NPL% 2005 Q1

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PlannedEconomy

Free MarketEconomy

Dependenton Sovereign

Support

BorrowerStands on

its own

Analysis is highlyContext Dependent

Explicit analysis ofcounterparty, -- less context dependent

FREE MARKET MINDSET:• Awareness of risk / return relationships• “Buy in” on legal and accounting concepts that allow for

setting up an explicit framework

3 Dimensions of Transition

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Major Risks that Banks Face

• Credit risk

• Operational risk

• Market risk

• Interest rate risk

• Strategic risk

• Reputation risk

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A lot of work done

• Risk tools and concepts

• Reinforcement of risk governance structure

• Tight NPL targets and goals

• Clamping down on lending, with continual emphasis on credit control

• Reprimand letters and penalties to send a strong message against breaking rules

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Results have varied

with some falling below expectations.

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Risk metrics and tools

• Absolutely essential to instilling a credit culture.

If done in haste:• Often done in an ivory

tower.• Not always matched to

business needs.• Users may not

understand or accept.

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Tight NPL targets and goals

• A highly visible metric.

• In isolation, what does it mean?

• How do we ensure it is accurate?

• Is it enough?

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Clamping down on lending, with continual emphasis on credit control

• Sends a clear message that the bank cares about credit risk.

• Encourages the credit underwriting participants to comprehensively vet their proposals.

• Often done unilaterally, in which case:

• It creates an adversarial atmosphere

• RMs still try to get “risky” deals through; it just takes them more work to “convince credit”.

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Reprimand letters and punishments to send a strong message

• A necessary initial tactic. • Often aimed at the consequence of an action rather than the action itself.

• In which case it may lose its effectiveness.

• Need tools which enable the bank to consistently discourage the actions themselves, regardless of whether the consequence is large or small.

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Risk Management as a control function toBusiness Development

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By strengthening

control…

…We can reduce risk

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Strengthen control to

reduce risk …

… But insist on growing assets

and profit

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What can happen when a bank strengthens control to reduce risk but separately insists on growing assets and

profit ?

• Slow decisions• Less business• Still have losses

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Special Issues

• Compensation system

• Branch centric structure

• Impacts on risk identification and NPL identification.

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Process Implications

• Long cycle times

• Unnecessary repetitive steps

• Rework

• Fragmented approach

• Ill-defined monitoring policies (if they exist at all)

poor risk management

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Toward tearing down walls and building an integrated approach

• Common language

• Shared metrics and methodology

• Aligned roles

• Integrated strategy

• To achieve a united goal: “Profit from Risk”

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Common Language:Profit from “Risk”

Do we understand risk to be:a) The probability of default and

its consequences?

b) Factors that influence volatility?

c) What we can’t define?

d) An unacceptable degree of any of the above?

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Divided by a common word

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Shared metrics and methodology

• Need common understanding of what we are trying to measure.

• Establish buy-in with the RMs that measuring, managing, and pricing for risk is worthwhile, not just for “risk management” but for business.

• Financial modeling with inaccurate financial statements – does this make sense?

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Analyzing Financial Risk:Reliability of Financial Statements

• Adherence to accounting standards

• Historical orientation toward funds allocation

• Emphasis on rules rather than principles

• Tax emphasis

• Inventory is valued at cost, not lower of cost or market

• Liberal terms for accounting for bad debt

• Lack of disclosure for contingents

• Exchange gains/losses not recognized when incurred, rather amortized over up to 5 years

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Analyzing Financial Risk:Other special factors

• Difficult to ascertain the conditions under which other banks are lending in order to access pari passu status

• Tendency for companies to have manufacturing and company holding activity reflected in its financial statements - difficult to evaluate the investments.

• Difficult to ascertain specific entity or person who has ownership or control

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Assessing Secondary Sources of Repayment

• Collateral– Legal Recourse to Collateral– Gaining Possession– Liquidation

• Guarantee– Legal / ethical recourse to guarantor– Guarantor’s ability to honor guarantee

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The “five grade classification system” compared with grading systems used by certain international banks

五级分类

关注类次级类可疑类损失类

正常类

Loss

Normal

Loan Classificaiton System

Especially Mentioned

Substandard

Doubfull

CreditGrade (PD)

Product Risk(EAD and LGD)

EL

1 2 3 4 5 6 7 8 9

10 11

Loss

Especially Mentioned

Substandard

Doubfull

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Credit Spreads

0

100

200

300

400

500

600

700

800

AAA AA A BBB BB B CCC

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Aligned Roles

Typical Traditional Mission:• The mission of credit

management is to uphold the asset quality for the Bank to be a bank of best asset quality in the market.

• The purpose of credit policy is thus to ensure that credit risk … is identified so as to reduce it to the minimum.

Revised Mission:• Our mission is to work in

partnership with business units to align and execute the Bank’s risk strategies

• in order to build a well diversified, accurately assessed risk portfolio

• which produces reliable and attractive risk-adjusted return to investors.

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What’s the difference?Traditional Mission: Revised Mission:

• Credit Management upholds quality

• Risk and Business work in partnership

• We want the BEST asset quality

• We want accurately assessed asset quality

• We want to keep risk to a Minimum

• We want reliable and attractive risk-adjusted return.

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Messages to RMs and Credit Approvers

• We need to be highly disciplined in managing risk..

• When business development contemplates a deal, they should incorporate the cost of risk into their profitability calculations.

Risk is a cost of doing business, and an extremely precious resource.

• When examining deals, risk managers should maintain an integrated view, remembering that risk is but one component of profitability, and not eliminate revenue potential by mechanically insisting on eliminating all risk.

• By achieving that we can most effectively cooperate together to achieve our goal of “profiting from risk”

With that as a prerequisite:

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What does this have to do with Basel II?

Everything!

How do we as Risk Managers pitch Basel so that Bankers view it as “good

business” and not just a compliance task?

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