Guidelines for Risk Management of the Merger Loans of Commercial Banks

Since 1996, banks in China (including Chinese subsidiaries of foreign banks) have been prohibited from loaning money to fund corporate mergers and acquisitions. In an explicit effort to stimulate M&A activity in China—while at the same time modulating risk—on December 6, 2008, the China Banking Regulatory Commission issued the Guidelines for Risk Management of the Merger Loans of Commercial Banks (Merger Loan Guidelines), allowing merger lending by commercial banks in China for the first time. As such, the Merger Loan Guidelines are expected to bring profound and continuous change to China's finance industry.

Purpose of Merger-Related Loans

Under the Merger Loan Guidelines, loan money can be used:

i) for the purpose of acquiring an existing equity interest in a company;

ii) to increase a company's capital;

iii) to purchase assets; or

iv) to assume existing debts;

when the result is either a merger and acquisition, or the acquiring of control of an established target company.

Although the Merger Loan Guidelines are not entirely clear on this point, it appears that companies cannot borrow money to acquire a minority (non-controlling) interest in the target company.

Qualified Commercial Banks

Though commercial banks do not need a special license to engage in M&A activity, they must adopt certain business procedures and internal control policies, according to the Merger Loan Guidelines, and report them to the appropriate authorities before engaging in any merger lending activity. In order to qualify to provide merger loan services, a commercial bank must satisfy the following conditions, as stipulated in the Merger Loan Guidelines:

• It must have strong risk management and effective internal control systems;
• It must have a loan loss reserve adequacy rate of no less than 100 percent;
• It must have a capital adequacy rate of no less than 10 percent;
• It must have a general reserve balance of no less than 1 percent of the loan balance for the same period; and
• It must establish a professional team for the investigation and risk appraisal of merger loans.

The above requirements set a high threshold for commercial banks to participate in M&A activity in China. At present, only China's four state-owned commercial banks, a few other giant domestic banks and large international banks can qualify.

If at any time a bank can no longer satisfy any one of the above conditions during the process of carrying on merger lending business, the commercial bank must halt any new merger lending.

Risk Management

The Merger Loan Guidelines also regulate the risk management of merger loans:

• The balance of all merger loans for a commercial bank must be no more than 50 percent of the bank's net core capital during any given period.
• The balance of merger loans to an individual borrower by a commercial bank must be no greater than 5 percent of the net core capital of the bank.
• Loans can make up no more than 50 percent of the total source funds for an M&A transaction.
• The term of a merger loan can generally be no longer than five years.

Risk Appraisal

Commercial banks must carry out an appraisal of merger loan risk on the basis of a comprehensive analysis of the various types of risks associated with mergers and acquisitions, including without limitation strategic risks, legal and regulatory compliance risks, integration risks, operating risks and financial risks. Where a merger loan from a commercial bank involves one or more cross-border transactions, the bank must also analyze risks associated with the other country, exchange rate risks and international monetary transfer risks.

Expected Impact on the Chinese Economy

As noted above, by making M&A loans more available in China, the Merger Loan Guidelines are expected to have a dramatic impact on China's finance industry. Implementation of the Merger Loan Guidelines appears to have gone smoothly after their passage. Already Baosteel Group Corporation, China's state-owned—and largest—steel producer, has obtained one loan of RMB 750 million from Jiaotong Bank and a second loan of RMB 800 million from China Construction Bank to facilitate its acquisition of 56.15 percent of the outstanding shares of Ningbo Steel Co., Ltd. The total price of the acquisition is RMB 3.14 billion.