China's revised capital rules have major implications for TLAC funding. In June 2023, S&P Global Ratings estimated that the country's globally systemically important banks would have a shortfall in their total loss absorption capital of up to RMB2.5 trillion by year end. But we now believe this figure can be much lower partially because of a realignment of capital rules with the Basel III framework.

Indicatively, three of China's five GSIBs recently announced plans to collectively issue Chinese renminbi (RMB) 260 billion of TLAC noncapital bonds. These three banks are: Industrial and Commercial Bank of China Ltd. (ICBC; A/Stable/A-1), Agricultural Bank of China Ltd. (A/Stable/A-1), and Bank of China Ltd. (A/Stable/A-1).

China Construction Bank Corp. (A/Stable/A-1), with the same TLAC requirement deadline at year end, has yet to announce its TLAC issuance plan.

The collective size of the three banks' announced issuance plans on TLAC bonds and other capital instruments are well below our prior estimates of their probable TLAC shortfall. That's likely because of the downward adjustment in the calculation of risk-weighted assets (RWA) as China aligns its capital rules to global norms.

Breaking Down The Rules Shift

China's new capital management rules make some important amendments to the stricter standards the country formulated more than 10 years ago.

China's new standards took effect at the start of the year and take cues from the latest moves in international regulatory reform. One important change was to revise down the RWA output floor to 72.5%--the floor set in Basel III--from a previous 80% threshold.

Most banks in China, like their global peers, use the standardized approach to calculating RWAs for credit risk. Starting from the days of the Basel II framework, banks with best practices in risk management are granted lower capital requirements than their peers. This is achieved by allowing qualified banks (include GSIBs) to calculate the RWA by using internal parameters for assessing credit risk, which usually results in a smaller value. This is the internal ratings-based (IRB) approach.

Other banks, which are not approved by the regulators to use IRB approach, must adopt the standardized approach to calculating their RWA for regulatory capital.

China's regulators took a conservative approach to this IRB method when formulating its capital rules in 2012. They only allowed a few of the largest lenders to adopt the internal ratings-based approach. They also set a limit on the RWA reduction under the IRB approach: banks could not report their RWA output lower than 80% of the RWA estimated using the standardized approach.

This 80% output floor set the maximum capital savings banks could get from adopting the IRB approach. By lowering this floor to 72.5%, China's GSIBs could likely arrive at a lower RWA, and therefore a lower TLAC requirement.

Take Bank of China as an example. If we assume the bank could fully utilize the reduction in RWA output, to 72.5% from 80%, the lender would be able to meet its TLAC requirements. That assumes moderately fast loan growth in 2024, the successful issuance of all planned capital instruments and of its TLAC bonds. There would be no TLAC shortfall for this lender by year-end, in other words.

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Differentiated Risk Weightings Will Likely Ease Strains on Capital Buffers

China's new capital rules also allow for more differentiated risk weightings that more accurately reflect their lending risks. For example, instead of a universal risk weight of 50% for all mortgage loans (the old standard), the new rules allow for lower risk weights for mortgages with stronger credit enhancements. This will be reflected in a lower loan to value ratio (see "China's New Capital Rules Will Ease Strain On Banks Ahead Of TLAC Rollout," published Nov. 10, 2023).

In our view, Chinese GSIBs are walking a tightrope to balance loan growth with the need to comply with global TLAC standards, amid declining profitability. The new output floor, together with parameter revisions on a few asset classes, can mitigate strains on their capital buffers. The revised capital rules will give these entities some breathing space as they manage this transition.

While Deposit Insurance Fund May Help, Uncertainties Linger

China's likely inclusion by year end of the deposit insurance fund (DIF) in TLAC capital could help. However, the impact may be limited by the current small balance of China's DIF. We are still waiting for regulatory clarification on how the DIF will be factored into TLAC capital.

Currently, China has thin DIF reserves given its short (nine year) history. The reserves were RMB55 billion as of end-2022, equivalent to about 25-35 basis points of the RWA of the four largest Chinese GSIBs, a small fraction of their TLAC shortfall.

This balance could fall if funds are used to address bank failures. DIF suffered large outflows in 2022 to save failing institutions.

Conversely, in Japan, the other GSIB jurisdiction in Asia-Pacific, the DIF has sufficient reserves to be fully counted as TLAC capital at the prescribed level. Unless there is a big increase in deposit insurance premium rates, or Chinese authorities contribute significantly to the fund, the DIF is likely to remain a minor factor.

Similar to Japan's TLAC rules, DIF can be included in the external TLAC in China, up to 2.5% of RWA for each GSIB before 2025. The percentage rises to 3.5% of RWA before 2028.

China's final TLAC rules support the GSIBs' conformance by broadening the definition of DIF as "funds under management," instead of "funds paid-in." This change in definition could help increase the funds eligible to be counted as TLAC capital.

China's TLAC Bonds Are Ready To Set Sail

We expect all five Chinese GSIBs to make their debut TLAC issuance soon. Given cheaper funding costs, the banks may prefer to do this onshore, at least until the U.S. Fed cuts rates significantly. ICBC indicated that its TLAC quota would all be used in mainland China, for instance.

The volume of TLAC bond issuance will grow quickly. The inclusion of Bank of Communications Co. Ltd. in the list of Chinese GSIBs will add to this sum. Of China's five GSIBs, Bank of Communications has a transition period of three years to meet the phase one requirement. The other four lenders have a deadline of end-2024. We also expect the Chinese GSIBs to gradually rebalance issuance between TLAC bonds and other high-cost capital instruments.

Domestic institutional investors such as asset managers, fund managers, insurance companies, and pension funds are likely to be the main investors in TLAC bonds. The attractiveness of these securities to overseas investors will largely depend on pricing and investors' appetite for geopolitical risk.

In line with the international standards, Chinese capital rules stipulate a capital deduction when GSIBs hold each other's TLAC issuance.

Authorities have also set up a transition period of five years before this capital deduction takes effect, possibly considering the market conditions on liquidity and demand. Despite this exemption, we do not expect GSIBs to strategically invest in the securities given a high risk weight of 150%, as per new capital rules, up from 100%.

China's adjustments to its bank capital rules will realign some of its requirements to the global norm. Lenders had been weighing potentially massive issuance of TLAC bonds by year end. The regulatory realignment may materially reduce this funding need. That in turn would help banks to cut their funding costs under the previous rules, which in certain aspects were more demanding than the international norm.

Editor: Jasper Moiseiwitsch

Related Research

• China's New Capital Rules Will Ease Strain On Banks Ahead Of TLAC Rollout, Nov. 10, 2023
• Credit FAQ: Asia-Pacific Bank Hybrids Bounce Back In The Wake Of Credit Suisse, Sept. 28, 2023
• China's Tightening Capital Rules To Hit Aggressive Banks, Feb. 22, 2023
• China's Major Banks Still Have An RMB3.7 Trillion Shortfall On TLAC Requirement, Jan. 18, 2023