Last week the China Banking Regulatory Commission published new capital and liquidity standards for mainland banks.
By the end of 2013 China's big banks will be required to hold capital equal to 11.5 per cent of their assets. Their core tier one capital - the highest-quality type of capital, essentially consisting of equity together with retained earnings - must come to no less than 5 per cent of their assets. That's a tougher requirement even than under the new Basel III international banking standards.
The capital requirements for smaller banks, which would pose less of a threat to the stability of the overall banking system if they were to get into trouble, are less onerous. But all banks will be required to make provisions against losses on bad loans equal to 2.5 per cent of their total loan books; a level considered high by international standards.
Mainland regulators are clearly anxious to avoid the kind of insolvency and illiquidity crises that devastated banking systems in the United States and Europe in 2008. And for the most part market analysts believe the CBRC is on the right track, welcoming the new rules as a model of prudent banking supervision.
Coming on top of the news that mainland bank profits were up an impressive 33 per cent in the first quarter of the year compared with the same period in 2010, with the sector accounting for very nearly half of all the profits made by mainland-listed companies, the new rules are likely to bolster investors' confidence in mainland banks.
And that confidence is already pretty high. As the charts below illustrate, the shares of mainland banks listed in Hong Kong have performed strongly this year. Shares in Agricultural Bank of China are up 17.7 per cent, while ICBC has risen 11.4 per cent. Even the shares of some second-tier banks usually considered weaker than their larger competitors have done well. Citic Bank, for example, is up 8.9 per cent over the year so far. That's an impressive gain given that the overall market, in the form of the H-share index, has risen by just 1.9 per cent.
Even so, despite the CBRC's new capital standards and the banks' profitability, there are still grave doubts about the financial soundness of the mainland's banking sector.
Although most of its big banks either already meet the regulator's new capital and provisioning requirements or are close to doing so, it is unlikely that even the new standards will be sufficient to buffer the banking sector against expected future increases in bad loan levels.
We got an idea of the scale of the risk last summer when details emerged of a CBRC investigation into bank lending to local- government-backed investment projects.
According to the CBRC outstanding loans to the sector totalled 7.7 trillion yuan (HK$9.2 trillion). Of these it reckoned only 27 per cent could be adequately serviced from the projects' cashflow.
The CBRC warned that as many as 23 per cent, or 1.7 trillion yuan, were highly likely to turn bad, while another 50 per cent, or 3.8 trillion yuan, looked as if they would need extra support from their local government backers to stay above water.
Unfortunately, the guarantees offered by local government borrowers are implicit rather than explicit, and there is a good chance that they may walk away from their financing vehicles if the underlying projects run into difficulties. As a result, based on the CBRC study, there is a considerable risk that as much as 5.62 trillion yuan in bank loans to local government investment projects could turn bad. That would push the non-performing loan ratio for the mainland's banking system as a whole up from an official rate of 1.1 per cent at the end of last year to more than 11 per cent.
Given the past failure of mainland banks to recover any more than around 20 cents on the dollar - or rather 20 fen on the yuan - from non-performing assets, that implies banks could suffer losses from local government lending equal to 9 per cent of their entire loan books.
Viewed like that, the CBRC's new loan loss provisioning standard of 2.5 per cent of outstanding lending looks deeply inadequate.
If mainland banks were forced to recognise such heavy losses, it would not only wipe out all their profits - 899 billion yuan for the sector as a whole last year - but would also knock a sizeable hole in their capital bases, pushing their capital ratios back down into single figures.
To meet the CBRC's new standards, the banks would then have to go back to the capital markets for a major new round of capital raising, which would severely punish existing shareholders.
As a result, it looks as if the market's new-found confidence in the mainland's banking sector may be badly misplaced.