18 August 2017

The knives are out - Penalties in the banking sector point towards a regulatory storm

This article was written by Chen Yun (Robert) (Partner) and Liang Yixuan (Associate).

2017 has been a busy year for Chinese regulators with the CBRC, CSRC and CIRC issuing dozens of decrees, circulars and rules aimed at cleaning up the country’s financial markets and controlling its financial risks. In particular, CBRC issued 8 circulars in just a few days from late March to early April, launching a strong regulatory campaign in the banking sector against what is known as the "3 (three types of violations) 3 (three types of arbitrages) 4 (four types of improper conducts)".  

Under this CBRC regulatory storm, all commercial banks in China are subject to CBRC onsite inspections and are required to conduct self-examinations in order to identify malpractice and non-compliance in their business operations. Most self-examinations and onsite inspections were completed by the beginning of July.  Since then, CBRC local offices have imposed, and are continuing to impose, penalties on commercial banks for their identified malpractice and legal non-compliance. 

Penalties imposed

Our preliminary review indicates that since June 2017 CBRC local offices have imposed 110 penalties (totaling RMB 65.47 million) on 54 commercial banks (including 5 locally-incorporated foreign banks), asset management companies and trust companies. 10 of these penalties  involve exceeded RMB 1 million and one penalty exceeded RMB 10 million.  

Most of the penalties issued were imposed against violations relating to loan and draft matters, with penalties reaching 29.12 million and accounting for 44.5% of the total penalty amount.  

Malpractice and non-compliance matters

Penalties are imposed by regulators for the following violations:

  • Internal control systems which are incomplete or flawed in their implementation, resulting in serious violations of prudent operation principles and a failure to identify and correct violations through internal control measures in a timely manner;
  • Failure to perform "three inspections" (pre-loan inspections, loan inspections and post-loan inspections) when granting loans;
  • Using proceeds of loans illegally to invest in stock markets and futures markets;
  • Granting real estate related loans in violation of PRC law;
  • Credit line approvals for  credit cards in violation of prudent operation principles;
  • Illegal credit asset transfers;
  • Non-performing loans that are sold, disposed of or written-off in violation of PRC law;
  • Issuing bank acceptance drafts without genuine underlying transactions;
  • Depositing the proceeds of loans and discounting transactions as margins to falsely increase the scale of loans;
  • Circumventing regulatory indicators such as financial accounting reports, risk measurements and capital requirements, and failing to adopt a ‘substance over form’ principle when calculating such indicators;
  • Bank employees selling financial products that are not offered or authorized by the bank;
  • Improperly increasing the financing costs of the borrowers by requiring proceeds of loans be deposited with the bank, charging improper fees for granting loans, bundling the granting of loans with the selling of other financial products, or passing the costs of granting loans to borrowers, etc. 

Key takeaways from CBRC’s regulatory penalties

There are several notable features in this round of CBRC’s administrative penalties.  

Firstly, there has been a strong increase in the number of penalties handed out. Based on our calculation, CBRC local offices made approximately 500 penalty decisions from 1 January 2017 to 16 August 2017, comparing to approximately 150 penalty decisions during the same period last year, indicating a growth of more than 200%.  

Secondly, the penalties involve a wide range of commercial banks.  Penalties have been imposed on almost all large stated owned commercial banks, most joint-equity commercial banks, many municipal commercial banks, several rural commercial banks and 5 locally-incorporated foreign banks, which is very rare in the history of the CBRC penalty decision making.  

Thirdly, the intensity of penalties is extremely high.  CBRC imposed  2 penalties in excess of RMB 10 million at the end of March 2017. Following this, CBRC Shanghai also imposed a penalty in excess of RMB 10 million on a locally-incorporated foreign bank, a new record for the local office.  

Importantly, we also noticed that penalties were not only imposed on commercial banks as entities, but also on many directors, senior managers and staff who were directly-responsible.  While some senior managers’ qualifications were suspended for 1-3 years, others have been banned from entering the banking sector for life. 

Based upon the above, all domestic and foreign banks should note it is essential to have:

  • A complete internal control system which is comprehensive, systematic and standardized to reflect different regulatory requirements and to cover all types of businesses that a bank may have;
  • Strict compliance and legal awareness, an enhanced internal audit program, and a effective compliance accountability system to ensure every violation is accountable and the relevant personnel held responsible;
  • A comprehensive and genuine risk management system to constantly monitor and control all risks in a timely manner (including credit risk, market risk, liquidity risk and operational risk) to ensure an accurate and sufficient calculation of regulatory indicators (such as financial accounting, risk measurements and capital requirements), and to strictly implement the regulatory indicator requirements from regulatory authorities;
  • Improved employee behavior codes (in particular, directors, supervisors and senior managers shall be prudential in carrying out their duties). 

In addition, it should be noted that the Supreme People’s Court of the PRC ("SPC") has recently issued a judicial interpretation titled ‘Several Opinions on Further Strengthening the Judicial Work in Financial Fields’.  In this judicial interpretation, SPC emphasizes the importance of financial compliance, the lowering of financing costs of enterprises and calls for the financial industry’s support of the real economy. Domestic and foreign banks should note two points in the judicial interpretation in particular:  

  1. All banks should avoid benefiting from regulatory loopholes. SPC states that PRC courts will see through the financial innovations used to disguise the financial risks,  circumvent financial regulatory requirements and  benefit from regulatory loopholes, and will determine the validity of  civil activities as well as the rights and obligations of the parties based on the actually constituted relationship from a legal perspective.  
  2. All banks should avoid increasing the financing costs of  enterprises in any disguised form.  SPC emphasizes that, in regards to the extremely high interests rates (compounded interests, penalty interests, liquidated damages and other fees payable) which in aggregate results in a financing burden for the borrower exceeding an amount calculated at an interest rate of 24% per annum, the PRC court may, upon the request of the borrower, order a reduction adjustment of the exceeding part.

We anticipate that CBRC local offices may issue more penalty decisions in the near future.  KWM will closely follow future regulatory developments.  If you have any questions or need any assistance, you are more than welcome to contact us.

Note: Special thanks to our intern Wang Jimin for his contribution to this article.

A Guide to Doing Business in China

We explore the key issues being considered by clients looking to unlock investment opportunities in the People’s Republic of China.

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