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A Step Forward for China’s Interbank Market

by | May 17th, 2014 | 07:42 pm
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After several months of negotiation behind closed doors, new regulations for the interbank market have now emerged. Last fall, talk of a new set of rules began to surface as regulators caught on to the scope and scale of regulatory arbitrage in the interbank market. The momentum for reform seemed to then fizzle out for the next six months or so, leaving many to speculate that the banks had managed to fight back against the new regulations. Without much forewarning, the rules emerged yesterday in a joint statement by the PBoC, CBRC, CSRC, CIRC, and SAFE, referred to as Document 127.

There are two core risks that have emerged from the rapid growth of the interbank market in recent years. First, banks have devised a series of roundabout ways to transform corporate and trust loans into interbank assets. This effectively transforms assets with high risk weightings into assets with low risk weightings, reducing the amount of capital banks must hold. Second, many medium and small-sized banks have become large net borrowers in the interbank market, growing more rapidly than their deposit bases would normally allow. This shift has led many of these banks to have significant exposure to wholesale funding markets, increasing the risk of sudden liquidity crunches.

The new regulations try to address these problems with several new reforms and regulations. Banks are now all required to report interbank loans on their balance sheets. Banks will also be required to track the total borrowings of firms through both interbank and traditional lending channels. Additionally, third-party guarantees for financial assets available for resale are now prohibited. This puts a crimp on the sale of trust beneficiary rights through the interbank market.

New quantitative limitations are also being added to banks’ interbank activities. Interbank exposure to a single counter-party cannot exceed 50 percent of a bank’s Tier 1 capital. A bank’s total interbank liabilities cannot exceed one-third of its total liabilities. Maturities for interbank loans may not exceed 3 years and maturities for other interbank products may not exceed 1 year.

These restrictions are useful in terms of heading off some of the growing in the interbank market, even if they are a bit watered down compared to what was being discussed last fall. However, the incentives for regulatory arbitrage will remain as long the financial system remains distorted. Banks will inevitably find new ways to avoid prudential regulations on loan amounts and capital requirements. The new reforms are a step in the right direction, but more followup is needed to put China’s financial system back on safer footing.