VZCZCXRO1037
RR RUEHCN RUEHGH
DE RUEHGH #0401/01 2650556
ZNR UUUUU ZZH
R 220556Z SEP 09
FM AMCONSUL SHANGHAI
TO RUEHC/SECSTATE WASHDC 8290
INFO RUEHBK/AMEMBASSY BANGKOK 0228
RUEHBJ/AMEMBASSY BEIJING 3078
RUEHRL/AMEMBASSY BERLIN 0020
RUEHBS/USEU BRUSSELS 0030
RUEHBY/USDAO CANBERRA ACT AS
RUEHCN/AMCONSUL CHENGDU 2212
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUEHGV/USMISSION GENEVA 0070
RUEHGZ/AMCONSUL GUANGZHOU 0670
RUEHHI/AMEMBASSY HANOI 0042
RUEHHK/AMCONSUL HONG KONG 2377
RUEHJA/AMEMBASSY JAKARTA 0036
RUEHLO/AMEMBASSY LONDON 8778
RUEHML/AMEMBASSY MANILA 0105
RUEHMO/AMEMBASSY MOSCOW 0079
RHEHAAA/NATIONAL SECURITY COUNCIL WASHINGTON DC
RUEHNE/AMEMBASSY NEW DELHI 0069
RUEHOT/AMEMBASSY OTTAWA 0043
RUEHFR/AMEMBASSY PARIS 0017
RUEHRO/AMEMBASSY ROME 0018
RUEHUL/AMEMBASSY SEOUL 0562
RUEHGH/AMCONSUL SHANGHAI 8942
RUEHSH/AMCONSUL SHENYANG 2203
RUEHIN/AIT TAIPEI 2008
RUEHKO/AMEMBASSY TOKYO 0773

UNCLAS SECTION 01 OF 04 SHANGHAI 000401 
 
SENSITIVE 
SIPDIS 
 
DEPT FOR EAP/CM 
NSC FOR LOI, MEDEIROS 
STATE PASS USTR FOR STRATFORD/WINTER/MCCARTIN/KATZ/MAIN 
GENEVA ALSO FOR USTR 
USDOC FOR ITA DAS KASOFF, MELCHER, SZYMANSKI, MAC/OCEA 
TREASURY FOR OASIA/INA -- DOHNER/HAARSAGER/WINSHIP 
TREASURY FOR IMFP -- SOBEL/CUSHMAN 
STATE PASS CEA FOR BLOCK 
STATE PASS CFTC FOR OIA/GORLICK 
MANILA FOR ADB USED 
 
E.O. 12958: N/A 
TAGS: CH ECON EFIN EINV PGOV
SUBJECT: CHINESE BANKS DEMANDING ASSURANCES ON FOREIGN BANKS' 
DERIVATIVE TRANSACTIONS 
 
¶1.  (SBU) Summary:  New Chinese regulations governing 
derivatives trading that went into effect September 16 are 
having a disproportionate negative impact on foreign-invested 
firms.  In the face of efforts by foreign-invested banks to 
modify or roll back the requirements, the major Chinese banks 
are acting in unison to largely refuse compromise.  As a result, 
foreign-invested bank market share and profits are at risk.  End 
Summary. 
 
========== 
Background 
========== 
 
¶2.  (SBU) One year after the Lehman bankruptcy, China's Central 
Government and domestic banks are beginning to implement 
measures to reduce counterparty risk in financial transactions. 
Beginning September 16, the largest Chinese domestic banks, with 
the support of the People's Bank of China (PBOC) -- are 
requiring their foreign-invested counterparts to obtain credit 
guarantees from their parent companies before engaging in 
over-the-counter foreign exchange derivatives transactions.  The 
banks' demand is part of a new master agreement structure 
announced on March 16, 2009, by the National Association of 
Financial Market Institutional Investors (NAFMII) -- nominally 
an industry self-regulatory body spun off from the PBOC -- and 
formally endorsed by the PBOC in a notice dated March 11, 2009. 
Under the measures, counterparty banks had six months to sign 
agreements, and the major domestic banks have elected to make 
the parent guarantee a precondition. 
 
¶3.  (SBU) EconOff spoke about the impact of the new regulations 
with several senior executives in Shanghai-based 
foreign-invested banks that are prominent players in the Chinese 
over-the-counter derivatives market, as well as with an academic 
contact.  Foreign-invested banks with operations in Shanghai 
include Citibank, HSBC, Standard Chartered, JPMorgan, and 
Deutsche Bank.  The Big Five Chinese domestic banks are 
Industrial and Commercial Bank of China (ICBC), China 
Construction Bank, Bank of China, Agricultural Bank of China, 
and Bank of Communications; in addition, China Development Bank 
was mentioned by contacts as among the major domestic players in 
derivatives trades. 
 
===================================== 
New Guarantees Seen As Discriminatory 
===================================== 
 
¶4.  (SBU) Most foreign-invested banks view as discriminatory the 
demands by their domestic counterparts to obtain parent-bank 
guarantees for over-the-counter derivatives trades.  Starting in 
2006, said several contacts, the China Banking Regulatory 
Commission and other Chinese regulators put pressure on 
foreign-invested banks to incorporate locally.  This placed a 
substantial compliance burden on the foreign-invested banks, 
 
SHANGHAI 00000401  002 OF 004 
 
 
including:  a lengthy application process; continued monitoring 
that the locally incorporated subsidiary has decision making 
authority independent of its parent bank; and minimum paid-in 
capital of RMB one billion (approximately US$150 million).  Now, 
the largest domestic Chinese banks are, in effect, seeking to 
renege on the benefits foreign-invested banks were supposed to 
enjoy as a result of local incorporation, said the contacts -- 
creating the perception of arbitrary rulemaking.  In addition, 
Chinese domestic banks are not requiring their domestic bank 
counterparties to offer additional guarantees for derivatives 
trades.  One contact also noted that this requirement has not 
been imposed on foreign subsidiary banks in any other market 
around the world, and another said that multinational bank 
holding companies are not structured to provide guarantees to 
their overseas subsidiaries. 
 
¶5.  (SBU) Major domestic banks are currently acting in unison 
with respect to the parent-bank guarantees.  One contact 
mentioned that Bank of China is the strongest proponent of the 
requirement.  (Note: Bank of China is historically the most 
exposed among the Chinese domestic banks to overseas 
transactions, as it has the largest overseas branch network and 
dominates the market for foreign-invested enterprise services. 
End note.)  At one point, ICBC was not requiring a parent 
guarantee in its revised master agreements, and contacts stated 
that Citi and Deutsche Bank had signed with ICBC without giving 
one.  However, the other large banks then put pressure on ICBC 
and it fell into line. 
 
¶6.  (SBU) NAFMII is not seen by foreign-invested banks as 
completely neutral in the process of rolling out the new master 
agreements.  One bank executive said that NAFMII tends to 
represent the interests of domestic banks, since Citi and HSBC 
are the only foreign banks represented on the board.  (Comment: 
This limits the role that NAFMII might play in brokering a 
compromise between the major Chinese banks and the 
foreign-invested banks.  End comment.) 
 
 
=========================================== 
Compromise Has Been Struck In Limited Cases 
=========================================== 
 
¶7.  (SBU) Some locally incorporated foreign-invested banks have 
been able to sign master agreements with smaller banks, 
providing some cause for hope that major Chinese banks may also 
eventually do so.  One contact put the number at around twenty 
for all foreign-invested banks, about half with other 
foreign-invested banks and the other half with local Chinese 
banks.  For example, one executive said his bank had signed 
master agreements without the parent guarantee with several 
local medium-size banks. 
 
¶8.  (SBU) Other banks are seeking to modify the major Chinese 
 
SHANGHAI 00000401  003 OF 004 
 
 
banks' parent guarantee requirement.  For example, one contact 
said that foreign-invested wholesale banks such as JPMorgan had 
trouble meeting the paid-in capital standard when applying for 
local incorporation, and in the end had used a form of parent 
guarantee.  These banks are working with local counterparties to 
see if this will cover the new requirement.  An executive in one 
bank in these circumstances said that an agreement under these 
conditions had been negotiated with ICBC, but that ICBC had not 
signed it before the September 16 deadline because the relevant 
bank official was said to be "on travel." 
 
¶9.  (SBU) One bank executive suggested that the problem between 
the foreign-invested banks and the major domestic banks could 
resolve itself with time.  It has been a relatively short time 
to negotiate this complicated issue, he said, and it is possible 
that more agreements will be announced shortly. 
 
========================= 
Market Volume Has Dropped 
========================= 
 
¶10.  (SBU) The volume in the derivatives market was down 
significantly in the days following the September 16 deadline. 
According to the head of trading at a major derivatives trading 
firm among foreign-invested banks speaking on September 21, 
volume has been consistently half the normal level.  Others 
pointed out that the lower volume could be due, in part, to 
other factors as well.  For instance, interest rates have been 
relatively stable recently, meaning that firms have less reason 
to purchase derivatives to arbitrage or hedge against changes. 
 
===================================== 
Foreign-Invested Bank Profits at Risk 
===================================== 
 
¶11.  (SBU) Over the next few weeks, the lack of master 
agreements with Chinese domestic banks will start to cut into 
the profits of foreign-invested banks.  Banks that have not 
signed are prohibited by the PBOC from trading in derivatives 
markets, according to the March 11 PBOC notice.  Currently, 
foreign-invested banks have a strong market share, with 
approximately one-third of the volume of foreign-exchange swaps 
-- the larger and more liquid derivatives market in China -- and 
approximately half of the volume of interest rate swaps. 
(Comment: Derivatives trading is an area of competitive strength 
for foreign-invested banks, which by comparison only account for 
a little over 2 percent of total banking system assets in China. 
 End comment.) 
 
¶12.  (SBU) Even if master agreements are signed, domestic banks 
may be able to take advantage of the parent guarantee 
requirement to gain market share from foreign-invested banks. 
One bank executive said that adding the parent guarantee would 
force them to widen the bid-offer spread, due to additional 
 
SHANGHAI 00000401  004 OF 004 
 
 
transaction costs.  This would make foreign-invested banks less 
competitive vis-a-vis their domestic counterparts.  Since 
Chinese banks have a bigger customer base, they will be able to 
leverage this cost differential over time to sway customers 
towards their services. 
 
======= 
Comment 
======= 
 
¶13.  (SBU) The Chinese financial system's view of 
foreign-invested banks is shifting in the wake of the global 
financial turmoil that broke out in the fall of 2008.  Both 
Chinese domestic banks and Chinese regulators are taking a more 
cautious approach to financial derivatives and other 
foreign-developed products that they blame for instigating that 
crisis.  While the fears raised by the crisis may take time to 
work out -- and the Chinese authorities are looking in part to 
regulatory changes that their counterparts in the United States 
and other developed markets put in place -- there also appears 
to be room for the Chinese side to compromise on the demands for 
parent guarantees of over-the-counter derivatives transactions. 
The PBOC, for example, could extend the September 16 deadline 
for banks to negotiate amongst themselves while not disrupting 
the market, and perhaps also indicate to Chinese domestic banks 
that legitimate risk concerns can be accommodated without parent 
guarantees.  However, our Shanghai contacts did not offer 
specifics on how internal PBOC dynamics must be realigned in 
order to modify implementation of the new master agreement 
structure. 
CAMP