Chinese Non-performing Assets – Chinese Regulators Finalise Financial Asset Risk Classification Rules for Banks

1.   Background

Credit risk (i.e., the risk of debtor default) has been considered by Chinese financial regulators as one of the key risks faced by Chinese commercial banks and the Chinese branches of foreign banks (collectively, “banks”). Based on the existing risk classification guidelines published by the China Banking and Insurance Regulatory Commission (“CBIRC”), banks must classify their loans into five risk-based categories: (1) normal; (2) special mention; (3) sub-standard; (4) doubtful; and (5) loss. Loans in the bottom three categories are referred to as non-performing loans (“NPLs”). 

Following public consultation on a set of draft rules entitled Measures for the Risk Classification of Financial Assets of Commercial Banks published in April 2019, the CBIRC and the People’s Bank of China (“PBOC”) finalised the risk classification rules (“New Risk Classification Rules”) in February 2023.^[1]

The New Risk Classification Rules will take effect from 1 July 2023, subject to a transitional arrangement.

The New Risk Classification Rules largely retain the existing five risk-based categories, but expand their scope of application to cover a wider range of financial assets beyond loans, including receivables, bonds as well as other assets and off-balance sheet exposures that give rise to credit risk, but excluding trading book assets and derivatives exposures. 

The New Risk Classification Rules introduce more objective and nuanced standards for classifying financial assets, especially in the context of a restructuring. The New Risk Classification Rules also reflect some of the concepts set out in the Basel Committee’s 2017 guidelines entitled Prudential treatment of problem assets definitions of non-performing exposures and forbearance (“Basel Guidelines”). 

2.   The broader macroeconomic context

As China's economy is recovering from COVID-19 and undergoing significant transformations and reforms, Chinese companies – both private enterprises and state-owned enterprises – have been experiencing rising debt levels. As a result, both official statistics and unofficial estimates indicate that the amount of NPLs held by Chinese financial institutions and corporations are on the rise.

According to statistics published by the CBIRC, as at the end of Q3 2022, Chinese commercial banks held a total of RMB 3 trillion of NPLs, and RMB 4 trillion of special mention loans, which are one notch above NPLs.

Given uncertainties currently surrounding the regional and global economy, there is a general expectation that NPL levels will continue to rise in China. As NPLs have a countercyclical component, we expect they will continue to be of interest to investors notwithstanding recent economic headwinds.   

As part of its efforts to address the NPL issue and maintain financial and economic stability, the Chinese government is encouraging foreign investors to participate in China's growing NPL market through a number of channels. Please refer to our earlier publication on this topic.  

3.   Overarching principles for classifying financial assets

Under the New Risk Classification Rules, classification of financial assets should: (1) accurately reflect risk levels; (2) be carried out in a timely manner exercising independent judgment; and (3) apply a conservative approach that places a financial asset into a higher risk category if there is uncertainty regarding to which category it belongs. 

For non-retail assets (e.g., wholesale commercial loans and bonds), the New Risk Classification Rules require banks to adopt a “debtor-centric approach.” In principle, a bank’s risk classification decisions should primarily be based on a debtor's ability to repay, although any security/guarantee package may be taken into account as well. 

However, the New Risk Classification Rules also provide that debts that are more than 90 days past due must be classified as non-performing, regardless of the adequacy of any security/guarantee package. This new bright-line test is broadly consistent with the Basel Guidelines, which provide that “Collateralisation or received guarantees should have no direct influence on the categorisation of an exposure as non-performing . . . When the relevant criteria are met, an exposure should be categorised as nonperforming even if the collateral value exceeds the amount of the past-due exposure.” In contrast, under China’s existing risk classification guidelines, some banks were able to rely on the adequacy of the security/guarantee package to avoid classifying a 90-day past due debt as non-performing. 

The debtor-centric approach under the New Risk Classification Rules also means that if more than 10% of a bank’s total non-retail exposures to a particular debtor are more than 90 days past due, then all exposures to that debtor must be classified as non-performing. This rule draws inspiration from the Basel Guidelines, which provide that “When a material [non-retail] exposure to a counterparty is categorised as non-performing, all exposures to that counterparty should be categorised as non-performing.” A bank must also prudently review its risk classification of debts owed by a non-performing debtor’s affiliates. 

The debtor-centric approach is limited to non-retail financial assets. For retail financial assets such as personal loans, credit card receivables as well as small and micro enterprise loans, a bank’s risk classification decisions can retain their focus on the characteristics of each asset, such as the relevant commercial terms and the security/guarantee package. 

When classifying asset management products or securitisation products that they invest in, banks should generally look through to the underlying assets and classify them into one of the five risk categories. For products where full look-through is not possible, the risk classification is determined based on the riskiest underlying asset. For securitisation products that are divided into tranches of different seniority, securitisation products where the underlying assets are retail assets or non-performing assets, or other financial assets approved by the CBIRC, banks may conduct a wholistic assessment based on expected profits and losses of the investment instead of looking through to the underlying assets.

4.   A closer look at the five risk-based categories

The New Risk Classification Rules describe the five risk-based categories in respect of a debtor as follows:

5.   Moving up and down the risk categories

Under the New Risk Classification Rules, a financial asset’s classification can move up or down the various risk categories based on the following objective criteria:

“Special mention” classification:  A bank must classify a financial asset as “special mention” if any of the following circumstances exists:

1. the principal, interest or other fee amount is past due, except for short-term payment delays (i.e., within 7 days) due to operational or technical reasons;
2. the debtor changes the use of proceeds without the consent of the bank;
3. subject to certain exceptions, the debtor borrows new debts to repay existing debts; or
4. other debts owed by the same non-retail debtor has been classified as non-performing by the bank or any other bank.

“Sub-standard” classification: A bank must classify a financial asset as “sub-standard” (the first of three non-performing categories) if any of the following circumstances exists:

1. the principal, interest or other fee amount is more than 90 days past due;
2. the financial asset is credit-impaired under applicable Chinese accounting standards;
3. the external credit rating of the debtor or financial asset has been downgraded substantially, resulting in a significant decline in the debtor's ability to perform its contractual obligations; or
4. more than 20% of debts owed by the same non-retail debtor is more than 90 days past due.

“Doubtful” classification: A bank must classify a financial assets as “doubtful” (the second of three non-performing categories) if any of the following circumstances exists:

1. the principal, interest or other fee amount is more than 270 days past due;
2. the debtor deliberately refuses to repay the debt; or
3. the financial asset is credit-impaired under applicable Chinese accounting standards with an expected credit loss of more than 50% of its outstanding balance.

“Loss” classification: A bank must classify a financial assets as “loss” (the third of three non-performing categories) if any of the following circumstances exists:

1. the principal, interest or other fee amount is more than 360 days past due;
2. the debtor has entered into bankruptcy liquidation proceedings; or
3. the financial asset is credit-impaired under applicable Chinese accounting standards with an expected credit loss of more than 90% of its outstanding balance.

Exiting “non-performing” status: In order for a bank to upgrade a non-performing asset to the “normal” or “special mention” category, the financial asset must meet the criteria for that category and all of the following additional conditions must be satisfied:

1. all overdue amounts have been fully paid and full payment occurs on the next two consecutive payment dates or during the next 6 months (whichever is longer);
2. the bank determines that the debtor will be able to perform its contractual obligations in the future; and
3. none of the debts owed by the debtor to the bank is credit-impaired.  

6.   Risk classification in a restructuring context

Under the CBIRC’s existing risk classification guidelines, all restructured loans must be classified as non-performing. 

In contrast, the New Risk Classification Rules adopt a more objective and nuanced approach under which restructuring may not always result in non-performing status. Following are some of the key concepts and examples used for the purposes of classifying restructured assets:

• “Restructured assets” is defined as financial assets where the debtor experiences “financial difficulties” and the bank (1) makes “contractual adjustments” to the terms of the debt that are favourable to the debtor to facilitate repayment or (2) refinances the debt.
• Examples of “financial difficulties” experienced by a debtor include:
  • the principal, interest or other fee amount on the debtor's debt is past due;
  • the debtor's solvency declines and estimated cashflows are insufficient to cover principal, interest and fees;
  • the debtor's debt has been classified as non-performing;
  • the debtor cannot obtain financing from other banks at a fair market rate; or
  • securities publicly issued by the debtor have been, are or are about to be delisted, and this has a material adverse effect on the debtor's ability to perform its contractual obligations.
• Examples of “contractual adjustments” include:
  • extending the term of the debt;
  • relaxing the principal and interest payment plan;
  • adding or extending a payment grace period;
  • capitalisation of interest (i.e. conversion of interest into principal);
  • reducing the interest rate to below the fair market rate;
  • allowing the debtor to pay less principal, interest or related expenses;
  • releasing collateral or replacing existing collateral with lower quality collateral;
  • swapping the debt; or
  • other measures that relax the terms of the contract.

Where an existing contract gives the debtor the right to unilaterally change the contractual terms of a debt or to refinance the debt, if the debtor exercises this right due to financial difficulties, a restructured asset also arises.

• Restructuring observation period:

A bank must establish a restructuring observation period for a restructured asset. The observation period must: (1) begin on the first repayment date after the contractual adjustment is made; (2) include at least two consecutive repayment dates; and (3) last at least one year.  

At the end of the observation period, if the debtor has resolved its financial difficulties and made timely and full repayments during the observation period, the financial asset will no longer be classified as a restructured asset. However, if the debtor has not resolved its financial difficulties at the end of the observation period, the observation period is reset. If the debtor fails to make timely and full repayments within the observation period, the observation period is reset from the date of such failure. 

Financial assets that are classified as “normal” or “special mention” before a restructuring should at least be classified as special mention after the restructuring. Financial assets that meet the “non-performing” criteria during the observation period should be downgraded to non-performing assets and the observation period is reset. Conversely, if a financial asset meets the abovementioned criteria for exiting “non-performing” status during the observation period, it may be upgraded to the “special mention” category. 

• Risk classification of further restructured assets:
  • During the observation period, if:
    • the debtor fails to make timely and full repayment, or the debtor’s financial situation has not improved despite full repayment, and
    • the restructured asset has to undergo a further restructuring,

                       the restructured asset shall at least be classified as sub-standard, and the observation period is reset. 

7.   Compliance with the New Risk Classification Rules

A bank is required to comply with the following key regulatory obligations under the New Risk Classification Rules:

• implement a financial asset risk classification system which is at least as stringent as the minimum requirements set out in the New Risk Classification Rules;
• make a record filing with the CBRIC within 30 days after establishing or revising its financial asset risk classification system;
• conduct an internal audit of its risk classification system, procedures and implementation at least once a year, and report annual audit results promptly to its board of directors and the CBIRC;
• make risk classifications for all its financial assets at least once a quarter – if there are major changes in a debtor's financial status or factors affecting repayment, the relevant financial asset’s risk classification must be adjusted in a timely manner; and
• put in place a robust governance structure for its risk classification of financial assets, setting out responsibilities of its board of directors (which bears ultimate responsibility for risk classification decisions), senior management (which establishes and implements the risk classification system) and relevant departments.

Breaches of the New Risk Classification Rules carry significant regulatory consequences, including the imposition of higher provisioning and regulatory capital requirements as well as administrative penalties.   

8.   Looking ahead

The New Risk Classification Rules will have a significant impact on how banks classify their loans, bonds and other financial assets. 

Under the more nuanced and objective criteria, a large number of assets could be classified or re-classified as non-performing, which may present new business opportunities for market participants that are looking to invest in or otherwise gain exposure to Chinese non-performing assets. The new rules around the risk classification of restructured assets may also affect how Chinese banks go about restructuring their loans, bonds and other financial assets.  

At King & Wood Mallesons, we have been active in China's non-performing loans and distressed debt market since its inception in 2000. We regularly act for asset management companies, financial institutions as well as foreign and domestic investors and other participants in all types of domestic and cross-border non-performing asset-related transactions and restructurings. 

Should you wish to discuss what the legal and regulatory developments outlined in this article mean for you or your business, please contact a member of our cross-border team.

* The terms “China” and “Chinese” refer to the People’s Republic of China which, solely for the purpose of this publication, excludes the Hong Kong Special Administrative Region, the Macau Special Administrative Region and Taiwan.

Reference 

[1] The New Risk Classification Rules can be accessed at: http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/4791141/index.html