China Banking Regulatory Commission’s Reply To Questions On Close-Out Netting.
Legal News & Analysis - Asia Pacific - China - Regulatory & Compliance
17 August, 2017
With the global implementation of variation margin (VM) for non-centrally cleared derivatives, there has been much attention on the enforceability of close-out netting provisions under master derivative agreements with financial institutions incorporated in China. Asia Risk Magazine alone has recently published three separate articles looking at this hot topic and the divergence of views in the industry.1
It is therefore extremely timely that the China Banking Regulatory Commission (CBRC) has made public its reply dated 4th July 2017 (the Reply)2 in response to certain questions arising on close-out netting to the Financial and Economic Affairs Committee of the National People’s Congress (NPC).3 The Reply is of great significance since it contains positive statements from the highest places in the China Government on their support for close-out netting and its effect on regulatory capital treatment.
An English translation of the Reply is attached to this bulletin for reference.
The Reply Letter
Significantly, the Reply states that:
- China’s Enterprise Bankruptcy Law in principle does not conflict with the close-out netting provisions of an ISDA [Master Agreement]
- CBRC is currently drafting the Rules on the Resolution of Commercial Banks (which will be based on the Key Attributes of Effective Resolution Regimes for Financial Institutions issued by the Financial Stability Board) and will give due consideration to potential stay on close-out termination rights in financial derivative agreements
- CBRC would recognise netting for regulatory capital risk mitigation purposes
Having stated that China’s bankruptcy law in principle does not conflict with the close-out netting provisions, CBRC remarked that the court ultimately has the power to determine the validity of close-out netting provisions. This deference to the court is clearly appropriate since it is the court which has the authority to adjudicate and is best placed to do so on the specific facts and merits of each case.
In addition, having confirmed that the drafting of the Rules on the Resolution of Commercial Banks is in progress, the CBRC went on to indicate its commitment to work with the legislative body to promote any effort that will support and protect the concept of close-out netting.
It would also be particularly comforting for China’s banks now that the CBRC has confirmed they would be entitled to rely on close-out netting mechanism for the purposes of regulatory capital risk mitigation.
The Way Forward
It has been nearly 20 years since ISDA and industry participants started lobbying for the recognition of close-out netting in China and the Reply from the CBRC is undoubtedly a direct result of these efforts.
China’s banks may now look forward to embrace close-out netting provisions and take further strides in the global financial markets.
Linklaters have published a number of bulletins on China netting including Recent Supreme Court Notice – Potential effect on the adoption of Close-out Netting in China in November 2016 and China – The New Netting Jurisdiction in February 2014.
Index Number: 717804719/2017-07118
Subject Classification: Suggested Proposals
Office Department: China Banking Regulatory Commission prudential regulation
Title: Reply Letter to Proposal No. 2691 of the Fifth Session of the 12th National People 's Congress
Number: Other  No.105
China Banking Regulatory Commission (CBRC)
Number: Other  No.105
[Only agree to disclose to the representatives]
Yinjian Shen Han  No.105
Reply Letter to Proposal No. 2691 of the Fifth Session of the 12th National People's Congress
To the Office of National People 's Congress Finance and Economic Committee,
Reference is made to the proposal from Li Lihui and two other representatives to legislate for the recognition of close-out netting. We set out below our response to the proposal to the extent it relates to the functions of CBRC:
In recent years, as commercial banks from China make rapid strides abroad, some of them are increasingly expanding their business into derivatives and other complex instruments. A well-developed close-out netting arrangement will boost a commercial bank’s capability in risk management. CBRC will, within the scope of its duties and functions, actively promote the development of close-out netting arrangement:
1. There is no conflict between existing laws and close-out netting provision
Despite any remaining uncertainty in China’s Enterprise Bankruptcy Law and Contract Law and in China’s judicial procedures, there is in principle no conflict between China’s bankruptcy law and close-out netting provision. China’s bankruptcy law gives the judiciary a right to review transactions which are terminated pursuant to close-out netting and to set aside such termination where right to close out netting has been exercised in bad faith. Such rights of the judiciary do not conflict with the relevant provisions of the ISDA [Master Agreement].
The purpose of the procedures set out in Articles 18 and 40 of the Enterprise Bankruptcy Law is to preserve the continuity and valuation of the financial contracts of the entity subject to the insolvency proceeding. They do not necessarily lead to the invalidation of close-out netting.
2. Drafting progress of the Rules on the Resolution of Commercial Banks
CBRC is currently working on the draft Rules on the Resolution of Commercial Banks (the “Rules”). To provide sufficient protection for a quick and orderly resolution of a bank in financial difficulties, the Rules will be drafted in accordance with the requirements set out in Key Attributes of Effective Resolution Regimes for Financial Institutions issued by the Financial Stability Board and will give adequate consideration to the suspension of the right to close-out netting in respect of financial contracts governed by ISDA Master Agreement during a resolution procedure. In addition, CBRC will further coordinate with the legislative department to promote the support and protection of close-out netting.
In the meantime, CBRC and ISDA will continue to communicate with each other on the establishment of close-out netting arrangements for China’s commercial banks and fully exchange views with commercial banks. On 23 May 2017, CBRC held a meeting with four banks, including Bank of China, to discuss the latest development on close-out netting arrangement and margin requirements.
3. Other supporting measures
CBRB acknowledges the effect of netting in capital measurement and other areas. For example, pursuant to Appendix 6 of the Measures for Administration of Capital of Commercial Banks (Trial Implementation), netting may be adopted as a capital risk mitigation measure for the purposes of internal rating method. At present, CBRC is amending the measurement system for counterparties’ credit risk exposure and credit valuation adjustment, which also fully recognise the use of netting in risk hedging.
The above is our response for your reference.
1 These three articles are Lawyers divided over Isda’s China netting memo published on 22 June 2017, Non-netting opinion on China splits lawyers published on 12 July 2017 and Holes in the net: lawyers split over China netting opinions published on 27 July 2017.
2 Available here. A similar version of the Reply addressed to the General Office of the National People’s Congress Standing Committee is also available here.
3 The NPC is China’s legislative body while its Financial and Economic Affairs Committee is responsible for legislation relating to economic and financial affairs. On the other hand, the CBRC is the administrative authority in charge of banking financial institutions and banking regulatory matters. The Reply appears to be an official response to the Financial and Economic Affairs Committee which had raised some questions relating to the recognition of close-out netting for China’s banks.
4 This English translation has been prepared by Linklaters Hong Kong and may be reproduced solely for internal educational purposes. While every effort has been made to ensure the accuracy of the translation, it is not possible to guarantee an exact English translation since each language has its own grammatical structures, embodies different legal and cultural concepts and is open to different interpretation. Therefore, this English translation must not be relied upon by any person in making any decision or taking any action.
For further information, please contact:
Chin-Chong Liew, Partner, Linklaters