China's central bank and banking regulator Wednesday promulgated a regulation that allows commercial banks to issue subordinated bonds to boost their capital adequacy levels.

Proceeds from such bonds, which rank after other bank liabilities in terms of claims on bank assets, can be calculated as non-core or second-tier capital. The regulation, jointly enacted by the People's Bank of China (PBOC) and China Banking Regulatory Commission (CBRC), followed a CBRC circular at the end of last year which in effect gave commercial banks the long-awaited green light.

The new regulation specifies the applicant bank needs to have a 5 percent upwards core capital ratio if it applies to issue subordinated bonds in the interbank bond market. The core capital requirement is 4 percent for those planning private placements.

All applicants must have adopted the stricter five-category loan classification system which the CBRC is promoting in the industry. They must also have adequately set aside bad loan provisions, and have sound corporate governance mechanisms, according to the regulation.

The new rule "enables commercial banks to broaden capital-raising channels, enhance capital strength, and is conducive to improving the situation of inherited bank capital inadequacy and limited capital-replenishing channels," said a joint spokesperson for the PBOC and CBRC. Allowing banks to issue bonds will also increase public scrutiny of them and help improve regulatory efficiency, he said, as the issuing banks will have to enhance information disclosure for their investors and try harder to improve performance to keep the borrowing cost from going up.

The majority of Chinese banks, including three of the four state-owned commercial banks, have fallen short of the 8 percent minimum requirement for capital adequacy ratios, making the sector vulnerable to financial risks.

This is especially so given their massive non-performing loans. Total non-performing loans currently stand at around a staggering 2 trillion yuan (US$240 billion), according to banking regulators.

Failure to meet the internationally accepted 8 per cent minimum capital adequacy ratio is also a major hurdle to the banks' plans to list on the stock market. The Bank of China and China Construction Bank, the two pilot banks that won a combined US$45 billion government recapitalization at the end of last year, both have plans to list on overseas stock markets as early as next year.

China formulated its capital supervision framework in the 1990s according to the Basel Capital Accord of the 1988, but stopped short of including subordinated debt as part of its second-tier capital, as many countries do.

Previously, only additional paid-in capital, undistributed profits, reserves, and stock offerings were eligible avenues for broadening the capital base of commercial banks.

Prior to the regulation, a few joint-stock commercial banks had already issued subordinated bonds, which were all privately sold to institutional investors, many of whom were insurance companies.

(China Daily June 24, 2004)