China adopted a series of financial reform measures since 1995. The National People's Congress promulgated legislation in four areas of finance:

• the Law of the People's Republic: of China on the People's Bank of China,
• the Law of the People's Republic of China on Commercial Banks,
• the Law of the People's Republic of China on Negotiable Instruments, and
• the Law of the People's Republic of China on Insurance.

The first one establishes a legal basis for the status of the People's Bank of China (PBOC) as the central bank and authorizes the bank to formulate and implement monetary policies and exercise supervision and control over the financial industry under the leadership of the State Council.

The second one sets up three state banks to implement government spending -- the State Development Bank of China, the Agricultural Development Bank of China and the Import and Export Bank of China -- and separates government-mandated banking from commercial banking.

All loans made by commercial banks are now subject to the following rules on asset-liability ratios:

• minimum ratio of 8% for a bank's total capital to its risk-weighted assets, and 4% for the minimum ratio of Tier 1capital to risk-weighted assets;
• maximum ratio of 73% for the bank's loan balance to its deposit balance;
• minimum ratio of 25% for the balance of liquid assets to the balance of liquid liabilities;
• 10% for the general per-customer lending limit in terms of the bank's total amount of capital and surplus.

Every commercial bank must submit a statement on its load/deposit radio on a monthly basis. The "Report on Capital Adequacy" must be filed semi-annually. Statements on all other ratios are submitted each quarter.

Supervision Regulations

Regulations on Financial Institutions Administration" provides that the PBOC shall conduct an annual on-site examination for all financial institutions. The examination will focus on the evaluation of overall activities and performance, the adequacy of capital and working capital, and management's efforts in complying with all applicable laws and regulations. The on-site examination will take place in the first quarter of each year, and the financial institutions must, within 15 days after receiving the formal notice for annual examination, submit its balance sheet, income statement and other required reports and statements to the central bank.

Regarding the banking supervision process, China has released "Regulations Concerning Auditing and Supervision by the People's Bank of China," "Penalty Regulations Concerning Financial Auditing and Examination" and "People's Bank of China Auditing and Supervision Reporting System."

All banks in China now have auditing departments totaling 30,000 employees. Of them, more than 9,000 work at the PBOC's 2,000 supervision departments in the head office and the provincial or municipal branches.

Business Overlapping Problem

It has been a significant problem that the business of banks and non-bank financial institutions overlaps. For example, banks are involved in trust investment, securities transactions, insurance and real estate; insurance companies extend credit and are involved in securities transactions; securities companies receive deposits, set up fund loans for investors, repurchase returned securities, and permit investors to overdraw or borrow on their accounts.

If banks and non-bank financial institutions engage in each other's line of business, there is a problem that short-term money may be used for long-term purposes, creating a risk of asset/liability mismatches. There is also a concern that, if the operations of banking, trust, securities, insurance and real estate are mixed and overlapped, the interests of depositors, insureds and investors may not be properly protected and may enlarge the risk of financial operations. Speculation in securities markets and problems in real estate markets could also increase.

The new Law of the People's Republic of China on Commercial Banks is intended to separate banking business from non-banking business, to prevent commercial banks from committing capital and deposit money to high-risk securities business and long-term investments, to ensure safety and liquidity of the banking institution and maintain normal financial order. It prohibits a commercial bank from engaging in any equity transactions, trust business, or real estate investment. It also stipulates that commercial banks should not invest in any non-bank financial institution or other business sector. Thus, all investment banking activities, such as underwriting and dealing in securities other than treasury bills and bonds as well as merger and acquisition advice, are only conducted by security firms and trust investment companies.

A clear separation between different financial operations should be a fundamental principle in establishing a modern financial system. China will implement the separation of financial operations along the following lines:

• banks are not allowed to provide trust services for firms or individuals, to make investment in industrial and commercial enterprises, or to run securities operations except buying treasury bills and bonds;
• securities companies are not allowed in any form to extend credit or to borrow money through repurchase agreements or by taking long or short positions;
• trust investment companies should focus on the trust operation and are forbidden from receiving ordinary deposits in the name of trust deposits, or to make loans and investment in violation of the loan and investment ratios; and
• insurance companies are not allowed to offer credit directly or to conduct securities transactions.

Those non-bank financial institutions run by state-owned commercial banks should haveseparate management and be divorced thoroughly from banks.

Regulations on Foreign Financial Institutions

The basic rules applied to foreign financial institutions are Regulations on the Administration of Foreign Financial Institutions in China promulgated by the State Council on April 1, 1994. The PBOC also issued relevant rules to ensure the effective implementation of this regulation. There are two other regulations governing foreign financial institutions -- the Provisional Administrative Regulations Governing Foreign Insurance Companies in Shanghai and the Administrative Regulations of the People's Bank of China ".on Establishment of Resident Representative Offices in China by Foreign Financial Institutions.

The PBOC is formulating additional regulations, including the Provisional Regulations Governing Chinese and Foreign Investment Banks. These regulations will define the applicant's qualifications, application procedure and scope of business. Application priority will be given to the examination of both capital strength and operational condition.

The PBOC has supervised foreign and joint-venture financial institutions at the levels of the head office and branches. Provisional Regulations Concerning Off-site Examination, issued on April 5, 1993 by the PBOC, apply to both Chinese and foreign-owned banks and non-bank financial institutions. The rules specify the scope of the off-site examination that falls basically into two categories. The first is related to risk management that evaluates capital adequacy, asset quality and liquidity, profitability and operational controls. The second concerns the effectiveness of compliance to ensure that a financial institution meets all applicable regulation requirements. This category includes the institution's (1) lending limit and asset/liability ratio; (2) reserve requirements and government-mandated deposits; and (3) ratios on inter-bank funding and lending.

Foreign financial institutions in the Chinese financial market are restricted by these laws and regulations which feature both operational and geographic limitations. Therefore, foreign financial institutions have been treated differently from Chinese institutions. Foreign financial institutions are only allowed to establish operational branches in 24 cities that have a relatively developed foreign-oriented economy. Such branches may only conduct banking operations in foreign currencies. They can take deposits only from foreign-owned companies and nonresidents, as well as from those Chinese enterprises whose deposits are actually transferred from the loans made by foreign banks.

Taxation

The non-parity of treatment between foreign and Chinese financial institutions in like circumstance is premised on the fact that the former enjoy advantages from a number of special and favorable rules and policies. Under the Income Tax Law of the People's Republic of China on Foreign-funded Enterprises, foreign banks are subject to a 33% corporation income tax. For those wholly-owned foreign banks and joint-venture banks located in the special economic zones, the applicable tax rate is as low as 15%. By contrast, Chinese institutions, such as the four state-owned commercial banks and the three policy-oriented banks, are all required to pay the much higher rate of 55%.