China's draft financial stability law will help to mitigate systemic shocks from the failure of smaller banks with limited central government links, says Fitch Ratings. The law aims to create a funding backstop to the financial stability guarantee fund that provides emergency funding to weak banks to preserve system financial stability.

We do not expect the law to diminish government support prospects for large Fitch-rated Chinese banks. Systemic importance and state linkages will remain important differentiating factors in our assessment of government support propensity for banks in China. We expect the proposed law to augment existing regulations and strengthen the legal framework on bank resolution, especially for smaller banks.

China is likely to implement the law this year. It completed its first legislative deliberation on 30 December 2022 and a public consultation on 28 January 2023.

A key highlight compared with an earlier draft unveiled in April 2022 is the specification of central bank support. In the latest version, the State Council can grant permission to the People’s Bank of China to deploy its re-lending facility to provide direct liquidity support to the financial stability guarantee fund, when needed. This would reduce the reliance on other public funds to replenish the guarantee fund. The use of other public funds was stipulated in the April draft.

The latest draft also requires institutions that borrow from the guarantee fund to pledge eligible collateral. We believe this should help ensure loan repayment and the guarantee fund’s sustainability, while reducing moral hazard.

Deliberations on the draft law coincide with rising challenges at smaller banks, linked to China’s prolonged property market stress and pandemic disruptions, and aggravated by an unfavourable bond market last year. In 2022, 2% of outstanding onshore Tier 2 capital bonds that became callable were not redeemed – around two-thirds (by value) were issued by rural commercial banks, and the remainder by city commercial banks. Many banks would have seen their capital adequacy ratios fall below the minimum regulatory threshold of 10.5% had they redeemed the callable bonds while being unable to refinance.



We view the proposed law as complementary to policymakers' efforts to address rising credit risks and funding pressures among smaller banks. The law will help streamline the risk resolution process by laying the legal groundwork for a coordination mechanism across multiple governmental bodies to mitigate systemic risks.

It will not affect our outstanding ratings for Tier 2 and additional Tier 1 capital instruments, which are anchored from banks’ Issuer Default Ratings and incorporate our government support assessments. We expect the government to pre-emptively back the performance of liabilities for highly systemic important banks, including their subordinated and hybrid instruments. Any loss or perception of potential loss on these securities could trigger significant systemic risk, and we expect the authorities to intervene at an early stage to prevent such a scenario.