SNAI Symposium

1. SNAI Symposium Risk Management Commercial Banks in China Observations, Issues, and Approaches

2. Overall China Banking System Central Bank Policy Banks Commercial Banks • China Development Bank • Export/Import Bank • Agricultural Development Bank • State Commercial Bank • National Commercial Banks • Regional Commercial Banks • City Commercial Bank • Foreign Bank • Joint-Venture Banks • Foreign Bank Branches State Commercial Banks National Joint-Stock Commercial Banks Other Commercial Banks • Foreign Banks • 190 + foreign banks • Other Institutions • trust & investment companies • financial companies • lease companies • Industrial & Commercial Bank of China • Agricultural Bank of China • Bank of China • China Construction Bank • Bank of Communications • China Everbright Bank • China Merchants Bank • China Minsheng Banking Corporation • CITIC Industrial Bank • Guangdong Development Bank • Hua Xia Bank • Industrial Bank • Shanghai Pudong Development Bank • Shenzhen Development Bank • 100+ city commercial banks • 1,000+ urban cooperatives • 38,0000+ rural cooperatives

3. Macro Backdrop

4. Borrower Stands on its own Explicit analysis of counterparty, -- less context dependent Dependent on Sovereign Support Analysis is highly Context Dependent Planned Economy Free Market Economy 3 Dimensions of Transition • FREE MARKET MINDSET: • Awareness of risk / return relationships • “Buy in” on legal and accounting concepts that allow for setting up an explicit framework

5. Major Risks that Banks Face • Credit risk • Operational risk • Market risk • Interest rate risk • Strategic risk • Reputation risk

6. A lot of work done • Risk tools and concepts • Reinforcement of risk governance structure • Tight NPL targets and goals • Clamping down on lending, with continual emphasis on credit control • Reprimand letters and penalties to send a strong message against breaking rules

7. Results have varied with some falling below expectations.

8. Absolutely essential to instilling a credit culture. If done in haste: Often done in an ivory tower. Not always matched to business needs. Users may not understand or accept. Risk metrics and tools

9. A highly visible metric. In isolation, what does it mean? How do we ensure it is accurate? Is it enough? Tight NPL targets and goals

10. Sends a clear message that the bank cares about credit risk. Encourages the credit underwriting participants to comprehensively vet their proposals. Often done unilaterally, in which case: It creates an adversarial atmosphere RMs still try to get “risky” deals through; it just takes them more work to “convince credit”. Clamping down on lending, with continual emphasis on credit control

11. A necessary initial tactic. Often aimed at the consequence of an action rather than the action itself. In which case it may lose its effectiveness. Need tools which enable the bank to consistently discourage the actions themselves, regardless of whether the consequence is large or small. Reprimand letters and punishments to send a strong message

12. Risk Management as a control function toBusiness Development

13. By strengthening control… …We can reduce risk

14. Strengthen control to reduce risk … … But insist on growing assets and profit

15. Slow decisions Less business Still have losses What can happen when a bank strengthens control to reduce risk but separately insists on growing assets and profit ?

16. Special Issues • Compensation system • Branch centric structure • Impacts on risk identification and NPL identification.

17. Process Implications • Long cycle times • Unnecessary repetitive steps • Rework • Fragmented approach • Ill-defined monitoring policies (if they exist at all) • poor risk management

18. Toward tearing down walls and building an integrated approach • Common language • Shared metrics and methodology • Aligned roles • Integrated strategy • To achieve a united goal: “Profit from Risk”

19. Common Language:Profit from “Risk” Do we understand risk to be: • The probability of default and its consequences? • Factors that influence volatility? • What we can’t define? • An unacceptable degree of any of the above?

20. Divided by a common word

21. Shared metrics and methodology • Need common understanding of what we are trying to measure. • Establish buy-in with the RMs that measuring, managing, and pricing for risk is worthwhile, not just for “risk management” but for business. • Financial modeling with inaccurate financial statements – does this make sense?

22. Analyzing Financial Risk:Reliability of Financial Statements • Adherence to accounting standards • Historical orientation toward funds allocation • Emphasis on rules rather than principles • Tax emphasis • Inventory is valued at cost, not lower of cost or market • Liberal terms for accounting for bad debt • Lack of disclosure for contingents • Exchange gains/losses not recognized when incurred, rather amortized over up to 5 years

23. Analyzing Financial Risk:Other special factors • Difficult to ascertain the conditions under which other banks are lending in order to access pari passu status • Tendency for companies to have manufacturing and company holding activity reflected in its financial statements - difficult to evaluate the investments. • Difficult to ascertain specific entity or person who has ownership or control

24. Assessing Secondary Sources of Repayment • Collateral • Legal Recourse to Collateral • Gaining Possession • Liquidation • Guarantee • Legal / ethical recourse to guarantor • Guarantor’s ability to honor guarantee

25. The “five grade classification system” compared with grading systems used by certain international banks

29. Aligned Roles Revised Mission: • Our mission is to work in partnership with business units to align and execute the Bank’s risk strategies • in order to build a well diversified, accurately assessed risk portfolio • which produces reliable and attractive risk-adjusted return to investors. Typical Traditional Mission: • The mission of credit management is to uphold the asset quality for the Bank to be a bank of best asset quality in the market. • The purpose of credit policy is thus to ensure that credit risk … is identified so as to reduce it to the minimum.

30. What’s the difference? Revised Mission: Traditional Mission: • Credit Management upholds quality • Risk and Business work in partnership • We want the BEST asset quality • We want accurately assessed asset quality • We want reliable and attractive risk-adjusted return. • We want to keep risk to a Minimum

31. Messages to RMs and Credit Approvers Risk is a cost of doing business, and an extremely precious resource. • We need to be highly disciplined in managing risk.. • When business development contemplates a deal, they should incorporate the cost of risk into their profitability calculations. With that as a prerequisite: • When examining deals, risk managers should maintain an integrated view, remembering that risk is but one component of profitability, and not eliminate revenue potential by mechanically insisting on eliminating all risk. • By achieving that we can most effectively cooperate together to achieve our goal of “profiting from risk”

32. What does this have to do with Basel II? Everything! How do we as Risk Managers pitch Basel so that Bankers view it as “good business” and not just a compliance task?