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China's rules put foreign banks in a bind
Published on: 2009-09-03
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SHANGHAI -- Their credit reputations damaged by the global financial crisis, foreign banks face the prospect of being largely shut out of China's rapidly expanding markets for financial derivatives, a potential key source of revenue.

On Sept. 16, China will put into effect an agreement governing how banks trade domestic derivative products among themselves. But as a condition of dealing with foreign banks, China's five largest commercial banks are seeking to impose tough credit demands that will be difficult to comply with, according to lawyers and knowledgeable people at several foreign banks.

Bank of China Ltd., Industrial & Commercial Bank of China Ltd., China Construction Bank, Agricultural Bank of China Co. and Bank of Communications dominate the domestic money markets, supplying as much as 80% of market liquidity. Not being able to deal with them would punch a big hole in the operations of foreign banks in China.

China's derivatives markets are rapidly developing, and foreign banks have been hoping their extensive international experience will help them tap a stream of revenue from those markets.

At HSBC Holding PLC, the only bank that gives a breakdown of its China operations, mainland China was the fourth most-profitable country last year for its unit that trades local currencies, bonds and derivatives for large corporate customers, earning $353 million in pretax profit.

Under the new trading regime, banks will be allowed to trade only with counterparties with whom they have signed a master agreement. That agreement will initially cover existing trading in interest-rate swaps, bond forwards, foreign-exchange swaps and forwards and cross-currency swaps.

But the five big banks are insisting that foreign banks, and in some cases their major shareholders, guarantee the credit of their China units before they sign any agreement, according to foreign bankers with direct knowledge of the situation.

All five banks declined to comment on the new arrangements.

Under existing arrangements, foreign banks can trade derivatives with those banks without providing credit guarantees.

Agreeing to cover any trading defaults would force foreign banks to put aside capital that could otherwise be used productively. Calling on banks' major shareholders to provide an additional guarantee is highly unusual elsewhere in the world, and may be an even greater stumbling block.

Simon Zhang, a managing associate in Hong Kong for Linklaters law firm, noted that bank-holding companies typically don't conduct banking business, making it "particularly difficult to ask their shareholders to open themselves up to such risk."

Linklaters was one of several foreign law firms that advised on the drafting of the master agreement, which was rolled out in March by the National Association of Financial Market Institutional Investors, nominally an industry group responsible for interbank market self-regulation but overseen by China's central bank. The association declined to comment.

Banking analysts say the demands are a direct result of the financial crisis.

Most major Chinese banks had at least some exposure to Lehman Brothers Holdings, the Wall Street investment bank whose collapse last September sparked a global credit crunch, or were hit by losses on complex derivative products. The size of their losses, however, pale in comparison with those of major Western banks.

"What Lehman showed them is that a listed company that's double A or A-plus-rated doesn't in and of itself mean much," said a lawyer at an international law firm in Shanghai who has acted for both Chinese and foreign banks on this issue. "Some Chinese banks got stung and that brought an awakening."

The demand for credit guarantees is a further source of frustration for foreign banks, given that many of them recently have been through a costly process of incorporating their local units, which are generally capitalized at around four billion yuan ($586 million).

That was supposed to qualify them for equal treatment with Chinese banks.

"It goes against the regulator wanting us to stand on our own," said a treasury official at a big foreign bank in Shanghai. "It defeats the purpose of a local subsidiary."

Beijing's rules, which require local incorporation as a prerequisite for conducting domestic-currency retail business, have allowed the regulator to tighten control over the banking sector, giving it recourse to assets held within the country in case a foreign bank defaults, while also fencing off foreign banks' local operations from potential risks elsewhere in their organizations.

While some of the Chinese banks are applying their demands uniformly, lawyers say others are requesting guarantees from only some foreign banks, based on their own assessment of credit risk.

So far, the Guangzhou branch of the Bank of Montreal, which isn't incorporated in China, is the only foreign bank listed on the industry regulator's Web site as having signed the master agreement with a big Chinese bank, Bank of Communications. Knowledgeable people at Bank of Montreal say the bank has also signed with China Construction Bank.

Robert Martin, Bank of Montreal's managing director and head of Asia, who is based in Shanghai, declined to discuss details of the agreements signed with the two Chinese banks. He noted that the general perception of his bank's credit quality had been enhanced by the success of the Canadian financial system in weathering the global financial crisis.

Meanwhile, other foreign banks have signed the master agreement with each other, as well as smaller, regional Chinese banks that are particularly active in derivatives markets. The most aggressive Chinese banks have been Industrial Bank Co., which has signed with 10 foreign banks, and Bank of Ningbo Co., which has signed with six.

Some foreign banks are holding out against the new requirements, hoping that they will be relaxed. China's regulators in the past have welcomed the role of foreign banks in the country's financial markets as a way to introduce innovation.

"In the long term, for us not to be able to trade with Chinese banks is just as unfortunate for them as it is for us," said one treasury official at a European bank in Shanghai.

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