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Five things to know about how China is tackling 'too-big-to-fail'

Work proceeding on 'living wills' for financial institutions, but details fuzzy

High-profile bailouts have sent shock waves through China’s financial sector and capital markets. (Source photos by Reuters)

Bailing out failed financial institutions has been a big headache for China's financial regulators over the past three years, as they have tried to protect the financial system from the risks posed by massively indebted companies. Two of the highest-profile rescues have been of Anbang Insurance Group, and Baoshang Bank. Others that have been or are being restructured by national-level regulators or local governments include Hengfeng Bank and Bank of Jinzhou.

The takeover and restructuring of Anbang, whose collapse was brought about by an aggressive, debt-fueled expansion undertaken by its now-imprisoned founder, began in February 2018 and took two years to complete as regulators and financial experts struggled to untangle its complex and opaque operations.

Baoshang Bank, an Inner Mongolia-based regional lender, was next. Taken over by the central bank and the country's banking regulator in May 2019, it was the first high-profile seizure of a bank in two decades. Investigators found a 220 billion yuan ($34 billion) hole in its books, due largely to misappropriation by Tomorrow Holding, its largest shareholder.

These high-profile rescues sent shock waves through China's financial sector and capital markets. They exposed not only how much of a risk some of the country's smaller banks posed to financial stability but also the inadequacies of the regulatory framework in identifying risks early on and dealing with them.

In the wake of the bailouts, and the expectation that more failures were likely as the government overhauled the financial sector and recapitalized the banks, regulators worked to put a more robust system in place to deal with potential collapses.

The result is the "Interim Measures for the Implementation of the Recovery and Resolution Plans of Banking and Insurance Institutions" issued by the China Banking and Insurance Regulatory Commission (CBIRC) in early June. The measures, which include provisions for "living wills," aim to prevent and resolve major risks, ensure the orderly recovery and resolution of problematic financial institutions, and maintain financial stability, the commission said.

Here are five things to know about living wills.

What are living wills?

Living wills, formally known as recovery and resolution plans (RRPs), are contingency plans that key financial institutions, especially those considered too big to fail, must put together to plan their own recovery if they get into serious trouble, or to ensure an orderly winding down if they cannot be saved. The plans are aimed at identifying and preventing risk and, in the event of a financial crisis, minimizing the need for taxpayer-funded bailouts.

RRPs came into being in the wake of the Global Financial Crisis when several large, globally active financial institutions either failed, like Lehman Brothers, were sold cheaply to other institutions, such as Bear Stearns and Merrill Lynch, or had to be rescued through taxpayer bailouts, such as Lloyds Banking Group and Royal Bank of Scotland in the U.K.

Leaders of Group of 20 nations tasked the Financial Stability Board (FSB), the international body that monitors the global financial system, with developing a policy framework to strengthen scrutiny of these "too-big-to-fail institutions" to prevent any more disorderly collapses that could threaten financial stability, and to help avoid further government bailouts. The FSB came up with a set of principles and standards for the supervision of global systemically important financial institutions (G-SIFIs), which went into effect in 2011. RRPs are part of that framework.

Although regulators in individual countries are tied to the FSB's guidelines for G-SIFIs, they have more flexibility for domestic systemically important financial institutions (D-SIFIs). They make the decisions about what constitutes a D-SIFI, and can pick and choose which bits of the FSB's regime are appropriate for their country, as well as formulate their own laws and rules to apply to the designated institutions.

There are two parts to an RRP. The first is the recovery plan, which is meant to detail how a financial institution will rescue itself. It should identify potential triggers of crisis and should cover issues such as how the institution will overcome capital or liquidity shortages, how it will raise money from shareholders to fund a rescue and how it will continue to operate while the rescue is underway.

The second is the resolution plan, which sets out how the orderly winding down of a financial institution should be handled if the recovery plan fails or causes spillover effects that could endanger the financial system, and what kind of external help might be required to do this, such as a capital injection from strategic shareholders, sale to another institution, a bailout or liquidation.

Why does China want financial institutions to draw up living wills?

As the bailouts of the last three years have shown, most of the risks to financial stability in China stem not from the biggest banks and insurers but from smaller lenders, insurance companies and other financial institutions such as trust companies. Many of these institutions have been brought down by corruption, risky lending or poor management decisions, but big shareholders or top management have been willing to take these risks because of the implicit guarantee that should they get into trouble the government will bail them out.

"Too-big-to-fail" and "small-but-easy-to-fail" are two pain points that living wills are aimed at addressing, the CBIRC said at a news conference announcing the rules in June.

Regulators have been determined to put a stop to this moral hazard and in recent years have repeatedly indicated that the days of a guaranteed rescue are over. The living will measures reinforce this message by putting the onus on the companies themselves to come up with viable rescue plans that force shareholders and creditors to bear most of the pain.

Chinese regulators have been testing the waters with living wills for several years. As the world's second-largest economy and home to four of the 10 biggest commercial banks by assets, China has become a key part of the global financial system, and as such needs to comply with international standards and regulations.

State-owned commercial lenders Bank of China, Industrial and Commercial Bank of China, Agricultural Bank of China and China Construction Bank, were identified as G-SIFIs, respectively, in 2011, 2013, 2014 and 2015, and Ping An Insurance of China was also added in 2013. As a result, they have had to regularly update their RRPs and submit them to the CBIRC.

Although China's regulators have yet to name the country's D-SIFIs, in December, they released rules to evaluate lenders and enable regulators to identify which need to be included in a list of domestic systemically important banks (D-SIBs). Those on the register will be subject to additional, as yet unspecified, regulatory requirements in terms of capital, leverage ratios and information disclosure.

Who is affected by the new rules?

-- Commercial banks, rural credit cooperatives and other deposit-taking institutions, as well as financial leasing and asset management companies with consolidated assets exceeding 300 billion yuan ($46.4 billion);

-- Insurance companies with assets of more than 200 billion yuan;

-- Other banking and insurance institutions that do not meet the above criteria but are identified by the CBIRC as needing to submit RRPs based on their business characteristics, risk status and the potential spillover effects should they fail.

However, the CBIRC has yet to name any institutions that will be subject to the measures.

Who is responsible for drawing up living wills?

The onus is firmly on the financial institutions themselves. They will have to prepare their own RRP and submit it to the CBIRC, which will assess it and ask for adjustments if problems are found. The recovery plan must be updated every year and the resolution plan at least every two years.

The rules stipulate that the board of directors of a financial institution bear ultimate responsibility for the development of and updates to the living will, and a clear division of responsibilities among shareholders and senior management during times of crisis must be spelled out.

China has followed regulators in other major economies as far as implementation of the recovery part of the RRP is concerned, leaving the institution to draw up its plans for the CBIRC's evaluation.

It has also taken a similar path to the U.S. for the resolution part, requiring the financial institution to put together a proposal that is then submitted to the regulator for assessment. The process is different in Europe, where the responsibility for drawing up a resolution plan is held by the Single Resolution Board (SRB), a European Union agency that acts as the resolution authority for banks in the euro area, and national resolution authorities, not the institution itself.

The CBIRC hasn't publicly specified deadlines for institutions to submit their RRPs, but industry insiders have told Caixin that some banks and insurers will need to hand in their proposals to regulators this year, while others will be given until next year.

What challenges do living wills pose for financial institutions?

Drawing up a credible living will is easier said than done. Many financial institutions lack the resources and capability to develop these plans, finance experts have told Caixin.

"As part of the recovery plan, institutions are instructed to carry out stress tests to analyze fluctuations in capital and liquidity under various scenarios, which will require them to develop quantitative analysis models," said Cao Jin, head of financial risk management at KPMG China, an accountancy. "To do this, they need effective risk data aggregation, but the ability of Chinese institutions in this area is still relatively weak."

The majority of domestic financial institutions are not sufficiently prioritizing the stress tests, as they still assume that a government bailout is guaranteed, Cao said. At the same time, the stigma around bankruptcy and crisis may make institutions reluctant to touch on such issues.

Key analyses appearing in the plans all rely on comprehensive and accurate data from banks' transactions, risk and finances, which may be difficult for banks with weak data governance to produce, said Zeng Gang, a deputy director-general of the National Institution for Finance and Development.

Financial institutions also face the challenge of having to constantly update their living wills, as stipulated by the CBIRC.

The requirement will add significantly to their workload, as updating the plans involves repeated data analysis, and conducting stress tests, Zeng said. Each update will require the establishment of a working group of three to five people and take up to three months to complete, which might be a tough job for banks both in terms of the added demands on their internal systems and employees.


Read also the original story. is the English-language online news portal of Chinese financial and business news media group Caixin. Nikkei recently agreed with the company to exchange articles in English.

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