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I. Financial Indicator Dimensions of the Central Bank System#

(1) Money Supply#

1. Currency Issuance and Base Currency (also known as Central Bank Reserve Currency)
   (1) Currency issuance = commercial banks' cash reserves + M0
   (2) Base currency (Central Bank Reserve Currency) = currency issuance + statutory deposit reserves + excess deposit reserves
   = commercial banks' cash reserves + circulating M0 + statutory deposit reserves + excess deposit reserves
   (3) Total amount of tradable funds in the interbank market = total excess deposit reserves of all financial institutions
   Therefore, only monetary policies that affect excess deposit reserves can influence the liquidity of the banking system. It should be noted that the reserve requirement reduction policy can only cause a trade-off between the statutory reserve requirement and the excess reserve requirement, with almost no impact on the base currency, but the central bank's open market operations and other policies can directly affect the base foreign currency.

2. M0, M1 (Narrow Money) and M2 (Broad Money)
   (1) M0 = cash in circulation
   (2) M1 = M0 + corporate deposits (excluding unit time deposits and self-raised infrastructure deposits) + deposits from government agencies, organizations, and military + rural deposits + personal credit card deposits;
   (3) M2 = M1 + personal deposits + corporate time deposits + foreign currency deposits + trust deposits. Among them, (M2-M1) is quasi-money.
   First, in June 2001, due to the rapid development of the stock market, the central bank included the margin deposits of securities company clients into M2.
   Second, in 2002, influenced by joining the WTO, the central bank will count the RMB deposits of foreign and joint venture financial institutions in China into different levels of money supply.
   Third, in October 2011, the central bank included the deposits of non-deposit financial institutions in deposit financial institutions and housing provident fund deposits into M2.
   Fourth, in January 2018, the central bank replaced the money market fund deposits (including certificates of deposit) held by non-deposit institutions with money market funds.

3. Deposit Reserve Ratio and Excess Reserves: Statutory and Excess
   According to regulations, commercial banks are required to deposit a certain percentage of their deposits with the central bank, known as the deposit reserve ratio. Among them, the statutory deposit reserve ratio and excess deposit reserve ratio are collectively referred to as the deposit reserve ratio.
   Excess reserves = commercial banks' excess reserve deposits with the central bank + cash reserves.
   Currently, the central bank has eliminated the requirement for commercial banks' reserve ratios, merging it with the reserve requirement ratio.

4. Foreign Exchange Occupation and Foreign Exchange Reserves
   First, foreign exchange occupation refers to the domestic currency issued by the central bank in exchange for foreign exchange assets, valued at historical cost, emphasizing the quantitative aspect.
   Second, under normal circumstances, foreign exchange occupation is the source of base currency. For a long time, foreign exchange occupation contributed over 80% of all base currency, which is why China's money supply could not be autonomous for a long time.
   Third, generally speaking, the more foreign exchange assets the central bank acquires, the larger the scale of foreign exchange occupation, and the subsequent foreign exchange occupation will enter the central bank's foreign exchange reserves (measured at market price, mainly managed uniformly by the investment department of the State Administration of Foreign Exchange), so there is a strong positive correlation between foreign exchange occupation and foreign exchange reserves.
   Fourth, due to different valuation methods, foreign exchange reserves and foreign exchange occupation have significant differences while remaining generally consistent. Foreign exchange reserves are also affected by exchange rate changes, interest rate changes, investment returns, and other factors, which is the underlying reason for the persistent differences between foreign exchange reserves and foreign exchange occupation.

5. Bank Foreign Exchange Settlement and Sale
   (1) This refers to the foreign exchange settlement (converting foreign exchange into RMB) and sale (converting RMB into foreign exchange) services provided by banks for clients and themselves. Since commercial banks summarize the actual settlement and sale data daily and report it to the foreign exchange administration, this indicator is less affected by policy regulation and better reflects market changes.
   (2) Bank foreign exchange settlement and sale can be further divided into client foreign exchange settlement and sale (which better reflects market sentiment and RMB appreciation/depreciation) and self foreign exchange settlement and sale (mainly reflecting changes in international gold prices). Client foreign exchange settlement and sale can also be further divided into spot and forward foreign exchange settlement and sale. For example, if there is appreciation, the demand for settlement will be relatively large, and vice versa.
   (3) Spot foreign exchange settlement and sale mainly includes the amount of spot foreign exchange settlement and sale occurring in the current month, the amount of forward foreign exchange settlement and sale performed in the current month, and the amount of foreign exchange options exercised in the current month (currently small data, not published by the foreign exchange administration). Among them, the latter two mainly reflect the market participants' views on past market trends.
   (4) Considering that China is a surplus country, the amount of spot foreign exchange settlement and sale in the current month should generally be a surplus (settlement greater than sale), so if the surplus narrows, it indicates a strong expectation of RMB depreciation.

(2) Monetary Policy Tools#

1. OMO (Open Market Operations)
   First, in 1994, with the foreign exchange reform, open market operations were initiated, marking the origin of OMO.
   Second, in 1998, the first-level dealer system for open market operations was established, restoring RMB open market operations.
   Third, open market operations are divided into reverse repos and repos, with the former being the central bank purchasing securities from primary dealers to inject liquidity, and the latter being the opposite.
   Fourth, the current central bank's open market operation terms mainly include 7 days, 14 days, 28 days, and 63 days, but usually focus on 7 days and 14 days.

2. Rediscounting and Re-lending
   First, these two tools are the earliest means for the central bank to inject base currency (second only to foreign exchange occupation).
   Second, the rediscount policy refers to the central bank providing financing support to commercial banks through commercial bills that have been discounted but have not yet matured.
   Third, the re-lending policy refers to loans issued by the central bank to financial institutions to achieve monetary policy objectives. After the central bank specifically exercised its functions in 1984, re-lending became the basis for regulating base currency and provided 70-90% of the total base currency supply for a long time thereafter.

3. SLO (Short-term Liquidity Operations) / SLF (also known as Spicy Noodles, Standing Lending Facility)
   (1) In January 2013, the central bank established SLO (Short-term Liquidity Operations) to address significant fluctuations in market funding supply and demand, mainly with terms of less than 7 days (complementing the 7-day reverse repo tool), with collateral being government-supported agency bonds and commercial bank bonds.
   (2) In early 2013, SLF (Standing Lending Facility) was established to meet the long-term liquidity needs of financial institutions, mainly with terms of 1-3 months, targeting policy banks and national commercial banks, with collateral being high credit-rated bond assets and quality credit assets.

4. Chinese-style "Interest Rate Corridor"
   The concept of "interest rate corridor" in China originated in May 2014, proposed by central bank governor Zhou Xiaochuan. Since then, the term "interest rate corridor" has been frequently used. However, research on the "interest rate corridor" can be traced back to the 1990s. The upper limit of China's "interest rate corridor" is the SLF rate, and the lower limit is the excess deposit reserve rate. In simple terms, the upper limit of the "interest rate corridor" is the interest rate at which commercial banks borrow money from the central bank, and the lower limit is the interest rate at which commercial banks deposit money with the central bank, with the corridor range being about 200 basis points.
   In foreign research literature, the earliest discussions on the operational methods and procedures of the interest rate corridor were mainly by Kevin Clinton in two papers completed in 1991 and 1997, which detailed the actual operational steps and procedures of the interest rate corridor.

5. MLF (Medium-term Lending Facility, also known as Spicy Noodles) and TMLF (Targeted Medium-term Lending Facility, also known as Special Spicy Noodles)
   First, both tools mainly target loans to "three rural issues," small and micro enterprises, and private enterprises (new additions), with terms of 3 months, 6 months, and 1 year (mostly).
   Second, the central bank established MLF in September 2014 and TMLF on December 19, 2018. The former mainly supports small and micro enterprises and debt-to-equity swaps, while the latter is aimed at targeted support for financial institutions to lend to small and micro enterprises and private enterprises, with a 15 basis point interest spread between the two tools.

6. PSL (also known as Pizza, Pledged Supplementary Lending)
   On April 25, 2014, the central bank established PSL (Pledged Supplementary Lending) to provide funding for specific policies or project construction (mainly targeting shantytown renovation), with terms usually ranging from 3 to 5 years, mainly targeting policy banks, with collateral being high-grade bond assets and quality credit assets.

7. TLF (also known as Special Spicy Noodles, Temporary Liquidity Facility) and CRA (Temporary Reserve Utilization Arrangement)
   First, on January 20, 2017, the central bank established the Temporary Liquidity Facility (TLF) to provide 28 days of temporary liquidity support to several large commercial banks with high cash injection volumes.
   Second, on December 29, 2017, to address cash expenditure disturbances during the Spring Festival, the central bank established a temporary reserve utilization arrangement, allowing national commercial banks with a high proportion of cash injection to temporarily use up to two percentage points of statutory deposit reserves during the Spring Festival when there is a temporary liquidity gap, with a usage period of 30 days.

8. LPR (Loan Prime Rate)
   In October 2013, the central bank officially launched LPR, positioned as the average loan rate for the best clients of 10 banks (excluding the highest and lowest levels). In the nearly six years since its establishment, LPR has consistently maintained the same announcement frequency and change amplitude as the loan benchmark rate, with a relatively stable value, indicating that it has not played its intended role well.
   On August 17, 2019, the central bank issued Notice No. 15, introducing a new LPR, which was first released on August 20 at 9:30 AM, with one-year and five-year LPRs set at 4.25% and 4.85%, respectively. At the same time, the number of LPR quoting banks increased to 18, with a release frequency of 9:30 AM on the 20th of each month, and the LPR is formed by adding points on the basis of MLF.

9. Offshore Central Bank Bills
   On September 20, 2018, the central bank and the Hong Kong Monetary Authority signed a memorandum of cooperation on issuing People's Bank of China bills using debt instruments in the Centralized Settlement System, officially marking the beginning of offshore central bank bills. On August 9, 2019, the central bank released the second quarter monetary policy implementation report, clearly stating that it would establish a regular issuance mechanism for offshore central bank bills in the future. Since September 2018, the central bank has issued a total of 120 billion offshore central bank bills (approximately 600 billion RMB in offshore RMB) in November 2018 (20 billion), February 2019 (20 billion), May 2019 (20 billion), June 2019 (30 billion), and August 2019 (30 billion).

10. Deposit Reserve System (Five Tiers and Two Preferences)
    China's statutory deposit reserve system began in 1985 (when various banks were established) and maintained a "one-tier" model until 2008, meaning that regardless of the size, nature, or importance of financial institutions, a uniform statutory deposit reserve ratio was implemented.
    After the 2007-2008 financial crisis, monetary policy authorities began to realize that a uniform deposit reserve ratio policy could not solve the structural problems of the domestic economy or meet policy demands. Therefore, they set different deposit reserve ratios based on the importance, size, and nature of financial institutions, evolving from one tier to two tiers, and now to the current five tiers and two preferences (with three tiers and two preferences for the banking industry). This means that policy banks, state-owned large banks, small and medium banks, county-level rural financial institutions, and non-bank financial institutions each have one tier, while state-owned large banks and small and medium banks can also enjoy targeted assessments for inclusive finance, and county-level rural financial institutions can further enjoy preferential deposit reserve ratio policies based on local service conditions.

1. Foreign Exchange Risk Reserves
   Foreign exchange risk reserves originated from the central bank's announcement on August 31, 2015, regarding the "Notice on Strengthening the Macro-Prudential Management of Forward Foreign Exchange Sales (Yin Fa [2015] No. 273)," which required financial institutions (including finance companies) conducting client forward foreign exchange sales business to deposit foreign exchange risk reserves starting from October 15, 2015, with a reserve ratio tentatively set at 20%. This regulation increased the cost of clients' forward foreign exchange purchases and helped regulate the issue of excessive depreciation of the RMB.
   In September 2017, the central bank timely adjusted the previously implemented counter-cyclical macro-prudential management measures to curb cyclical fluctuations in the foreign exchange market, adjusting the foreign exchange risk reserve ratio to 0.

(3) Social Financing Scale#

The social financing scale was proposed in 2010 and is a unique indicator in China. The so-called social financing scale refers to the total amount of funds obtained by the real economy from the financial system within a certain period (monthly, quarterly, and annually), which has both stock and flow concepts, accommodating both absolute scale and relative indicators.
When discussing the social financing scale, it is inseparable from its sibling indicator M2. The social financing scale and M2 are like the two ends of a table, one representing the application of assets (social financing scale) and the other representing the source of funds (M2). In simple terms, the monetary authority issues currency (represented by broad money M2), and financial institutions obtain currency to meet the financing needs of the real economy. The currency then enters the real economy through bank financial institutions (domestic and foreign currency loans), non-bank financial institutions (entrusted loans, trust loans, and un-discounted bills), capital markets (stock and bond markets), and other channels. Theoretically, there should be a certain correspondence between the application of assets and the source of funds, especially in the case of only capital markets. However, the existence of indirect financing intermediaries complicates this correspondence, so a strict correspondence does not exist. In short, the social financing scale can be understood as the assets of the financial system and the liabilities of the real economy; while M2 can be understood as the liabilities of the financial system and the assets of the central bank (the central bank's liabilities to the state).

1. Development History
   (1) The People's Bank of China began researching and compiling the social financing scale indicator in November 2010;
   (2) In December 2010, the Central Economic Work Conference first proposed the concept of "maintaining a reasonable social financing scale";
   (3) In early 2011, the People's Bank of China officially established a quarterly statistical system for the incremental social financing scale and began to publish quarterly data on the incremental social financing scale; starting in 2012, it was changed to monthly publication;
   (4) From 2014, quarterly statistical data on the incremental social financing scale for various regions (provinces, autonomous regions, municipalities) began to be published;
   (5) From 2015, the stock data of the social financing scale began to be compiled and published quarterly, and from 2016, it was changed to monthly publication.
2. Scope and Range
   (1) On-balance sheet loans from financial institutions: RMB loans and foreign currency loans
   (2) Off-balance sheet loans from financial institutions: entrusted loans, trust loans, and un-discounted bank acceptance bills (discounted ones are on-balance sheet)
   (3) Direct financing: corporate bonds and non-financial corporate domestic stock financing
   (4) Others: asset-backed securities from deposit-taking financial institutions, loan write-offs, and local government special bonds.

First, on August 13, 2018, the central bank stated that starting from July 2018, the People's Bank of China improved the statistical methods for the social financing scale, incorporating "asset-backed securities from deposit-taking financial institutions" and "loan write-offs" into the social financing scale statistics, reflecting them under "other financing."

Second, on October 17, 2018, the central bank stated that starting from September 2018, "local government special bonds" would be included in the social financing scale statistics.

II. Asset Quality Dimension of Commercial Banks#

(1) Five-level Loan Classification
The five-level loan classification was clearly defined by the central bank in May 1998, referencing international practices. Previously, loans were classified into four categories: normal, overdue, stagnant, and bad debts, according to the "Financial and Insurance Enterprises Financial System" issued by the Ministry of Finance in 1993, with the last three categories collectively referred to as non-performing loans.

1. Normal Loans (Ratio)
   First, it specifically refers to loans where the borrower can normally fulfill the contract, with no sufficient reason to doubt their ability to repay the principal and interest on time.
   Second, there is no specific regulatory standard for the normal loan ratio; generally, the higher, the better, with normal loan ratios (i.e., normal loans/total loans) typically above 95%.
2. Attention Loans (Ratio)
   First, it specifically refers to loans that currently have the ability to repay principal and interest but have some factors that may negatively affect repayment.
   Second, attention loans are between normal loans and non-performing loans, and the attention loan ratio also has no specific regulatory standard.
3. Non-performing Loans (Ratio)
   First, this refers to loans where the borrower's repayment ability has obvious problems, mainly including substandard loans, doubtful loans, and loss loans. Among them,
   Substandard loans refer to loans where the repayment ability has obvious problems, relying entirely on normal operating income to repay the principal and interest, and even executing guarantees would cause certain losses.
   Doubtful loans refer to loans where the borrower cannot fully repay the principal and interest, and even executing guarantees may cause significant losses.
   Loss loans refer to loans where, after taking all possible measures or necessary legal procedures, the principal and interest cannot be recovered, or only a small portion can be recovered.
   Second, the non-performing loan ratio = non-performing loan balance / total loan balance = (substandard loan balance + doubtful loan balance + loss loan balance) / total loan balance.
   Third, there is no specific regulatory standard for the non-performing loan ratio; generally, the lower, the better, but there is some overlap between non-performing loans, attention loans, and overdue loans, resulting in a classification that is not rigorous enough.
   The "Core Indicators for Risk Supervision of Commercial Banks (Trial)" issued on December 31, 2005, stipulates that the non-performing loan ratio must not exceed 5%, and the non-performing asset ratio must not exceed 4%. Here, the non-performing asset ratio refers to the ratio of all non-performing assets (including interbank, client-side, and investment-side) to total assets.
   (2) Overdue Loans and Restructured Loans
4. Overdue Loans (Ratio)
   First, this refers to the portion of loans that have not been repaid within the term specified in the loan contract, which, from the overdue date, is transferred to the overdue loan account. Generally, overdue loans incur higher penalty interest.
   Second, overdue loans are further classified by duration: overdue within 3 months, overdue between 3 months to 1 year, overdue between 1 year to 3 years, and overdue over 3 years.
   Third, overdue loans and non-performing loans have a high degree of overlap, and there is no specific regulatory standard.
5. Restructured Loans (Ratio)
   First, restructured loans refer to loans where the borrower has deteriorated financial conditions or is unable to repay, leading to adjustments in the loan contract terms. The adjustment measures mainly include loan extensions, borrowing new to repay old, interest penalty waivers, principal reductions, debt-to-equity swaps, collateral additions, repayment method changes, etc.
   Second, the "Loan Risk Classification Guidelines" issued by the central bank in December 2001 clearly states that "loans requiring restructuring should at least be classified as substandard; if restructured loans are still overdue or the borrower is unable to repay, they should at least be classified as doubtful."
   Third, restructured loans mainly target non-performing loans and have no specific regulatory standard.
   (3) Loan Provisioning Ratio and Provision Coverage Ratio
   The non-performing loan ratio, loan provisioning ratio, and provision coverage ratio are three basic indicators of the asset quality of commercial banks, and the three are closely related. Among them,
   Non-performing loan ratio = loan provisioning ratio / provision coverage ratio.
6. Loan Provisioning Ratio (also known as Provision Ratio): The ratio of loan loss provisions to total loans
   First, the calculation formula for the loan provisioning ratio = loan impairment provisions / total loan balance = (general provisions + special provisions + specific provisions) / total loan balance.
   Second, in 2011, the China Banking Regulatory Commission issued the "Management Measures for Loan Loss Provisions of Commercial Banks" in the form of Order No. 9, unifying general provisions, specific provisions, and special provisions into "loan loss provisions" and listing them as provisions for resisting loan risks in costs. Among them,
   Loan impairment provision calculation = 1% * total loan balance + 2% * attention loans + 25% * substandard loans + 50% * doubtful loans + 100% * loss loans + special provisions.
   The provisioning ratios for substandard and doubtful loans can fluctuate by 20%, and special provisions are determined by commercial banks based on special risk situations, risk loss probabilities, and historical experiences.

Loan impairment provision ending balance
= beginning balance + beginning adjustments + current period provisions - current period reversals + current period transfers - discounted recoveries of previously written-off loans + recoveries of prior year write-offs - current period write-offs + other factor changes

Third, in 2015-2016, the business system update, "G11-II Asset Quality and Provisions" unified the three provisions into impairment provisions.
Fourth, the bad debt provision extraction ratio for accounts receivable of listed companies in China is 9%, meaning that 9% of the accounts receivable balance is set aside as bad debt provisions, which are included in the current profit and loss. Here, bad debt provisions are equivalent to impairment provisions.
Fifth, the regulatory standard for the loan provisioning ratio is 2.50%.

2. Provision Coverage Ratio
   First, this is an indicator used to measure whether the loan loss provisions of commercial banks are sufficient, with the calculation formula being:
   Provision coverage ratio = loan impairment provisions / non-performing loans.
   Second, generally, each bank's standards for provisioning for loan impairment differ, so comparability is low, and the loan impairment provisions included in the current profit and loss are also an important factor affecting performance, thus there is a strong correlation between asset quality and operating performance.
   Third, the regulatory standard for the provision coverage ratio is 150%.

(4) New Standard Loan Provisioning Ratio and Provision Coverage Ratio: Adjusted Regulatory Requirements Based on the Implementation of Three Dimensions
On February 28, 2018, the China Banking Regulatory Commission issued the "Notice on Adjusting the Regulatory Requirements for Loan Loss Provisions of Commercial Banks" (Yin Jian Fa [2018] No. 7), clarifying that the regulatory requirement for the provision coverage ratio was adjusted from 150% to 120-150%, and the regulatory requirement for the loan provisioning ratio was adjusted from 2.5% to 1.5-2.5%.
Regulatory authorities at all levels should comprehensively consider the accuracy of loan classification, the proactivity in handling non-performing loans, and capital adequacy when determining the minimum regulatory requirements for loan loss provisions, following the principle of whichever is higher.

1. Accuracy of Loan Classification
   The minimum regulatory requirements for the provision coverage ratio and loan provisioning ratio are determined based on the proportion of loans overdue for more than 90 days classified as non-performing loans.
2. Proactivity in Handling Non-performing Loans
   The minimum regulatory requirements for the provision coverage ratio and loan provisioning ratio are determined based on the proportion of non-performing loans handled to newly formed non-performing loans.
3. Capital Adequacy
   The minimum regulatory requirements for the provision coverage ratio and loan provisioning ratio are determined based on the capital adequacy of different types of commercial banks.

(5) Other Indicators

1. Loan Migration Rate
   After the five-level classification of loans, the migration between different types of loans has also become a noteworthy indicator. The "Core Indicators for Risk Supervision of Commercial Banks (Trial)" issued by the China Banking Regulatory Commission in December 2005 clearly states that the main loan risk migration indicators include the migration rate of normal loans, attention loans, substandard loans, and doubtful loans. Here, migration mainly refers to downward migration, i.e., the ratio of relatively better loan categories migrating to worse loans, with no specific regulatory standard.
   First, the migration rate of normal loans = the balance of normal loans at the beginning of the period that migrated to the last four categories at the end of the period / the balance of normal loans at the beginning of the period.
   Second, the migration rate of attention loans = the balance of attention loans at the beginning of the period that migrated to non-performing loans at the end of the period / the balance of attention loans at the beginning of the period.
   Third, the migration rate of substandard loans = the balance of substandard loans at the beginning of the period that migrated to doubtful and loss loans at the end of the period / the balance of substandard loans at the beginning of the period.
   Fourth, the migration rate of doubtful loans = the balance of doubtful loans at the beginning of the period that migrated to loss loans at the end of the period / the balance of doubtful loans at the beginning of the period.
2. Non-performing Loan Generation Rate
   First, the non-performing loan generation rate = (newly added non-performing loan balance in the current period + non-performing loan write-offs in the current period) / total loan balance.
   Second, since the non-performing loan ratio is a stock indicator, it can only reflect past loan quality and risk control levels, and is influenced by write-offs, often leading to distorted data. Therefore, the non-performing loan generation rate better reflects the current asset quality situation.
3. Loan Deviation Degree
   First, the loan deviation degree, also known as loan classification deviation, specifically refers to the degree of deviation between the book classification of loans and the actual classification, with deviation = actual value / reported value.
   Second, a deviation exceeding 5% is considered abnormal.
   Third, the non-performing loan deviation generally refers to the ratio of loans overdue for more than 90 days to non-performing loans, exceeding 100% indicates inaccurate classification.

III. Capital Dimension of Commercial Banks#

(1) Types of Capital
This section refers to the "Measures for Capital Management of Commercial Banks (Trial)" issued by the China Banking Regulatory Commission in July 2012.

1. Tier 1 Capital (also known as Core Capital)
   Core capital specifically refers to the self-owned funds that commercial banks can use and allocate permanently.
   (1) Tier 1 capital includes two categories: core tier 1 capital and other tier 1 capital.
   (2) Core tier 1 capital includes paid-in capital, capital reserves, surplus reserves, general risk reserves, undistributed profits, and portions of minority shareholders' capital that can be included.
   (3) Other tier 1 capital includes perpetual bonds, preferred stocks, and other tier 1 capital instruments, as well as portions of minority shareholders' capital that can be included.
   (4) The proportion of tier 1 capital to total capital must be over 50%.
   (5) The deductions from tier 1 capital should include:
   First, goodwill, other intangible assets (excluding land use rights), net deferred tax assets arising from operating losses, and loan loss provision gaps;
   Second, gains from the sale of asset securitization, net amounts of defined benefit pension assets, and direct or indirect holdings of the bank's own stock;
   Third, cash flow reserves formed by hedging items not measured at fair value on the balance sheet (positive values are deducted, negative values are added back);
   Fourth, unrealized gains and losses arising from changes in the fair value of liabilities due to changes in the bank's own credit risk.

2. Tier 2 Capital (also known as Supplementary Capital)#

Tier 2 capital mainly includes subordinated debt, tier 2 capital bonds, hybrid capital instruments, excess loan loss provisions, and portions of minority shareholders' capital that can be included. Among them, the excess loan loss provisions calculated using the risk-weighted assets under the standard approach and internal rating approach can be included in tier 2 capital, but the proportion must not exceed 1.25% and 0.60% of risk-weighted assets, respectively.
Second, if tier 2 capital instruments issued by commercial banks have a definite maturity date, they should be gradually reduced to tier 2 capital at a rate of 100%, 80%, 80%, 60%, 40%, and 20% in the last five years before maturity.
(2) Risk-Weighted Assets
Risk-weighted assets include three categories: credit risk-weighted assets, market risk-weighted assets, and operational risk-weighted assets.

1. Credit Risk-Weighted Assets
   (1) They can be measured using the standard approach or internal rating approach. Generally, small and medium banks mainly use the standard approach to calculate credit risk-weighted assets.
   (2) The so-called standard approach means first deducting the corresponding impairment provisions from the book value of on-balance sheet assets, then multiplying by the risk weight. Off-balance sheet items are treated by multiplying the nominal amount by the credit conversion factor to obtain equivalent on-balance sheet assets, and then processed in the same way as on-balance sheet assets.
   (3) The risk-weighting method for on-balance sheet assets is as follows:
   First, the risk weight for commercial banks holding claims on the central government, central bank, and policy banks is 0, while the risk weight for bonds issued specifically for acquiring non-performing loans from state-owned banks is also 0. Additionally, the risk weight for claims on financial assets with a risk weight of 0 used as collateral is also 0.
   Second, the risk weight for claims on public sector entities (provincial and separately listed city governments, public sector entities with income from the central government, etc.), on other commercial banks with an original maturity of three months or less (inclusive), and on ABS is 20%, excluding claims on industrial enterprises invested by public sector entities.
   Third, the risk weight for claims on other commercial banks is 25%, and for subordinated debts is 100%.
   Fourth, the risk weight for claims on general enterprises is 100%, while for eligible small and micro enterprise claims, it is 75%. The risk weight for equity investments in industrial enterprises is 400% (passively held or held for policy reasons) and 1250% (others).
   Fifth, the risk weight for personal housing mortgage loans is 50% (150% for additional loans), and for other personal claims, it is 75%.

2. Market Risk-Weighted Assets
   First, market risk refers to the risk of loss in the bank's on-balance sheet and off-balance sheet business due to adverse changes in market prices (including interest rates, exchange rates, stock prices, and commodity prices). This includes interest rate risk and stock risk in the bank's trading account, as well as all exchange rate risk and commodity risk.
   Second, commercial banks can use the standard approach or internal model approach to measure market risk capital requirements.
   Third, market risk-weighted assets = market risk capital requirements * 12.50.

3. Operational Risk-Weighted Assets
   First, operational risk specifically refers to the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events, including legal risk but excluding strategic and reputational risks.
   Second, commercial banks can use the basic indicator approach, standard approach, or advanced measurement approach to measure operational risk capital requirements.
   Third, operational risk-weighted assets = operational risk capital requirements * 12.50.
   (3) Capital Adequacy Indicators
   There are three capital adequacy indicators: capital adequacy ratio, tier 1 capital adequacy ratio, and core tier 1 capital adequacy ratio. Among them,
   Capital adequacy ratio = net capital / risk-weighted assets = net capital / (credit risk-weighted assets + operational risk capital * 12.50 + market risk capital * 12.50)

4. General Regulatory Standards: The minimum capital adequacy ratio, tier 1 capital adequacy ratio, and core tier 1 capital adequacy ratio are 8%, 6%, and 5%, respectively.
   In 2012, China issued the "Measures for Capital Management of Commercial Banks (Trial)" based on the Basel III Agreement, clarifying that:
   First, core tier 1 capital includes paid-in capital (ordinary shares), capital reserves, surplus reserves, general risk reserves, undistributed profits, and portions of minority shareholders' capital that can be included, and should deduct goodwill, other intangible assets (excluding land use rights), net deferred tax assets arising from operating losses, and loan loss provision gaps.
   Second, other tier 1 capital includes other tier 1 capital instruments and their premiums, as well as portions of minority shareholders' capital that can be included.
   Third, tier 2 capital includes tier 2 capital instruments and their premiums, as well as excess loan loss provisions. Among them, the proportion of excess loan loss provisions included in tier 2 capital must not exceed 1.25% (standard approach) or 0.6% (internal rating approach) of risk-weighted assets.
   Fourth, the minimum standards for core tier 1 capital adequacy ratio, tier 1 capital adequacy ratio, and capital adequacy ratio are 5%, 6%, and 8%, respectively.

5. Final Regulatory Standards:
   The minimum capital adequacy ratio, tier 1 capital adequacy ratio, and core tier 1 capital adequacy ratio are 10.50%, 8.50%, and 7.50%, respectively. In addition, the capital management measures also stipulate that on top of the minimum requirements, an additional 2.5% of reserve capital, 0-2.5% of counter-cyclical capital, and 1% of additional capital must be set aside, with reserve capital, counter-cyclical capital, and additional capital all supplemented by core tier 1 capital.

Among them, the 1% additional capital only needs to be set aside by systemically important banks. This means that the regulatory minimum standards for capital adequacy ratio, tier 1 capital adequacy ratio, and core tier 1 capital adequacy ratio for systemically important commercial banks are actually 11.5%, 9.5%, and 8.50%, respectively. For non-systemically important commercial banks, the regulatory minimum standards for capital adequacy ratio, tier 1 capital adequacy ratio, and core tier 1 capital adequacy ratio are actually 10.5%, 8.5%, and 7.50%, respectively.
Currently, China is clarifying the list of systemically important financial institutions, which is expected to be released in a timely manner in 2019, at which point the 1% additional capital will take effect.

3. MPA Special Provisions: Macro-Prudential Capital Adequacy Ratio
   So far, the China Banking Regulatory Commission has not issued relevant details regarding counter-cyclical capital, so it can be largely ignored. However, although the China Banking Regulatory Commission has not mentioned it, the central bank's MPA assessment involves the concept of counter-cyclical capital. The central bank introduced the concept of macro-prudential capital adequacy ratio in the MPA, with the calculation formula being:

It should be noted that the reserve capital here is not the same concept as the systemically important additional capital and the China Banking Regulatory Commission's standards.
Among them, reserve capital is met by core tier 1 capital (2.5%), and counter-cyclical capital is met by core tier 1 capital (0-2.5%). Therefore, the actual minimum standards for core tier 1 capital adequacy ratio, tier 1 capital adequacy ratio, and capital adequacy ratio should be 7.5%, 8.5%, and 10.5%, respectively.
4. Leverage Ratio
First, the leverage ratio refers to the ratio of commercial banks' tier 1 capital to the adjusted balance of on-balance sheet and off-balance sheet assets, with a higher value indicating greater capital adequacy of the commercial bank.
Second, in April 2015, the China Banking Regulatory Commission revised the "Measures for the Management of Leverage Ratio of Commercial Banks" (Order No. 3 of the China Banking Regulatory Commission in 2011) and issued the "Revised Measures for the Management of Leverage Ratio of Commercial Banks."
Third, the calculation formula for the leverage ratio is tier 1 capital net amount / adjusted balance of on-balance sheet and off-balance sheet assets. Among them,
Adjusted balance of on-balance sheet and off-balance sheet assets = adjusted balance of on-balance sheet assets (excluding on-balance sheet derivatives and securities financing transactions) + balance of derivative assets + balance of securities financing transaction assets + adjusted balance of off-balance sheet items + deductions from tier 1 capital.
Four, Commercial Bank Liquidity Dimension
(1) Regulatory Indicators

1. Liquidity Coverage Ratio (LCR): High-quality liquid assets / net cash outflows over the next 30 days
   First, specific regulations can be found in the "Measures for the Management of Liquidity Risk of Commercial Banks" issued on May 25, 2018 (Order No. 3 of the China Banking and Insurance Regulatory Commission in 2018).
   Second, it applies to banks with assets over 200 billion RMB, with a regulatory standard of 100%.
   Third, the calculation method and regulatory standards for both domestic and foreign currencies are consistent.
2. Net Stable Funding Ratio (NSFR): Available stable funding / required stable funding
   First, specific regulations can be found in the "Measures for the Management of Liquidity Risk of Commercial Banks" issued on May 25, 2018 (Order No. 3 of the China Banking and Insurance Regulatory Commission in 2018).
   Second, it applies to banks with assets over 200 billion RMB, with a regulatory standard of 100%.
3. Liquidity Matching Ratio: Weighted sources of funds / weighted uses of funds
   First, specific regulations can be found in the "Measures for the Management of Liquidity Risk of Commercial Banks" issued on May 25, 2018 (Order No. 3 of the China Banking and Insurance Regulatory Commission in 2018).
   Second, it applies to all banks, with a regulatory standard of 100%.
   Third, starting from January 1, 2020, the liquidity matching ratio will be implemented according to regulatory indicators, and before 2020, it will be treated as a monitoring indicator.
4. High-Quality Liquid Asset Adequacy Ratio: High-quality liquid assets / short-term net cash outflows
   First, it applies to banks with assets below 200 billion RMB, with a regulatory standard of 100%.
   Second, it should reach 80% and 100% before the end of 2018 and June 30, 2019, respectively.
5. Liquidity Ratio: Liquid assets / liquid liabilities
   First, it applies to all banks, with a regulatory standard of 25% for both domestic and foreign currencies.
   Second, liquid assets include cash, gold, excess reserve deposits, net assets after netting interbank transactions due within one month, bond investments maturing within one month, bonds that can be liquidated in domestic and foreign secondary markets, and other assets that can be liquidated within one month (excluding non-performing assets).
   Third, liquid liabilities include demand deposits (excluding fiscal deposits), time deposits maturing within one month (excluding policy deposits), net interbank liabilities due within one month, bonds issued due within one month, interest payable and various payables due within one month, central bank borrowings due within one month, and other liabilities due within one month.
   (2) Monitoring Indicators
6. Loan-to-Deposit Ratio: Adjusted loan balance / adjusted deposit balance
   On June 24, 2015, the State Council executive meeting approved the "Amendment to the Commercial Banking Law of the People's Republic of China (Draft)," removing the regulation that the loan-to-deposit ratio must not exceed 75%, changing it from a statutory regulatory indicator to a liquidity monitoring indicator.
7. Liquidity Gap: Future cash flow gap (on-balance sheet and off-balance sheet assets - on-balance sheet and off-balance sheet liabilities)
   Future cash flow gap = future cash inflows - future cash outflows for each time period. Additionally, the liquidity gap ratio (i.e., future liquidity gap for each time period / corresponding time period's on-balance sheet and off-balance sheet assets) can be further derived.
   Regulatory requirements state that the liquidity gap ratio must not be less than -10%.
8. Core Liability Ratio: Core liabilities / total liabilities
   Core liabilities specifically refer to stable portions of time deposits with a maturity of more than three months (inclusive) and issued bonds, as well as demand deposits.
   Regulatory requirements state that the core liability ratio must not be less than 60%.
9. (Top Ten) Interbank Borrowing Ratio
   This refers to the ratio of (interbank lending + interbank deposits + sell-buyback + entrusted interbank payments + issued interbank certificates of deposit - settlement interbank deposits) / total liabilities. Among them, the top ten interbank borrowing ratio refers to the ratio of (interbank lending + interbank deposits + sell-buyback + entrusted interbank payments + issued interbank certificates of deposit - settlement interbank deposits) from the top ten interbank institutions to total liabilities.
10. Maximum Ten Deposits (Loans) Ratio: Total deposits from the top ten deposit (loan) clients / total deposits (loans)
11. Single Largest Client Loan to Net Capital Ratio: Not exceeding 10%
12. Cumulative Foreign Exchange Exposure Position to Net Capital Ratio: Not exceeding 20%
13. Deposit Deviation Degree
    First, deposit deviation degree = (last day's total deposits - average daily deposits) / average daily deposits.
    Second, on June 8, 2018, the China Banking and Insurance Regulatory Commission and the central bank jointly issued the "Notice on Improving the Management of Deposit Deviation Degree of Commercial Banks" (Yin Jian Ban Fa [2018] No. 48), adjusting the monthly deposit deviation indicator value of commercial banks from 3% to 4%, with the same indicator calculation for quarter-end and non-quarter-end months.
    Third, Document No. 48 also clarified that commercial banks must not establish point-in-time deposit scale evaluation indicators, nor set evaluation indicators based on deposit market share, ranking, or interbank comparisons.
    Five. Market Risk Dimension of Commercial Banks
    This section mainly derives from the "Guidelines for Market Risk Management of Commercial Banks" issued on December 29, 2004, when the China Banking Regulatory Commission was just established.
    (1) Four Major Sources of Risk
14. Repricing Risk
    Also known as maturity mismatch risk, it is the most significant and common form of interest rate risk, mainly referring to the risk arising from differences in the maturity dates (for fixed rates) or repricing dates (for floating rates) of bank assets, liabilities, and off-balance sheet businesses. The asymmetry in pricing on both sides of assets and liabilities causes the bank's income or intrinsic economic value to change with interest rate fluctuations. For example, if a bank uses short-term deposits as a funding source for long-term fixed-rate loans, when interest rates rise, the interest income from loans is fixed, but the interest expense on deposits will increase with rising rates, thereby reducing the bank's future income and economic value.
15. Yield Curve Risk
    This refers to the adverse impact on the bank's income or intrinsic economic value due to non-parallel movements of the yield curve, forming yield curve risk, also known as interest rate term structure change risk. For example, if a short position in a five-year government bond is hedged against a long position in a ten-year government bond, when the yield curve steepens, although the above arrangement has hedged against parallel movements of the yield curve, the economic value of the ten-year bond long position will still decline.
16. Basis Risk
    Basis risk is another important source of interest rate risk. When the benchmark interest rates on which interest income and interest expenses are based change inconsistently, although the repricing characteristics of assets, liabilities, and off-balance sheet businesses are similar, changes in their cash flows and income spreads will also adversely affect the bank's income or intrinsic economic value.
    For example, if a bank issues a one-year loan based on a one-year deposit, although there is no repricing risk due to the identical repricing dates of interest-sensitive liabilities and assets, the changes in the benchmark interest rates may not be fully correlated, leading to basis risk due to changes in the interest spread.
17. Optionality Risk
    Optionality risk arises from the options embedded in the bank's assets, liabilities, and off-balance sheet businesses. Options can be standalone financial instruments, such as exchange-traded options and over-the-counter options contracts, or they can be embedded in other standardized financial instruments, such as early redemption of bonds or deposits, early repayment of loans, and other optional clauses.
    Generally, options and optional clauses are executed when they are favorable to the buyer and unfavorable to the seller, so such optionality tools pose risks to the seller due to their asymmetric payment characteristics. For instance, if interest rate changes favor depositors or borrowers, depositors may choose to rearrange deposits, and borrowers may choose to rearrange loans, adversely affecting the bank.
    (2) Gap Analysis
    Gap analysis is a method to measure the impact of interest rate changes on the current income of banks. Specifically, it involves classifying all interest-earning assets and interest-bearing liabilities of the bank into different time periods (e.g., less than 1 month, 1-3 months, 3 months-1 year, 1-5 years, over 5 years). In each time period, the interest-sensitive assets are subtracted from the interest-sensitive liabilities, and the off-balance sheet positions are added to obtain the repricing "gap" for that time period. Multiplying this gap by the assumed interest rate change yields the approximate impact of this interest rate change on net interest income.
    When liabilities exceed assets (including off-balance sheet positions) in a certain time period, a negative gap occurs, i.e., a liability-sensitive gap, where an increase in market interest rates will lead to a decrease in the bank's net interest income. Conversely, when assets (including off-balance sheet positions) exceed liabilities in a certain time period, a positive gap occurs, i.e., an asset-sensitive gap, where a decrease in market interest rates will lead to a decrease in the bank's net interest income.
    The assumed interest rate changes in gap analysis can be determined in various ways, such as historical experience, management judgment, and simulating potential future interest rate changes. Gap analysis also has the following drawbacks:
18. It ignores the differences in maturity dates or repricing periods of different positions within the same time period. The higher the aggregation level within the same time period, the greater the impact on the accuracy of the measurement results.
19. It only considers the interest rate risk arising from differences in repricing periods, i.e., repricing risk, and does not account for the interest rate risk arising from different adjustments in benchmark rates when interest rate levels change, i.e., basis risk. Additionally, gap analysis does not consider changes in payment timing due to changes in the interest rate environment, thus ignoring the differences in income sensitivity related to positions with options.
20. Non-interest income and expenses are significant sources of current income for banks, but most gap analyses fail to reflect the impact of interest rate changes on non-interest income and expenses. Fourth, gap analysis mainly measures the impact of interest rate changes on current income, without considering the impact of interest rate changes on the bank's economic value, so it can only reflect the short-term effects of interest rate changes. Therefore, gap analysis is merely a primary and rough method for measuring interest rate risk.
    (3) Duration Analysis
    Duration analysis, also known as duration elasticity analysis, is a method to measure the impact of interest rate changes on the bank's economic value. Specifically, it assigns corresponding sensitivity weights to the gaps of each time period to obtain a weighted gap, and then aggregates the weighted gaps across all time periods to estimate the potential impact of a given small (usually less than 1%) interest rate change on the bank's economic value (expressed as a percentage change in economic value). The sensitivity weights for each time period are usually determined by multiplying the assumed interest rate change by the assumed average duration of positions in that time period.
    Of course, banks can evolve the standard duration analysis method, such as not using the average duration for each time period's positions, but instead calculating the precise duration of each asset, liability, and off-balance sheet position to measure the impact of market interest rate changes, thus eliminating errors that may arise from aggregating positions/cash flows. Additionally, banks can also use effective duration analysis, applying different weights to different time periods based on the actual percentage changes in market values of financial instruments under specific interest rate changes, to better reflect the non-linear changes in prices caused by significant fluctuations in market interest rates.
    Duration analysis also has certain limitations:
21. If the average duration is used for each time period in calculating sensitivity weights, i.e., using the standard duration analysis method, duration analysis can only reflect repricing risk and cannot reflect basis risk, nor can it accurately reflect the actual interest rate sensitivity differences of positions due to differences in interest rates and payment timings, and it cannot effectively reflect optionality risk.
22. For significant interest rate changes (greater than 1%), since the price changes of positions cannot be approximated as a linear relationship with interest rate changes, the accuracy of duration analysis is reduced.

(4) Foreign Exchange Exposure Analysis#

Foreign exchange exposure analysis is a method to measure the impact of exchange rate changes on the current income of banks. Foreign exchange exposure mainly arises from currency mismatches in the bank's on-balance sheet and off-balance sheet businesses. When the long and short positions of a certain currency do not match within a certain time period, the resulting difference forms foreign exchange exposure. In the presence of foreign exchange exposure, exchange rate changes may cause losses to the bank's current income or economic value, thus forming exchange rate risk. When conducting exposure analysis, banks should analyze the foreign exchange exposure of a single currency, as well as the total foreign exchange exposure after converting and netting the exposures of various currencies into the reporting currency. For a single currency's foreign exchange exposure, banks should analyze spot foreign exchange exposure, forward foreign exchange exposure, and the total foreign exchange exposure after netting spot and forward exposures. Banks should also distinguish between foreign exchange exposures arising from trading and non-trading businesses. To control exchange rate risks arising from foreign exchange exposure, banks typically use hedging and limit management strategies. Foreign exchange exposure limits include limits on single currency exposures and total foreign exchange exposure limits. Foreign exchange exposure analysis is one of the earliest methods adopted by the banking industry to measure exchange rate risk, with the advantages of being simple to calculate and easy to understand. However, foreign exchange exposure analysis also has certain limitations, mainly overlooking the correlation of exchange rate changes among various currencies, making it difficult to reveal the exchange rate risks arising from the correlation of exchange rate changes among various currencies.
(5) Sensitivity Analysis
Sensitivity analysis refers to studying the potential impact of changes in a single market risk factor (interest rates, exchange rates, stock prices, and commodity prices) on the income or economic value of financial instruments or asset portfolios, while keeping other conditions unchanged. In the "Principles for Interest Rate Risk Management and Supervision" published by the Basel Committee in 2004, banks are required to assess the impact of standard interest rate shocks (such as an increase or decrease of 200 basis points) on the bank's economic value, which is also a method of interest rate sensitivity analysis. The aim is to enable regulatory authorities to evaluate whether the bank's internal measurement system adequately reflects its actual interest rate risk level and capital adequacy based on the assessment results of standard interest rate shocks, and to compare the interest rate risks undertaken by different institutions.
Sensitivity analysis is simple to calculate and easy to understand, and has been widely applied in market risk analysis. However, sensitivity analysis also has certain limitations, mainly in that it cannot measure the non-linear changes in income or economic value relative to market risk factors for more complex financial instruments or asset portfolios. Therefore, when using sensitivity analysis, attention should be paid to its applicability, and other market risk analysis methods should be supplemented when necessary.
(6) Scenario Analysis
Unlike sensitivity analysis, which analyzes a single factor, scenario analysis is a multi-factor analysis method that studies the potential impacts when multiple factors act simultaneously, considering the probabilities of various possible scenarios. In the scenario analysis process, it is important to consider the correlations and interactions of various positions. The scenarios used in scenario analysis typically include baseline scenarios, best-case scenarios, and worst-case scenarios. Scenarios can be artificially set (such as directly using historically occurred scenarios) or derived from statistical analyses of historical data changes in market risk factors, or through running stochastic processes that describe changes in market risk factors under specific conditions. For example, banks can analyze the potential impacts on their market risk levels when interest rates and exchange rates change simultaneously, or analyze how their market risk conditions may change in the event of historically significant political, economic events, or financial crises, as well as hypothetical events.

(7) Value at Risk (VaR)#

Value at risk refers to the potential maximum loss that changes in market risk factors such as interest rates and exchange rates may cause to a certain position, asset portfolio, or institution over a specified holding period and given confidence level. For example, if the calculated value at risk is $10,000 with a holding period of one day and a confidence level of 99%, it indicates that there is a 99% probability that the bank's asset portfolio will not lose more than $10,000 in one day. Value at risk is usually estimated by the bank's internal quantitative risk management model for market risk.
Currently, there are three commonly used value at risk modeling techniques: Variance-Covariance Method, Historical Simulation Method, and Monte Carlo Simulation Method.
The Basel Committee's "Supplementary Regulations on Market Risk of the Capital Accord" issued in 1996 proposed the following quantitative requirements for internal models of market risk: a confidence level of 99% for a one-tailed confidence interval; a holding period of 10 business days; a historical observation period of at least one year for market risk factor prices; and data updates at least every three months. However, in terms of modeling techniques, the Basel Committee and national regulatory authorities have not imposed rigid requirements, allowing banks to choose any of the three commonly used modeling techniques. Even the quantitative provisions for setting VaR model parameters are limited to the calculation of regulatory market risk capital, and commercial banks can use different parameter values for internal risk management. For instance, while the Basel Committee requires a 99% confidence level for calculating regulatory capital, many banks use confidence levels of 95% or 97.5% for internal management. Additionally, considering the inherent deficiencies of market risk internal models, the Basel Committee requires that the calculated value at risk be multiplied by a multiplication factor to ensure that the resulting capital amount is sufficient to cover potential losses due to adverse market changes. The multiplication factor is generally determined by national regulatory authorities based on their assessment of the quality of the bank's risk management system, with the Basel Committee stipulating that this value must not be less than 3.
The market risk internal model method also has certain limitations. First, the risk levels calculated by the market risk internal model are highly generalized and cannot reflect the composition of the asset portfolio and its sensitivity to price fluctuations, thus having limited utility in specific risk management processes, necessitating supplementation with sensitivity analysis, scenario analysis, and other non-statistical methods. Second, the market risk internal model method does not cover sudden low-probability events that may cause significant losses to banks, such as extreme price fluctuations, thus requiring supplementation with stress testing. Third, most market risk internal models can only measure market risks in trading businesses and cannot measure market risks in non-trading businesses. Therefore, banks using market risk internal models should fully recognize their limitations and appropriately understand and apply the calculation results of the models.

(8) Back Testing#

Back testing refers to comparing the estimated results of market risk measurement methods or models with actual gains and losses to verify the accuracy and reliability of the measurement methods or models, and to adjust and improve them accordingly. If the estimated results are close to the actual results, it indicates that the accuracy and reliability of the risk measurement method or model are high; if there is a significant gap between the two, it indicates that the accuracy and reliability of the risk measurement method or model are low, or that there are issues with the assumptions underlying the back testing; results that fall between these two situations suggest that there are problems with the risk measurement method or model, but the conclusions are uncertain. Currently, back testing as a means of verifying market risk measurement methods or models is still in development. Different banks adopt different back testing methods and standards for interpreting back testing results.
The Basel Committee's "Supplementary Regulations on Market Risk of the Capital Accord" issued in 1996 requires banks that use internal models to calculate market risk capital to conduct back testing to verify and improve the accuracy and reliability of the models. Regulatory authorities should determine whether to set additional factors to increase the regulatory capital requirements for market risk based on the results of back testing. The additional factor is set above the minimum multiplication factor (which the Basel Committee stipulates to be 3), with values ranging from 0 to 1. If the regulatory authority is satisfied with the back testing results of the model, and the model meets other quantitative and qualitative standards set by the regulatory authority, the additional factor can be set to 0; otherwise, it can be set to a value between 0 and 1, thereby increasing the calculated VaR value's multiplication factor and imposing higher regulatory capital requirements on banks with deficiencies in their internal models.

(9) Stress Testing#

Banks should not only use various market risk measurement methods to analyze the market risks they face under normal market conditions but also conduct stress testing to estimate potential losses that may arise from extreme adverse situations, such as significant fluctuations in interest rates, exchange rates, stock prices, or unexpected political and economic events, or the simultaneous occurrence of several scenarios. The purpose of stress testing is to assess the bank's ability to withstand losses in extremely adverse conditions, mainly using sensitivity analysis and scenario analysis methods for simulation and estimation.
When conducting stress testing using sensitivity analysis, questions to be answered include: the impact of exchange rate shocks on the bank's net foreign exchange position, the impact of interest rate shocks on the bank's economic value or income, etc. When conducting stress testing using scenario analysis, scenarios that may have the greatest impact on market risk should be selected, including scenarios that have historically caused significant losses (such as the Asian financial crisis in 1997) and hypothetical scenarios. Hypothetical scenarios include situations where model assumptions and parameters are no longer applicable, situations where market prices fluctuate significantly, situations where market liquidity is severely insufficient, and situations where significant changes in the external environment may lead to substantial losses or uncontrollable risks. These scenarios may be prescribed by regulatory authorities or designed by commercial banks based on the characteristics of their asset portfolios. When designing stress scenarios, both micro factors such as changes in market risk factors and macro factors such as changes in a country's economic structure and macroeconomic policies should be considered.

(10) Banking Book and Trading Book#

The on-balance sheet and off-balance sheet assets of banks can be divided into two main categories: banking book and trading book assets. The Basel Committee's "New Capital Accord" in 2004 modified the definition of the trading book in its "Supplementary Regulations on Market Risk of the Capital Accord" issued in 1996. The revised definition states that the trading book records financial instruments and commodity positions that banks hold for trading purposes or to hedge risks from other items in the trading book. Positions recorded in the trading book must be unrestricted in terms of trading and must be able to fully hedge their own risks. Moreover, banks should regularly and accurately value trading book positions and actively manage that investment portfolio. Positions held for trading purposes refer to those held with the intention of selling them in the short term to profit from actual or anticipated short-term price fluctuations or to lock in arbitrage profits, such as proprietary positions, client trading positions, and market-making positions. Positions recorded in the trading book must meet the following basic requirements: first, they must have a written trading strategy for positions/financial instruments and investment portfolios approved by senior management (including holding periods); second, they must have clear policies and procedures for managing positions; third, they must have clear policies and procedures for monitoring whether trading positions are consistent with the bank's trading strategy, including monitoring trading volumes and trading book position balances. Whether a trading purpose is established is determined at the beginning of the trade and generally cannot be changed arbitrarily thereafter. In contrast to the trading book, other businesses of the bank fall into the banking book, with the most typical being deposit and loan businesses. Items in the trading book are usually valued at market prices (mark-to-market), and when there are no reference market prices, they can be priced using models (mark-to-model). Mark-to-model pricing refers to inputting other relevant data obtained from the market into a model to calculate or estimate the value of trading positions. Items in the banking book are usually valued at historical cost.
Commercial banks should establish internal policies and procedures regarding account classification, which should include: definitions of trading businesses, financial instruments to be included in the trading book, strict delineation of trading and non-trading positions and their responsibilities, trading strategies for financial instruments or investment portfolios, policies and procedures for managing trading positions, and procedures for monitoring whether trading positions are consistent with trading strategies. At the same time, banks should maintain complete records of trading and account classification for inquiry and accept internal, external audits and regulatory supervision. Additionally, commercial banks should adopt corresponding methods for identifying, measuring, monitoring, and controlling market risks based on the nature and characteristics of banking books and trading books.
Moreover, the classification of banking books and trading books is also the basis for accurately calculating market risk regulatory capital. The "Supplementary Regulations on Market Risk of the Capital Accord" issued by the Basel Committee in January 1996, as well as capital accords formulated by most countries based on this, included market risk in the scope of capital requirements but did not cover all market risks. The included risks are interest rate and stock price risks in the trading book and exchange rate and commodity price risks in both banking and trading books. Therefore, improper account classification can affect the accuracy of market risk capital requirements; if banks arbitrarily adjust positions between the two accounts, it may provide regulatory arbitrage opportunities for adjusting their calculated capital adequacy ratios as needed. Currently, banking regulatory authorities in countries/regions implementing market risk regulatory capital requirements have established basic principles for the classification of banking books and trading books and require commercial banks to formulate internal policies and procedures accordingly, detailing account classification standards and procedures. Regulatory authorities regularly inspect banks' account classification situations, focusing on whether their internal account classification policies and procedures comply with regulatory requirements, whether they adhere to internal account classification policies and procedures, and whether they artificially adjust positions between the two accounts to reduce regulatory capital requirements.

(11) Limits Management#

Commercial banks implementing market risk management should ensure that the market risks they undertake are controlled within a bearable reasonable range, aligning the level of market risk with their risk management capabilities and capital strength. Limits management is an important means of controlling market risk. Banks should set market risk limits based on the market risk measurement methods they adopt. Market risk limits can be allocated to different regions, business units, and traders, and can also be broken down by asset portfolio, financial instruments, and risk categories. The department responsible for market risk management should monitor compliance with market risk limits and promptly report any exceedances to management. Common market risk limits include trading limits, risk limits, and stop-loss limits.
Trading limits refer to limits set on total trading positions or net trading positions. Total position limits restrict long or short positions on specific trading instruments, while net position limits restrict the net amount after offsetting long and short positions. In practice, banks typically use a combination of these two types of trading limits.
Risk limits refer to limits set on market risks measured according to certain measurement methods, such as limits on value-at-risk (VaR) calculated using internal models and limits on optional positions. Optional position limits refer to limits set on sensitivity parameters that reflect the value of options, typically including: Delta, which measures the sensitivity of option value to changes in the price of the underlying asset; Gamma, which measures Delta's sensitivity to changes in the price of the underlying asset; Vega, which measures the sensitivity of option value to market expectations of the underlying asset's price volatility; Theta, which measures the change in value as the option approaches expiration; and Rho, which measures the sensitivity of option value to changes in short-term interest rates.
Stop-loss limits refer to the maximum allowable loss amount. Typically, when the cumulative loss of a position reaches or approaches the stop-loss limit, hedging transactions or liquidation of that position must be executed. Typical stop-loss limits are retrospective, meaning they apply to cumulative losses over a period of one day, one week, or one month.

(12) Risk-Adjusted Rate of Return#

For a long time, the profitability of enterprises has generally been measured using return on equity (ROE) and return on assets (ROA) indicators, whose shortcomings lie in only considering the enterprise's book profits while neglecting risk factors. Banks are high-risk enterprises dealing with special goods, and measuring their profitability using indicators that do not consider risk factors is highly limited. Currently, the trend in international banking is to adopt risk-adjusted rates of return, comprehensively assessing banks' profitability and risk management capabilities. Risk-adjusted rates of return overcome the shortcomings of traditional performance assessments where profit targets do not adequately reflect risk costs, directly linking and organically combining banks' returns with risks, reflecting the inherent unity of business development and risk management, and achieving the unity of operational objectives and performance assessments. Using risk-adjusted rates of return is conducive to establishing a good incentive mechanism within banks, fundamentally changing the operating mode of banks that neglect risks and blindly pursue profits, encouraging banks to fully understand the risks they undertake and consciously identify, measure, monitor, and control these risks, thereby expanding business and creating profits under prudent management.
Among risk-adjusted rates of return, the risk-adjusted return on capital (RAROC) is widely accepted and commonly used. The risk-adjusted return on capital refers to the rate of return adjusted for expected losses (EL) and unexpected losses (UL) measured by economic capital (CaR), with the calculation formula as follows:

RAROC = (Revenue - Expected Loss) / Economic Capital (or Unexpected Loss)

Risk-adjusted rates of return, such as RAROC, emphasize that banks incur costs for the risks they undertake. In the numerator of the RAROC calculation formula, the expected losses brought by risks are quantified as current costs, directly reducing current profits to measure the risk-adjusted returns; in the denominator, economic capital or unexpected losses replace the equity in the traditional ROE indicator, meaning that banks should allocate corresponding economic capital for unpredictable risks. The entire formula measures the efficiency of using economic capital.
Currently, RAROC and other risk-adjusted rates of return have been widely applied in advanced international banks, playing an important role in various operational management activities at all levels. At the individual business level, RAROC can be used to measure whether the risks and returns of a business match, providing a basis for banks to decide whether to engage in that business and how to price it. At the asset portfolio level, banks can measure whether the risks and returns of the asset portfolio match based on the risks of individual businesses and the portfolio effect, timely addressing asset portfolios that show a significantly adverse trend in RAROC indicators, thereby freeing up space for more profitable businesses. At the overall bank level, RAROC can be used for target setting, business decision-making, capital allocation, and performance assessment. Senior management, after determining the overall risk level that the bank can undertake, i.e., risk appetite, calculates the overall economic capital required by the bank to evaluate its capital adequacy; allocates economic capital among various risks, business departments, and types of businesses (capital allocation) to effectively control the overall risk of the bank and optimize resource allocation through economic capital allocation; at the same time, translates shareholder return requirements into operational objectives for the entire bank, each business department, and each business line for performance assessment, enabling the bank to maximize returns under bearable risk levels and ultimately maximize shareholder value.

VI. Profitability Dimension of Commercial Banks#

(1) Net Interest Margin and Net Interest Spread

1. Net Interest Spread (NIS)
   Net interest spread = average interest rate of interest-earning assets - average interest rate of interest-bearing liabilities.
2. Net Interest Margin (NIM)
   Net interest margin (also known as net interest yield) = net interest income / average balance of interest-earning assets.
   It can be further derived:
   Net interest margin (NIM) = net interest spread (NIS) + average interest rate of interest-bearing liabilities * (1 - interest-bearing liabilities / interest-earning assets)
   This means that when the cost on the liability side rises, the gap between net interest margin and net interest spread will widen. Since net interest margin considers scale factors while also incorporating structural and market factors, it often has higher analytical value than net interest spread.

(2) ROA and ROE#

1. ROA (Return on Assets)
   ROA = net profit / asset balance * 100%.

2. ROE (Return on Equity)
   (1) Also known as return on net assets, i.e., ROE = net profit / net asset balance.
   (2) Return on net assets can be divided into weighted average return on net assets and diluted return on net assets, among which
   First, weighted average return on net assets = 2 * net profit / (end net assets + beginning net assets)
   Second, diluted return on net assets = 2 * net profit / end net assets

3. Cost-to-Income Ratio
   Cost-to-income ratio = business and management expenses / operating income, generally the lower, the better.

4. Credit Cost
   Credit cost = current credit provisions / average loan balance for the current period (including discounts).
   The "Core Indicators for Risk Supervision of Commercial Banks (Trial)" issued on December 31, 2005, clearly stipulates that the cost-to-income ratio must not exceed 35%, the asset profit rate must not be less than 0.60%, and the capital profit rate must not be less than 11%.

VII. Concentration Management and Large Risk Exposures of Commercial Banks#

(1) Concentration and Relatedness (Originating from the "Core Indicators for Risk Supervision of Commercial Banks (Trial)" issued on December 31, 2005)
On December 31, 2005, the China Banking Regulatory Commission issued the "Core Indicators for Risk Supervision of Commercial Banks (Trial)," which stipulated three currently used regulatory indicators that can be integrated with large risk exposure regulations.

1. Single Group Client Credit Concentration (≤ 15%)
   First, the calculation formula for single group client credit concentration = total credit amount to the largest group client / net capital × 100%
   Second, the total credit amount to the largest group client refers to the highest total credit amount to a single group client at the end of the reporting period.
   Third, credit refers to funds directly provided by commercial banks to non-financial institution clients or guarantees made for clients' potential compensation or payment responsibilities in relevant economic activities, including loans, trade financing, bill financing, financing leasing, overdrafts, various advances, and other on-balance sheet businesses, as well as bill acceptance, issuing letters of credit, guarantees, standby letters of credit, bond issuance guarantees, borrowing guarantees, recourse asset sales, unused irrevocable loan commitments, and other off-balance sheet businesses.
2. Single Client Loan Concentration (≤ 10%)
   First, the calculation formula for single client loan concentration = total loan amount to the largest client / net capital × 100%
   Second, the total loan amount to the largest client refers to the highest total loan balance to a single client at the end of the reporting period.
   Third, a client refers to a legal person, other economic organization, individual business owner, or natural person obtaining a loan.
   Fourth, the definition of various loans is consistent with that in the non-performing loan ratio indicator.
3. Total Relatedness (≤ 50%)
   First, the calculation formula for total relatedness = total credit amount to all related parties / net capital × 100%
   Second, the total credit amount to all related parties refers to the total credit balance to all related parties of the commercial bank, excluding the guarantee deposits and pledged bank certificates of deposit and treasury bonds provided by related parties at the time of credit.

(2) Large Risk Exposures (Originating from the "Measures for the Management of Large Risk Exposures of Commercial Banks" issued on May 4, 2008)#

1. Main Definitions
   This section refers to the "Measures for the Management of Large Risk Exposures of Commercial Banks" issued on May 4, 2018 (Order No. 1 of the China Banking and Insurance Regulatory Commission in 2018). Among them,
   First, risk exposure refers to the credit risk exposure of commercial banks to a single client or a group of related clients, including various credit risk exposures within the bank's books and trading books.
   Second, large risk exposure refers to the risk exposure of commercial banks to a single client or a group of related clients exceeding 2.5% of their tier 1 capital.
2. For Non-Interbank Clients
   First, for single clients: loan balance / net capital <= 10%, risk exposure / tier 1 capital <= 15%
   Second, for related clients: total credit amount to group clients / net capital <= 15%, risk exposure / tier 1 capital <= 20%
3. For Interbank Clients and Non-Qualified Central Counterparties: risk exposure / tier 1 capital <= 25%
   In addition, interbank business currently has the following constraints: interbank liabilities must not exceed 1/3; and the balance of repurchase agreements must not exceed 80% of the previous quarter's net assets.
4. Global Systemically Important Banks and Qualified Central Counterparties
   First, for global systemically important banks: risk exposure / tier