Banking on foreign investment: recent developments

Since China's accession to the World Trade Organization ("WTO"), foreign banks have been waiting patiently for the opportunity to participate more actively in China's banking industry. China's WTO commitments provided new possibilities for business development but rather than opening the floodgates, China has welcomed a steady influx of foreign banks.

As of the end of October 2003, 191 business establishments had been set up in China by 62 foreign-funded banks from 19 countries and regions. Of these, 84 had obtained the authority to engage in Renminbi business. Though the stated objective of the China Banking Regulatory Commission (the "CBRC") is eventually to bring these institutions under the same regulatory regime as domestic banks, at present foreign-funded banks occupy a special position and are subject to specific foreign investment rules.

Banks and finance companies

Under Chinese law, foreign investors can invest in five types of foreign investment vehicle: (i) the wholly foreign-owned bank, (ii) the joint venture bank, (iii) the branch of a foreign bank, (iv) the wholly foreign-owned finance company and (v) the joint venture finance company (collectively "foreign-funded financial institutions" or "FFIs"). The main distinction between the banks and bank branches on one hand and the finance companies on the other hand is that the deposit-taking power of finance companies is severely restricted. Finance companies may take deposits of no less than RMB 1 million or the equivalent in a freely convertible currency for periods of no less than three months, whereas banks and bank branches have a general power to take deposits from the public. Also, banks and bank branches can provide letter of credit services, engage in foreign currency exchange, engage in bank card business and provide safe deposit box services, whereas finance companies cannot.

The new legislation

On December 27, 2003, China promulgated the Law of the People's Republic of China on the Regulation of the Banking Sector and amended the Law of the People's Republic of China on Commercial Banks and the Law of the People's Republic of China on the People's Bank of China. As discussed in Overhauling China's Banking System: The Regulatory Issues, the main purposes of this new legislation are to provide the legal basis for regulation by the CBRC and to move closer to Basel principles of prudential regulation. While the new legislation is important to FFIs because it establishes and sets out the powers and role of the regulator-the CBRC (see Overhauling China's Banking System: The Regulatory Issues), for FFIs the shift towards prudential regulation had begun earlier.

WTO, Basel and foreign-funded financial institutions

When joining the WTO, China promised that licensing criteria in the financial services sector would be solely prudential and there would be no economic needs test or quantitative limits on licenses. When securing this commitment, China's trading partners were not necessarily interested in increasing prudential regulation-they were more interested in getting rid of any economic needs tests or quotas for licenses. Nevertheless, China issued legislation almost immediately after WTO accession that moved closer to the prudential banking supervision principles advocated by the Basel Committee on Banking Supervision in its 1997 Core Principles for Effective Banking Supervision (the "Core Principles"): the Regulations of the People's Republic of China for the Administration of Foreign-Funded Financial Institutions (the "FFI Regulations") issued on December 20, 2001 and the Detailed Implementing Rules for the Foreign-Funded Financial Institutions (the "FFI Implementing Rules") issued on January 25, 2002.

Under the FFI Regulations, applicants to establish an FFI must meet "prudential conditions" specified by the regulator (at that time the People's Bank of China, now the CBRC). A key goal of the Core Principles is to ensure that regulatory authorities have the power to impose prudential requirements administratively. The Basel Committee considered this a necessary precondition for any effective banking supervision system. The FFI Regulations also introduce the requirement that the regulatory authority in the applicant's country must approve the application to establish an FFI in China. This follows Principle 3 of the Core Principles.

Apart from licensing, other ongoing regulatory requirements in the FFI were based on the Core Principles. The 8 percent capital adequacy ratio is based on the Basel Committee's 1988 Capital Accord, which is required to be applied for internationally active banks by Principle 6 of the Core Principles. The 25 percent cap on lending to a single borrower and its affiliates is based on Principle 9.[1] The FFI Implementing Rules' provisions prohibiting preferential lending to related parties is based on Principle 10.

Geographic restrictions on Renminbi business

When joining the WTO, China promised to lift restrictions on business in the local currency-Renminbi - in stages over a number of years. On October 24, 2003, the CBRC issued Announcement No. 2 to meet China's commitment for further liberalization within the second year after accession. Announcement No. 2 provides that beginning from December 1, 2003, FFIs in Jinan, Fuzhou, Chengdu and Chongqing may apply to engage in Renminbi business. FFIs that have already been authorized to engage in Renminbi business may expand their Renminbi business area to include the said four cities. Also, FFIs may, upon approval from the CBRC, begin providing Renminbi services to Chinese enterprises in areas that have already been opened up to Renminbi business. On February 4, 2004, China granted approval for the Shanghai Branch offices of HSBC, Mizhuo Corporate Bank, Ltd., Citibank and the Bank of East Asia to provide Renminbi services to Chinese enterprises.

Although the liberalization on Renminbi services is encouraging, foreign banks still face significant market access restrictions on banking services not least the prohibition on providing Renminbi services to Chinese individuals, which is not expected to be permitted until 2006.

Liberalization of restrictions on RMB business

Foreign investment in Chinese financial institutions

One of the components of China's plan to reform the Chinese banking system is to permit a certain amount of foreign investment in Chinese financial institutions. The Chinese authorities believe that the introduction of foreign capital will have a positive impact on capital conditions in Chinese banks and will help raise management standards. While China has approved such investment previously on a case-by-case basis, China has now decided to formalize the rules and procedures governing such investment. The CBRC, accordingly, issued the Measures for the Administration of Investment and Acquisition of Equity in Wholly Chinese-Owned Financial Institutions by Foreign Financial Institutions (the "Equity Acquisition Measures") on December 8, 2003. They came into force on December 31, 2003.

The Equity Acquisition Measures permit international financial institutions (such as the World Bank and other intergovernmental development banks) and foreign financial institutions to acquire equity in wholly Chinese-owned financial institutions. "Foreign financial institutions" are defined to mean financial holding companies, commercial banks, securities companies, insurance companies and funds registered and established in foreign countries as well as other foreign financial institutions recognized by the CBRC.

Permitted targets are wholly Chinese-owned commercial banks, municipal credit unions, rural credit unions, trust and investment companies, enterprise group financial companies, financial leasing companies and other wholly Chinese-owned financial institutions the establishment of which has been approved by the CBRC.

A single investor may not acquire equity of more than 20 percent in a Chinese financial institution.

If foreign investors together acquire 25 percent or more of an unlisted financial institution's total equity, the financial institution will be treated as a foreign-funded financial institution, presumably with the corresponding tax benefits and restrictions on types of permitted business. However, if foreign investors acquire more than 25 percent of the total equity in a listed financial institution, the financial institution will continue to be treated as a wholly Chinese-owned financial institution.

In order to qualify to invest, the foreign investor's total assets at the end of the preceding year must, in principle, have been at least:

- US$ 10 billion if the target is a commercial bank;

- US$ 1 billion if the target is a municipal or rural credit union;

- US$ 1 billion if the target is a nonbank financial institution.

The investor must have shown profits in the preceding two accounting years. The capital adequacy ratio of a commercial bank must be at least 8 percent. The total capital of a nonbank financial institution must not be less than 10 percent of its total risk-weighted assets. The investor must also have received a good long-term credit rating for the previous two years from an international rating agency recognized by the CBRC.

Conclusion

The recent measures heralding greater market access must be viewed as part of a long- term strategy for foreign banks in the Chinese market. The increase in foreign ownership limits and the expansion in the scope of permitted business activities are attempts by China to fulfill its WTO obligations and for the CBRC to introduce a more attractive operating environment for foreign banks. The banking regulator is aware that foreign banks will bring much needed financial expertise to the industry, which can help to improve the performance of China's domestic banks and providing adequate funding for China's growing economic needs.

[1] See Basel Committee on Banking Supervision, Core Principles Methodology (1999), "Additional Criteria" to Principle 9 on p. 24 (available at http://www.bis.org/publ/bcbs61.htm).