China's Troubled Bank Loans:Workout and Prevention

by

Jianbo Lou

KLUWER LAWINTERNATIONAL

LONDON - THE HAGUE - BOSTON

TABLE OF CONTENTS

Preface xixList ofAbbreviations xxi

PARTI BACKGROUND

Introduction

Background: The Problem Stated 3Structure of the Book 6Methodologies 11

Generalization versus Specialization 11Economic Analysis versus Legal Analysis 11

1. China's Bank Non-performing Loan Problem: Seriousness,Causes and Solution 13

1.1 Introduction 131.2 The Seriousness of the Bank NPL Problem in China 14

1.2.1 The Seriousness: The Large Amount of Existing NPLs andIncreasing New NPLs 14

1.2.2 Negative Effects of State Bank NPLs 161.2.2.1 Negative Effects on State Banks 161.2.2.2 Negative Effects on the Economic Reform and

the Growth of Real Economy 181.2.3 Summary 21

1.3 Causes of Bank NPLs—The Theoretical Framework 211.3.1 Soft Budget Constraints 22

1.3.1.1 The Concept of Soft Budget Constraints and ItsApplication 22

1.3.1.2 Consequences of Soft Budget Constraints 231.3.1.3 Sources of Soft Budget Constraints 23

1.3.2 Market Discipline—A Mechanism to Curb Soft Credit 241.3.2.1 General Introduction—The Theory of Market

Discipline 241.3.2.2 Market Discipline as a Mechanism to Curb

Unsustainable Borrowing and Its Conditions 25

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1.3.3 Failure of Market Discipline—the Ultimate Root of theBank NPL Problem in China 27

1.4 Causes of Bank NPLs—Empirical Analyses 281.4.1 The Bank-Centric and State-Bank-Dominated Financial

System in China 281.4.1.1 Bank-Centric Finance in China 281.4.1.2 The Domination of State Commercial Banks 31

1.4.2 Soft Budget Constraints on SOEs in the Form of PolicyLoans 331.4.2.1 General Introduction 331.4.2.2 Policy Loans for Development Purposes 341.4.2.3 Policy Loans to Subsidize Loss-Making SOEs 371.4.2.4 Failure of Market Discipline due to Policy

Loans 391.4.3 Administrative Controls on State Commercial Banks 39

1.4.3.1 Administrative Controls on State CommercialBanks as Instruments to Implement MonetaryPolicy 39

1.4.3.2 The Credit Plan 401.4.3.3 Interest Rate Controls 421.4.3.4 Division of Business Scope Among State

Specialized Banks 441.4.4 Weak Infernal Control Systems Within State

Commercial Banks 461.4.5 Inappropriate Banking Regulation and Supervision 471.4.6 Summary 48

1.5 Three Basic Strategies to Deal With the Bank NPL Problem 481.5.1 Large Scale Bank Closure and Liquidation 491.5.2 Regulatory Forbearance 51

1.5.2.1 Regulatory Forbearance in General 511.5.2.2 The Failure of Regulatory Forbearance Solution

to the Thrift Crisis in the United States 521.5.2.3 The Failure of Japan's Regulatory Forbearance

Policy and the Subsequent U-Turn 561.5.2.4 Regulatory Forbearance in China: A Failed

Policy 591.5.3 Bank Restructuring 60

1.5.3.1 Justification for Bank restructuring 601.5.3.2 Ten Critical Points in Managing and Resolving

a Systemic Bank Crisis and Their Implicationsfor China 61

1.5.4 Summary 631.6 Conclusion 63

1.6.1 A Systemic Problem 631.6.2 A Comprehensive Bank Restructuring is Needed in

China 641.6.2.1 The NPL Problem Must Be Solved Immediately 641.6.2.2 Enterprise Debt Restructuring 641.6.2.3 The Creation of New NPLs Must Be Prevented 65

Table of Contents ix

1.6.2.4 Avoiding Shocks from the NPL Problem 651.6.2.5 Enhancing Market Discipline Should Be the

Main Theme in NPL Workout and Prevention 65

PART II NON-PERFORMING LOAN WORKOUT

2. Bank Recapitalization and AMC Program 69

2.1 Introduction 692.2 Institutional Framework for Bank Restructuring 69

2.2.1 Institutional Framework for Bank Restructuring in theUnited States and Asian Crisis Countries 702.2.1.1 The Institutional Framework under FIRREA in

the United States 702.2.1.2 Institutional Framework in Asian Crisis

Countries 702.2.2 Institutional Framework for Bank Restructuring in

China 712.2.2.1 There is No Need for New Institutional

Framework in China 712.2.2.2 Who Should Take Responsibility for Bank and

Enterprise Restructuring in China? 722.3 Recapitalizing the Big Four 73

2.3.1 Justification for Government Recapitalization of theBig Four 742.3.1.1 The State Ownership of the Big Four 742.3.1.2 The Low Profitability of the Big Four Denotes

that they Cannot Grow out of the ProblemThemselves 74

2.3.1.3 The Difficulty of Raising Capital in Other Ways 752.3.2 Options for Recapitalization—Theoretical Analyses 76

2.3.2.1 Capital Injection versus Liquidity Provision 772.3.2.2 Asset Side versus Liability Side 78

2.3.3 How Should the Big Four be Recapitalized? 792.3.3.1 Central Bank versus Treasury 792.3.3.2 Cash Injection versus Bond-Bad Debt Swap 802.3.3.3 Ex-ante Recapitalization versus Ex-post

Recapitalization 822.3.4 Comments on China's Bank Recapitalization Practices 83

2.3.4.1 Special Treasury Bonds in China to RecapitalizeBanks 83

2.3.4.2 Bond-Bad Debt Swaps 852.3.5 The Conflicts Between Recapitalization and Market

Discipline 862.3.5.1 Methods to Enhance Market Discipline: Asian

Experiences 862.3.5.2 Implications for China 88

2.4 China's AMC Practices 902.4.1 Why Asset Management Companies in China? 90

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2.4.1.1 Polish Experience: Leaving the NPLs inside theBanks 90

2.4.1.2 Advantages and Disadvantages of theSpecialized Agency Solution: Experience ofAsian Crisis Countries 92

2.4.1.3 Implications for China 952.4.2 China's Use of AMCs 952.4.3 Characteristics of China's AMCs 97

2.4.3.1. Bank-Specific AMCs 972.4.3.2. State Ownership and Heavy Administrative

Colour 992.4.3.3 Wide Business Scope and Powers 100

2.4.4 Problems with AMC Practices in China andRecommended Solutions 1002.4.4.1 The Dilemma Faced by Chinese AMCs 1002.4.4.2 The Dependence of AMCs on Their Banks 1022.4.4.3 The Funding Problem 1032.4.4.4 The Lack of Expertise and Experience 1042.4.4.5 Difficulties in Evaluating Assets 105

2.4.5 Immediate Legal Issues Related to AMC Practices inChina 1062.4.5.1 The Notification Obligation Under Contract Law 1062.4.5.2 Accomplishing Legal Procedures for the

Transfer of Security Interests 1072.4.5.3 AMCs' Liabilities to Debtors 107

2.5 Summary 108

3. Non-performing Loan Disposal and Debt Restructuring 111

3.1 Introduction 1113.2 Two Management Strategies Towards NPLs and their

Implications for China 1123.2.1 Two Management Strategies Towards NPLs 1123.2.2 Choosing the Right Strategy: The Experience of

Malaysia and South Korea 1133.2.3 Implications for China 114

3.3 NPL Disposal 1153.3.1 Selling Collateral Underlying Loans 1153.3.2 Loan Collection 1173.3.3 Selling Off NPLs Directly 1183.3.4 Securitizing NPLs 118

3.3.4.1 Securitization: General 1183.3.4.2 Securitization in China 1193.3.4.3 A Proper Legal Infrastructure Must Be

Developed to Promote Securitization in China 1203.3.4.4 Prospects 123

3.3.5 The United States RTCs Practice in Quick Disposal ofAssets and its Implications for China 1243.3.5.1 The RTC Practice in Disposing of Assets 1243.3.5.2 Implications for China 126

Table of Contents xi

3.3.6 Obstacles to Selling NPLs to Foreign Investors 1273.3.7 Summary 128

3.4 Enterprise Debt Restructuring 1283.4.1 Debt Restructuring versus Financial Restructuring 1283.4.2 Why Debt Restructuring? 1293.4.3 A Theme for SOE Debt Restructuring—Reducing Their

Excessive Debt-Asset Ratio 1303.4.3.1 The Excessive Debt-Asset Ratio of SOEs in

China—An Explanation of SOEs'Deteriorating Profitability 130

3.4.3.2 Negative Effects of Excessive Debt-Asset Ratio 1313.4.3.3 Korean Experiences 1333.4.3.4 Conclusion 134

3.4.4 The Debt-Equity Swap Scheme 1343.4.4.1. Debt-Equity Swaps: International Experiences 1343.4.4.2 The Development of Debt-Equity Swap in

China 1353.4.4.3 Policies Behind the SETC Debt-Equity Swap

Scheme 1373.4.4.4 Problems with the Current Debt-Equity Swap

Scheme and Recommended Solutions 1413.4.4.5 AMCs' Exit Problem 1453.4.4.6 Summary 148

3.4.5 Problems with Debt Restructuring in China 1493.5 A Proper Legal Infrastructure for Debt Disposal and

Restructuring 1493.5.1 Creditor Passivity of Banks in China: The Lack of an

Efficient Loan Collecting Mechanism in China 1503.5.1.1 The Phenomenon 1503.5.1.2 The Causes 1513.5.1.3 Policy Recommendation 157

3.5.2 The Lack of Appropriate Arrangements to FacilitateNegotiation Between Creditors and Debtors 1573.5.2.1 Comparative Studies: Models and Principles for

Corporate Debt Restructuring 1573.5.2.2 Designing a Structure Fitting the Special Needs

of China 1683.5.2.3 Collective Action Problems in Debt

Restructuring 1743.5.2.4 Pro-claim debts 175

3.6 Conclusion 177

PART III NON-PERFORMING LOAN PREVENTION

4. Enhancing Prudential Banking Regulation and Supervision 181

4.1 Introduction 1814.2 The Evolution of the PBOC as Bank Regulator and Supervisor

in China 182

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4.2.1 The PBOC Before 1984 1824.2.1.1 1949-1952: The Establishment of the PBOC 1824.2.1.2 1953-1978: The Mono-Bank Period 1834.2.1.3 1979-1984: The Separation of Commercial

Banking Business from the PBOC 1844.2.2 The PBOC After 1984 184

4.2.2.1 1984-July 1993 1844.2.2.2 July 1993-June 1996: The PBOC as both Financial

Administrative Agency and Financial Police 1864.2.2.3 June 1995-Present: The Development of

Prudential Regulation in China 1874.2.3 The PBOC Develops into an Exclusive Banking

Regulator and Supervisor 1884.3 Enhancing the PBOC's Independence and Autonomy,

Restructuring the Organizational Structure of the PBOC and theDivision of Financial Supervisory Duties Between the PBOCHeadquarters and Branches 1904.3.1 Enhancing the PBOC's Independence and Autonomy 190

4.3.1.1 Why a More Independent PBOC? 1904.3.1.2 A Historie Review of the PBOC's Independence

and Autonomy before the 1995 CentralBanking Law 191

4.3.1.3 An Independent Central Bank Under theCentral Banking Law? 192

4.3.2 The PBOC Organizational Structure Restructuring 1974.3.2.1 Streamlining the PBOC Headquarters 1974.3.2.2 Reshuffling the PBOC Branches 198

4.3.3 The PBOC Regulations on Financial SupervisoryResponsibilities 2014.3.3.1 The Division of Supervisory Duties Between

the PBOC Headquarters and its Branches atVarious Levels 201

4.3.3.2 The Assessment and Monitoring of theFinancial Supervisors at Various Levels 202

4.3.4 Summary 2034.4 Removing Unnecessary Administration Restrictions on State

Commercial Banks 2034.4.1 Indirect Monetary Policy Instruments versus Direct

Monetary Policy Instruments 2044.4.2 Credit Guidance versus Credit Plan 204

4.4.2.1 The Removal of Credit Plan 2044.4.2.2 The Introduction of Credit Guidance 2064.4.2.3 The Implications of the Reform 207

4.4.3 Decontrol of Interest Rates 2074.4.3.1 China's Current RMB Interest Rate

Administration System under the 1999 InterestRate Administration Provisions 207

4.4.3.2 Efforts Towards the Liberalization of InterestRates 208

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4.4.3.3 Prospects of Interest Rate Liberalization inChina 211

4.5 Current Banking Regulation and Supervision in China:Compared to the Basle Core Principles for Effective BankingSupervision 2124.5.1 Licensing Process and Approval for Changes in

Structure 2134.5.1.1 The Core Principles' Requirements 2134.5.1.2 Licensing and Structure Change Approval in

China 2134.5.1.3. Are China's Requirements In Conformity with

the Basle Core Principle? 2154.5.2 Arrangements for Ongoing Banking Supervision 216

4.5.2.1 Prudential Regulations and Requirements 2164.5.2.2 Methods of Ongoing Banking Supervision 219

4.5.3 Sanctioning: Formal Powers of Supervisors 2274.5.3.1 China Has Developed a Set of Supervisory

Measures to Bring about Prompt CorrectiveAction (PCA) 227

4.5.3.2 Problems with China's PCAs and ImprovementRecommendations 228

4.6 Summary 230

5. Promoting Bank Internal Control Systems 234

5.1 Introduction 2345.2 The Basle Committee's Framework for Internal Control

Systems in Banking Organizations 2345.3 Development of Bank Internal Controls in China 235

5.3.1 Bank Internal Controls Before the Issuance of PBOCGuidelines for Enhancing Internal Controlsin Financial Institutions 235

5.3.2 The 1997 PBOC Guidelines for Enhancing InternalControls of Financial Institutions: In Comparison withthe Basle Committee Internal Control Paper 2365.3.2.1 Definition and Objectives of Internal Controls 2365.3.2.2 Primary Elements of Internal Controls of

Commercial Banks 2375.3.2.3 Evaluation of Internal Control Systems by

Supervisory Authorities 2455.4 Problems with Internal Controls of Chinese

Commercial Banks 2455.4.1 The Organizational Structure of State Commercial

Banks 2455.4.1.1 The Organizational Structure of State

Commercial Banks 2455.4.1.2 Diversifying the Ownership Structure of the

Big Four: A Solution to their CorporateGovernance Problem? 248

5.4.2 The Information Problem 251

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5.4.2.1 Efforts of the PBOC to Help Commercial BanksObtain External Information 251

5.4.2.2 Further Issues 2535.4.3 Prospects 253

5.5 The Introduction of a New Loan Classification System 2535.5.1 Basle Committee's Sound Practices for Loan Accounting

and Disclosure 2535.5.2 The Development of China's Loan Classification and

Provisioning System 2545.5.2.1 China's Former Loan Classification Systems and

their Problems 2545.5.2.2 The Introduction of the Five-Level Classification

System into China 2575.5.2.3 The New Loan Classification System—

Guidelines for Loan Classification 2585.5.2.4 The PBOC Guidelines versus Basle Committee

Sound Practices for Loan Accounting andDisclosure 264

5.5.3 Loan Provisioning 2675.5.3.1 The Insufficient Loan Provisioning of China's

Commercial Banks 2675.5.3.2 General Provisions versus Special Provisions 2685.5.3.3 Banks' Discretion to Make Provision for and to

Write off Loan Loss 2715.5.3.4 Taxation and Loan Loss Provisioning 272

5.6 Summary 272

6. Banking Safety Net: Mechanisms for Crisis Management 275

6.1 Introduction—Designing a Bank Safety Net 2756.2 Central Bank's Role as Lender-Of-Last-Resort 276

6.2.1 A General Introduction 2766.2.1.1 Understanding LOLR Properly 2766.2.1.2 The History and Theoretical Foundation of

LOLR 2776.2.1.3 Defining LOLR in Practice 2776.2.1.4 Rationale for LOLR— LOLR versus Market

Discipline 2796.2.2 Defining the PBOC's LOLR Role 280

6.2.2.1 The LOLR Role of the PBOC is not wellDefined in China 280

6.2.2.2 Legal Definition of LOLR: The United States,United Kingdom and Japan Models 282

6.2.2.3 Implications for China 2846.3 Introducing A Deposit Insurance System into China 285

6.3.1 Why Deposit Insurance? 2856.3.1.1 A Brief Survey of Deposit Insurance Programs

Worldwide 2856.3.1.2 Pros and Cons of Deposit Insurance 2866.3.1.3 Doctrine of Necessity 288

Table of Contents xv

6.3.1.4 Replacing the Implicit Government Guaranteein China With Explicit Deposit Insurance 289

6.3.2 Issues to be Considered and Principles to be Followedin Designing China's Deposit Insurance System 2916.3.2.1 Issues to be Considered 2916.3.2.2 Principles For Designing a Deposit Insurance

System 2926.3.3 Designing China's Deposit Insurance System 294

6.3.3.1 Organizational Structure, Coverage andFunding of the Deposit Insurance System 294

6.3.3.2 Deposit Insurance Premium 2976.3.3.3 Membership of the Deposit Insurance System 2986.3.3.4 Summary 299

6.3.4 Timing the Introduction of Deposit Insurance 3006.4 Insolvency Resolution 300

6.4.1 General Introduction 3006.4.2 Closure and Liquidation (Deposit Payoff) 301

6.4.2.1. Out of Court Liquidation: Voluntary Closureversus Administrative Closure 302

6.4.2.2 Bankruptcy 3066.4.3 Merger or Takeover (Purchase and Assumption) 311

6.4.3.1 General Introduction 3116.4.3.2 The Practice in China 312

6.4.4 Rescue Package or Open Bank Assistance 3136.4.4.1 General Introduction 3136.4.4.2 Application in China 314

6.4.5 Management Takeover (A Variation of Bridge Bank) 3156.4.5.1 Bridge Bank Practices 3156.4.5.2 Management Takeover in China 315

6.4.6 Problems with China's Bank Insolvency Resolution 3166.4.6.1 Uncertainty in Treating Foreign Creditors 3176.4.6.2 The PBOC's Autonomy in Dealing with

Problem Institutions 3186.4.6.3 Inadequate Transparency and Disclosure 318

6.4.7 Building up a Solid Legal Infrastructure for InsolvencyResolution 3196.4.7.1 General Consideration: Shall China Have

Special Legislation on Bank InsolvencyResolution? ' 319

6.4.7.2 Issues Need to be Clarified for BankInsolvency Resolution in China 321

6.5 Conclusion 322

PART IV CONCLUDING OBSERVATIONS

7. Concluding Observations and Recommendations for RestoringMarket Discipline in China 327

7.1 Introduction 327

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7.2 The Failure of Market Discipline—The Ultimate Root of theState Commercial Bank NPL Problem 3277.2.1 The Captive Financial Markets 3287.2.2 The Information Problem 3287.2.3 The Bailout Expectation 3297.2.4 The Lack of Response to Market Signals by Borrowers 329

7.3 Systematic Banking and SOE Restructuring—Strategies Towardsthe Bank NPL Problem in China 3307.3.1 The Need for Comprehensive Bank and SOE

Restructuring 3307.3.2 Key Steps for Bank and SOE Restructuring in China 331

7.4 Resolving the Stock of NPL: Bank Recapitalization and NPLManagement 3317.4.1 Recapitalization of State Commercial Banks versus

Market Discipline 3317.4.1.1 New Institutions to Lead Bank Restructuring 3327.4.1.2 Ex-ante Recapitalization versus Ex-post

Recapitalization 3327.4.1.3 Private Sector-Based Solutions and Conditioning

Public Support 3337.4.2 AMC Practices in China: Can AMC Impose Market

Discipline on SOEs? 3347.4.2.1 Characteristics of AMCs in China 3347.4.2.2 The Debt-Equity Swap Scheme in China 3357.4.2.3 Problems with China's AMC Practices 3357.4.2.4 A Necessary Legal Framework for NPL

Management in China 3387.4.2.5 Conclusion 340

7.5 NPL Prevention: Developing a Partnership RelationshipBetween Banking Regulation and Market Discipline 3407.5.1 Why a Partnership Relationship Between Banking

Regulation and Market Discipline? 3407.5.1.1 Rationale for Regulation, Rationale for Market

Discipline 3407.5.1.2 The Limitation of Regulation 3417.5.1.3 Conclusion 342

7.5.2 The Development of Prudential Banking Regulation inChina and its Compatibility with Market Discipline 3437.5.2.1 Fostering Competition Should be one of the

Objectives for Banking Regulation andSupervision in China 343

7.5.2.2 Removing Administrative Controls on BanksCompletely 343

7.5.2.3 Promoting Disclosure Standards andAccounting Practices 344

7.6 Designing an Appropriate Banking Safety Net to EnhanceMarket Discipline and Prudential Regulation in China 3457.6.1 The Overall Consistency Between Bank Safety Nets and

Market Discipline 345

Table of Contents xvii

7.6.1.1 The Inherent Moral Hazard Problem 3457.6.1.2 Understand Safety and Soundness Properly 3467.6.1.3 Bank Safety Net Must Be Well-Designed and

Operated 3467.6.2 The Relationship Between Bank Safety Net and Banking

Prudential Regulation 3487.7 Concluding Remarks 348

Selected Bibliograph}/ 351

Index 405