A wider range of TLAC-eligible instruments will help China's "big four" banks to narrow gaps in regulatory capital requirements set to come into effect in 2025. S&P Global Ratings anticipates a flurry of nonpreferred bond issuance over the next year will chip away at the shortfall, which we estimate at Chinese renminbi (RMB) 3.7 trillion (US$550 billion).

The relevant banks are required to hold total loss-absorbing capital (TLAC) that is equal to 16% of risk-weighted assets, by Jan. 1, 2025. To satisfy this requirement, the big four Chinese banks are likely to issue a combination of traditional regulatory capital instruments alongside a new class of bond. Senior nonpreferred instruments could comprise around 40% of total TLAC by the time the requirement becomes operative. This proportion is similar to that of peers in developed economies that began using the new instrument a few years back.

Four megabanks in China are designated as global systemically important banks (G-SIBs): Industrial and Commercial Bank of China Ltd., China Construction Bank Corp., Agricultural Bank of China Ltd., and Bank of China Ltd.

Still Hefty, But Down From Our Previous Estimates

Our latest capital gap estimate is about 40% below our previous estimate of RMB6 trillion, in 2020. This is because profits have been better than we expected and growth has slowed for risk-weighted assets as well as issuance of regulatory capital instruments by Chinese G-SIBs in the past few years. Moreover, in 2022, the Basel-based Financial Stability Board (FSB) lowered China Construction Bank to bucket 1 on the G-SIB list, from bucket 2. That in turn lowered the bank's capital-buffer requirement, alleviating the capital shortfall Chinese G-SIBs are facing (see "How Are China's Big Four Banks Addressing The RMB6 Trillion TLAC Gap?," published on RatingsDirect on Aug. 25, 2020).

In late April, the central bank and the China Banking and Insurance Regulatory Commission issued a directive outlining rules for Chinese G-SIBs' issuance of nonregulatory TLAC . The directive widens the channels for TLAC issuance from these banks, in our view.

We do not expect the issuance of the new TLAC bond class to add significantly to debt leverage, because the senior nonpreferred debt will likely replace some maturing senior unsecured debt. Based on current regulations, both TLAC-eligible senior debt and senior unsecured bonds will share the same regulation and the same issuance quota.

Chart 1

Cross-Holdings Of TLAC Instrument Add To Potential Contagion

The investor base of the new class of TLAC bonds will likely tilt toward Chinese financial institutions over the next one to two years, which could add to the contagion risks in the Chinese financial system. Historically, 60% of the onshore Tier-2 subordinated bonds issued by banks are invested in by Chinese banks, insurers, and wealth-management products (held by retail investors and some institutional investors). We see Tier-2 bonds as a close peer to senior nonpreferred debt, with the former being one level junior in the bank capital hierarchy.

China's bank capital market has a less-diversified investor base by global standards, in our view, because banks play a dominant role and nonbank financial institutions and institutional investors have less of a presence.

Chinese G-SIBs are granted a five-year grace period before being subject to the standard deduction period of such holdings. For non G-SIB Chinese banks, the capital charge on TLAC-eligible senior debt is more lenient than Basel standards. Hence, non-GSIB Chinese banks have more flexibility to invest in these instruments.

That said, we expect the investor base will widen, for a number of reasons. One is that the Chinese G-SIBS' potential cross-holding of TLAC will be constrained by regulations, as well as by capital deductions on banks' TLAC holdings after five-year grace periods. We also expect Chinese authorities will take measures to broaden the investor base of the bank TLAC capital market to reduce contagion risks in the banking system. Asset managers, pension funds, and insurers are among major buyers of TLAC-eligible senior debt by global practices, according to the FSB.

While current U.S. dollar rates are not competitive with domestic funding costs, over time, we expect Chinese G-SIBs will increasingly test the waters in offshore markets. Only about 4% of capital instruments by Chinese G-SIBs were issued in offshore in the past three years. By comparison, a significant portion of Japanese TLAC debt is taken up by offshore investors based in the U.S. and Europe.

Chinese G-SIBs Senior Nonpreferred TLAC Bonds Rating Likely To Be Supported By Pre-Emptive Government Support

We expect Chinese G-SIBs' senior nonpreferred instruments would receive pre-emptive support from the Chinese government ahead of a bank resolution, ensuring the G-SIBs do not fall into a distressed situation.

This view takes into account the four megabanks' strong ties with the central government and the extremely high likelihood of state support in a distress event, given the banks' key role in supporting the Chinese economy and advancing policy. The government is also the majority owner of these banks. For all these reasons, we see the Chinese government as being highly supportive of the banking sector.

We therefore expect the starting point of the ratings on Chinese G-SIBs' senior nonpreferred instruments would very likely be the issuer rating on the bank. This approach assumes state pre-emptive measures would kick in before the instruments failed. In these cases, we typically make a one-notch downward adjustment from the starting point to account for subordination. Additional loss-absorbing instruments like Chinese TLAC could fall into this category, given they are subordinated to more senior obligations.

Looking at other G-SIBs in other jurisdictions is instructive.   The starting point of TLAC-eligible senior debt instruments issued by Japanese G-SIBs is the issuer rating, incorporating our expectation of pre-emptive government support to the G-SIBs in distress. By contrast, the starting point of rated TLAC-eligible senior debt instruments in U.S. and Europe is the stand-alone credit profile, reflecting the uncertainty of government support to a bank in distress. The ratings on these outstanding TLAC instruments are typically one notch below the starting point, reflecting the subordination risk.

Subordination with Chinese characteristics

The TLAC rules require subordination, of which there are three types. Contractual, structural (via debt issued by nonoperating holding companies), and statutory (i.e., stipulated by law). While they may go by different names, the jurisdictions where we rate TLAC capital all reflect one of these three types of subordination. For example, Japanese instruments involve structural subordination; in France we find contractual subordination; and in Germany, statutory subordination.

In China, contractual subordination is the easiest and most practical way to build subordination into a senior debt instrument--thus ensuring it qualifies as TLAC-eligible. China's "big four" banks do not have nonoperating holding company structures through which they might structurally subordinate an issue. Revising laws and regulations to achieve statutory subordination is time-consuming. With no developments on the latter two fronts, we believe the contractual route is the likeliest path to TLAC eligibility.

Comparisons with Tier-2  In our view, TLAC instruments are less risky than Tier-2 instruments. This is because, according to the terms and conditions, Tier-2 instruments absorb losses at the point of non-viability (PONV), as opposed to the moment of resolution, as is the case for TLAC. A bank resolution event would arguably be more serious for a bank than the trigger of a PONV.

We've reflected the likelihood of extraordinary government support to Chinese GSIBs Tier-2 instruments before a bank passes PONV. We therefore expect pre-emptive government measures would kick in ahead of a resolution (see chart 2).

Chart 2

Resolution Regime Not Yet Effective

While authorities are setting parameters to increase resiliency in the system, the transition to market-based resolution will be gradual in our view. We continue to classify the Chinese government as highly supportive toward domestic banks. As such, we believe the Chinese government will retain the flexibility to provide pre-emptive support to troubled banks should a moment of resolution loom. We also assume governments will be heavily inclined to bail out local financial institutions, directly or indirectly, to prevent financial instability.

This doesn't mean, however, that the entire system would be bailed out in the event of crisis.   Even the vast resources of the Chinese government could be outmatched by contagion effects in the event of massive systemic crisis. Chinese banking system assets were RMB344.8 trillion, or about 3x annual GDP, as of end-2021.

Moreover, in line with efforts to increase resilience, state support of banks could become increasingly selective. It's possible Chinese authorities could declare a bank nonviable and require that bail-in-able regulatory instruments absorb losses. Tier-2 instruments issued by Baoshang Bank were bailed in after the midsized, private Chinese bank went bankrupt in 2020. Such increased selectivity indicates that bank failure is not impossible in China; although we expect the Chinese government would not likely let a major institution fail, given financial stability concerns.

China's visible regulatory developments put the country on a gradual path toward aligning with the supervisory framework for global practices in bank resolution. TLAC rules took effect in 2021. The authorities stipulate the build-up of bail-in buffers for G-SIBs, which is in line with FSB requirements. That same year the regulator also published its rules for domestic systemically important banks (D-SIBs), and published a list of D-SIB. The Chinese government's highly supportive stance toward domestic banks could evolve under these developments, but they are not material enough to change our assessments in our base case.

Appendix

Non-GSIB Chinese banks' investments in TLAC instruments are risk-weighted instead of being deducted from own capital if exceeds the 10% threshold. Chinese G-SIBs are also subject to the same favorable risk charge within the grace period ended in 2029, which provides them a time window to diversify away TLAC cross-holding. Meanwhile, the four G-SIB banks are at the very strong end of the creditworthiness spectrum among banks in China.

Table 1

Table 2

Related Research

• How Are China's Big Four Banks Addressing The RMB6 Trillion TLAC Gap?, Aug. 25, 2020