The past five years have witnessed a great challenge to the global banking industry. The financial crisis, which was triggered by the US subprime mortgage crisis in 2007, posed enormous burden on the banking industry. By taking the US financial sector as an example, we can have a general idea about its impact. "After growing steadily for years, employment in the financial sector fell by 128,000 in 2007, 273,000 in 2008, and another 310,000 in 2009. Between January 2009 and December 2010, 297 banks have failed; most were small and medium-size banks. The number of small banks on the FDIC's list of troubled institutions rose from 829 in the second quarter of 2010 to 860 in the third quarter, the largest number since March 1993" (The Financial Crisis Inquiry Commission p.401). Besides these failed local banks, such as Washington Mutual, and Nevada silver State Bank, some well-known international banks went bankrupted during the crisis as well, such as Lehman Brothers Holding Inc.,.
When we look into the detail that how a single industry crisis could develop into a global financial crisis, we can find a strong tie between the derivatives uses and the commercial banking. "Failure in credit rating and securitization transformed bad mortgages into toxic financial assets. Securitizers lowered the credit quality of the mortgages they securitized. Credit rating agencies erroneously rated mortgage-backed securities and their derivatives as safe investments. Buyers failed to look behind the credit ratings and do their own due diligence. These factors fueled the creation of more bad mortgages" (The Financial Crisis Inquiry Commission p418). Moreover, the shadow banking institutions play a significant role. In this case, the shadow banking refers to any financial activity that transforms short-term borrowing to long-term lending without a government backstop. These shadowing banking institutions include the tri-party repo market, Structured Investment Vehicles and other off-balance-sheet entities used to increase leverage, Fannie Mae and Freddie Mac, Credit default swaps, and hedge fund, mono-line insurers, commercial paper, money market mutual funds, and investment banks.
The derivatives use may put the commercial banking at risk, but why did the risk management system fail to control it? There are several reasons to name: concentration of highly correlated risk, insufficient capital, the imbalance between the solvency and liquidity, and the poor risk management system.
In response to the deficiencies in financial regulation reveled by this financial crisis, the Basel Committee introduced the third Basel Accord, in order to strengthen bank capital requirements and introduce new regulatory requirements on bank liquidity and bank leverage. "Basel III, when fully implemented by 2019, will require banks to hold 4.5% of common equity and 6% of Tier I capital (up from 4%) of risk-weighted assets (RWAs). Basel III also introduces additional capital buffers, a mandatory capital conservation buffer of 2.5% and a discretionary countercyclical buffer, which allows national regulators to require up to another 2.5% of capital during periods of high credit growth. In addition, Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios. The Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash flows over 30 days; the Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress" (Hal S. 2011 p.12-13).
Under this complex international financial background, Chinese banking industry, which has enjoyed a rapid growth of banking industry in recent years, faces severe challenges right now.
First, China has introduced and localized the Third Basel Accord, which posts more strict requirements. For minimum Capital Adequacy Ratio for core Tier I, Tier I, and total capital are set as 5%, 6%, and 8% respectively. On top of the minimum CAR, banks are also required to set aside 2.5% extra capital.This new regulation demands the bank for reserving more capital and thus is intractable for the whole Chinese banking industry, because, before the financial crisis, the capital reservation has not been much sufficient.
Second, although the macroeconomic condition of China returned to a previous stable way of development and thus created an opportunity for the banking industry in 2011, some banks and other financial intermediaries managed the risk in a wild way or even sometimes overlooked the great importance of risk management For example, the fast development of real estate in China has attracted the financial institutions to take part in. But too much focus on a single industry leads to a risky situation for these financial intermediaries. The mid-or-long-term loan for real estate is indeed an important part of business. However, it contributed a lot to the increase of the real estate bubbles. The chase of profit made banks blind of the non-rational factors in real estate industry, resulting to a rising platform risk.
Third, some banks lack the knowledge of risk management. Wen can see a large gap between Chinese banks and foreign banks, especially when Chinese banks faces the change of monetary policies, the increase of reserve rate and the challenge of foreign rate transformation.
It is time for Chinese banks to build up or to improve their own internal risk management system.
Why does this passage abstract the evidence from ICBC? What does make it suitable as an example to analyze? First, we need to take a glimpse of the history of China's financial industry.
The history of China's financial industry is relatively short, when compared to that of western developed countries. So except banking industry, other financial intermediaries are not so developed and their business volume is far less than the banking industry. As the majority of Chinese financial industry, the banking industry has an unique path of development. In the very beginning, there was only one bank in China, namely the People's Bank of China, also known as the central bank. PBC took the responsibilities of not only the central bank, but also the political bank, whose job is to finance the development of China's commerce and industry, agriculture, and construction. After the reformation, China set up five new political oriented banks to take the corresponding responsibility from the central bank. Those five banks are Industrial and Commercial Bank of China, Agriculture Bank of China, Construction Bank of China, Communication Bank of China, and Bank of China. Moreover, the main function of PBC was left to be the central bank. At that time, these five banks were fully state owned. When China became a member of WPO, these banks started to be commercialized but stayed dominated by the state. Besides the central bank and large commercial banks, China also set up three political banks, which specially finance the large projects of the country.
The large commercial banks take a market share of 49.2%, meanwhile the limited commercial banks only have a market share of 15.6% in total. Among all the large commercial banks, ICBC has been much outperforming than other large commercial banks in recent years. "At the end of 2011, total assets reached RMB 15,476.868 billion, representing an increase of RMB 2,018.246 billion, or 15.0% over the end of previous year; Total liabilities reached RMB 14,519.045 billion at the end of 2011, up RMB 1,882.08 billion, or 14.9% from a year earlier. Having a 25.6% increase against previous year in net profit to RMB 208.445 billion in 2011, ICBC defended its position as the world's most profitable bank" (ICBC 2011).
More importantly than the impressive financial performance, ICBC strives to create a global risk management system to better balance the risk/return profile and has a better knowledge in using derivatives to hedge the risk than other commercial banks. "In 2011, ICBC ramped up its credit risk consolidated management, authorization control, credit line approval process for overseas branches and set up one credit authorization system that spanned the entire ICBC Group. A new Global Market Risk Management ("GMRM") with the first version has been installed in overseas branches" (ICBC 2011). Taking into account the progress of risk management system construction of ICBC, as well as its strong and leading role in Chinese banking industry, this passage takes ICBC as an example, and then endeavors to demonstrate how the derivatives use affects the risk management of commercial banking in China.
In this passage, I would like to discuss (1) how the derivatives use affect the risk management of commercial banks, (2) to what degree the derivative use affect the risk management as well as the profitability of commercial banks, (3) the differences in usage of derivatives between ICBC and the average level of banking industry, (4) the differences in usage of derivatives between the average level of Chinese banking industry and that of developed country, such as France, (5) the reason why these differences occur.
This passage is divided into four parts. The first part is the introduction to the main global financial background, the reason why derivatives use matters, the current situation of Chinese financial industry, the importance of risk management for Chinese commercial banking, and the reason why this passage choose ICBC as an example. The second part is the literature review. In this part, this passage summarizes the main methods used in risk management, both quantitative and qualitative. The third part is the main body of the thesis. First, I will collect the data from the annual reports during the period from 2006 to 2011, and then do the analysis. I will use the linear regression model and make comparison of key financial ratios. The main body will answer the five questions I raised in the introduction. The last part is conclusion and suggestion.
