Analysis of the Main Changes and Implications of Capital Rules for ...
Title: Analysis of the Main Changes and Implications of Capital Rules for Commercial Banks (Draft for Comments)
On February 18，2023，the former China Banking and Insurance Regulatory Commission (now the National Administration of Financial Regulation) and the People's Bank of China (PBC) issued Capital Rules for Commercial Banks (Draft for Comments) (hereinafter referred to as the new Capital Rules)，which is scheduled to be officially implemented on January 1，2024. The new Capital Rules represent the first major revision of China's capital rules for commercial banks in the past decade. It incorporates and adopts the Basel Committee's final reform proposals for Basel III，which were released in December 2017，and makes appropriate adjustments based on China's national conditions. This is expected to help banks improve their risk management capabilities and enhance the quality and efficiency of their services to the real economy.
Main Changes in the New Capital Rules
Under the first pillar，implement differentiated supervision according to local conditions.
The diverse conditions of China's banks are taken into account，including differences in asset size，business positioning，and customer base. Based on the size of banks' on- and off-balance sheet assets (with 500 billion yuan and 10 billion yuan as the dividing lines) and whether they engage in cross-border business，banks will be divided into three tiers and subject to differentiated capital regulation. Tier 1 banks (with assets exceeding 500 billion yuan) will be subject to international standards. Tier 2 banks，with relatively fewer assets and smaller cross-border business sizes (assets between 10 billion and 5,000 billion yuan，or less than 10 billion yuan but engaged in cross-border business)，will be subject to simplified regulatory rules. Tier 3 banks with assets below 10 billion yuan will have further reduced capital requirements，simplified capital measurement，and will be encouraged to focus on serving the country economy and small and micro enterprises. Additionally，the regulatory authorities have made it clear that the level of a bank should only be raised，not lowered.
The Federal Reserve implements a tiered regulatory system for domestic banks，categorized into five tiers based on criteria such as bank size and asset quality. Banks should establish effective risk management and regulatory compliance measures in line with regulatory standards. In contrast，China's hierarchical regulatory system is more stringent. On the one hand，China's regulatory requirements for measuring the capital items of various banks are consistent. The Federal Reserve allows Tier 4 and Tier 5 banks to exclude Accumulated Other Comprehensive Income items from capital. The Silicon Valley Bank incident exposed the drawbacks of this system. On the other hand，the liquidity supervision of small and medium-sized banks under the segmented supervision of the US commercial banks tends to be loose，and there are no specific requirements for the LCR and NSFR of Tier 4 and Tier 5 banks. Chinese regulators have clearly established regulatory requirements for liquidity indicators for banks with asset sizes exceeding 200 billion yuan.
Reconstruction of Risk-Weighted Asset Measurement Standards
Based on the Basel Committee framework，Chinese regulatory authorities have balanced simplicity，comparability，and risk sensitivity to construct risk-weighted asset measurement rules with Chinese characteristics. Overall，this revision restricts and standardizes the use of the IRB approach and refines the risk categories of the standardized approach.
Enhanced comparability of credit risk internal rating-based approach
The new Capital Rules revised the scope，measurement standards and parameter settings of the internal rating-based (IRB) approach. Firstly，it restricted the use of the IRB approach，such as not allowing financial institutions and companies with annual revenues exceeding 3 billion yuan to use the advanced IRB approach to measure their risk exposure and requiring equity risk exposure to be measured only by the standardized approach. Secondly，it added requirements for qualified risk migration tools such as requiring full insurance for real estate assets and maintaining first priority liens. Thirdly，it adjusted risk measurement parameters，changing the method of calculating loss given default (LGD) slightly lowering the minimum value of LGD but increasing the discount factor and raising the minimum threshold of probability of default (PD). Fourthly，it set a permanent baseline of 72.5% for risk weighted assets (RWAs) which means that RWAs，calculated using the advanced IRB approach cannot be lower than 72.5% of RWAs calculated using the standardized approach，thus reducing the arbitrage space of internal models.
Enhancing the sensitivity of credit risk standardized approach
The new Capital Rules have made significant revisions to the risk classification and parameter settings of the standardized approach，aligning it with international regulatory reforms. Firstly，a more detailed risk classification system was introduced，which included ten categories such as sovereign exposures，exposures to non-central government public sector entities (PSEs)，and new additions such as real estate exposures and defaulted exposures. Secondly，it has applied more reasonable drivers，such as dividing commercial banks into four tiers (A+，A，B，C) based on their compliance with capital regulatory requirements，setting loan-to-value (LTV) parameters for real estate risk exposure，and assigning different risk weights accordingly. Furthermore，the risk weight categories have been adjusted to be more sensitive. For example，the risk weight for public sector entities has been reduced，the risk weight for general local government bonds has been lowered from 20% to 10%，and the risk weight for corporate exposures has been subdivided into investment-grade，small and medium-sized enterprises，and micro-enterprises，with weights of 75%，85%，and 75%，respectively.
Improving market risk measurement and reducing arbitrage space
The new Capital Rules strictly regulate the conversion process between trading and banking books，and construct Expected Tail Loss (ES) methods to replace the original internal model-based Value at Risk (VaR) and Stress VaR (SVaR) methods，capturing the fat tailed risk of market volatility.
Constructing an operational risk standard based on the "de-modeling" and "de-complexity" concept
The new Capital Rules abolish the advanced model-based measurement approach，restrict the low sensitivity ba