China’s Banks Adopt ‘Living Wills’ to Plan for Less Predictable Future and to provide a resolution plan to help regulators wind up a failing bank

Jan 1, 2014

China’s Banks Adopt ‘Living Wills’ to Plan for Less Predictable Future

China’s banks are starting to look to the hereafter.

The idea of a living will, sometimes likened to a near-death patient preparing for the inevitable, is to provide a resolution plan to help regulators wind up a failing bank—or bring it back to healthy operation.Last week, China Merchants Bank Co.600036.SH +2.74%, the country’s sixth-largest lender by assets, took a page from its Western counterparts and drafted a so-called “living will.” It didn’t have much to say about the contents, but in a filing to the Shanghai exchange it said the bank’s board had approved management’s proposal.

Earlier in the month, Bank of China sa601988.SH +0.38%id its board approved a resolution plan, while Industrial & Commercial Bank of China601398.SH +0.85% has said it expects to make similar plans.

The idea of a living will, sometimes likened to a near-death patient preparing for the inevitable, is to provide a resolution plan to help regulators wind up a failing bank—or bring it back to healthy operation. Reacting to the shocks of the global financial crisis, the G-20 Financial Stability Board, which has coordinated a multinational effort, agreed in 2010 to push banks to create living wills. The concept was also endorsed in the 2010Dodd-Frank financial law in the U.S.

The living will proposals come at an appropriate time for China, as the nation begins to address the prospect of bank failures. Its government-dominated banking sector is seen as having implicit state support. But Beijing wants to bring private capital to the sector and that could mean new risks. While China wants fresh competitors to shake up its banking system, it doesn’t want to be on the hook for management mistakes.

At the same time, China is also moving ahead with interest-rate liberalization, removing the protective cushion of state-set interest rates that spares banks the pain of head-on competition for deposits. Liberalized interest rates would almost certainly raise the cost of funds for banks as they scramble to offer depositors a better deal. That in turn could cut into profits and ultimately lead to the failure of some weaker players. Already, one Chinese official has publicly warned that China could see some smaller bank failures as early as next year.

Meanwhile, Beijing is pushing ahead with plans for a financial bankruptcy law, showing that it is serious about the risks to banks in a new environment.

China’s bank regulators are thinking seriously about applying a requirement for a living will to at least some banks. Yan Qingmin, vice chairman of China Banking Regulatory Commission, told a financial forum in November that the “living will” will be a prerequisite for any privately owned banks starting up here. Chinese banks with international operations also have to respond to requests from foreign regulators.

The need for some preparation for future shocks can also be seen in the signs of stress in the banking system. Chinese lenders experienced a serious credit crunch shortly before the end of the year as they scrambled for cash to meet regulatory requirements. That sent seven-day interest rates up to nearly 9% recently on the interbank market, where banks borrow and lend to one another. The central bank had to move into the market, bringing rates down to more normal levels of about 5.4% on Tuesday.

That was the second such squeeze in the last six months. In June, an even more severe credit crunch sent the overnight lending rate as high as 30% on the interbank market. Mid-sized China Everbright Bank601818.SH +1.14% conceded in an IPO prospectus that it was in technical default on some interbank obligations in June, though it said its counterparties agreed to accept payments one day after the funds were due.

Most of China’s banks are relatively healthy. But a bit more “worst-case” planning seems appropriate now—even if they don’t need to be read the last rights just yet.