During 2007, CDB made significant adjustments in its risk management system, namely, from credit risk management to an enterprise-wide risk management system. The Credit Management Department was renamed as the Risk Management Department and its roles and responsibilities redefined as the enterprise-wide risk management department of the Bank. It is responsible for managing enterprise-wide credit risk, market risk and operational risk.

During 2007, CDB undertook a major initiative to develop and enhance its enterprise-wide risk management capabilities to effectively identify, measure, control and report the risks arising from its lending operations, its treasury and trading operations and other investment activities.

Risk Management's Main Challenges

In pursuing its mission, CDB does not focus on short-term profit-making initiatives, but rather aims to achieve long-term balance between risk & return while seeking to maximize both financial and non-financial returns to society. The Management Team of CDB has always regarded the practice of sound risk management as a cornerstone of CDB's operating platform and, as a result, has been enhancing and upgrading the Bank's risk management framework, both in scope and depth. As the Bank's business progresses from its historically singular focus on supporting major infrastructure projects to maintaining its additional strategic mission to provide financial services for enhancing the well-being of the people of China, the credit risk that CDB faces is gradually becoming more diverse. Further as the process of interest and foreign exchange rates liberalization progressively accelerates and the scope and complexity of CDB's business continue to increase, the Bank faces greater challenges in managing market risk as well as operational risk.

Facilitating the Implementation of Basel II

CDB recognizes the importance of risk management in ensuring sustainable growth. During 2007, the Bank reviewed the risk management functions through various dimensions. Based on the gap analysis for the risk management practices, the Bank has defined the direction and measures for the continuous enhancement in enterprise-wide risk management.

CDB is a committed supporter of the implementation of Basel II in China. Following the guidance for Basel II implementation for China's financial institutions issued by the CBRC, the Bank has established a comprehensive Basel II implementation planning project that will actively facilitate the implementation of the requirements for Basel II readiness.

Given the importance and priority of the Basel II implementation, the Bank has established a dedicated Implementation Team led by one of the Bank's Governors. The team is supported by specific project working groups with standardized and consistently applied protocols for coordination. The Bank has invited reputable international consulting firms to assist with Basel II implementation planning, development of the various risk measurement capabilities and the data analysis required to meet Basel II readiness.

Risk Management Performance

The Bank maintains selected key operational indicators that allow regular comparison with its domestic and international peer group. One of the key indicators is the non-performing loan ratio, which was consistently at the lowest level relative to its domestic competitors during 2007. The non-performing loan ratio has remained at less than 1% for 11 consecutive quarters. Additionally, the Bank has achieved reduction in both the ratio and the amount of non-performing loans for 16 consecutive quarters. At the end of 2007, total non-performing loans were reduced to RMB 13.32 billion, and non-performing loan ratio was reduced to 0.59%, down by 0.13% from 2006.

Credit risk

Credit risk is the risk of loss that a borrower or a counter party may not meet its obligation in accordance with the original contractual terms of its facility. CDB continues to have significant focus on the management of its credit risk and on managing the potential impacts of changes in the economic cycle on both its short and long term lending and financing activities. During 2007, the Bank continued the enhancement of its credit risk management capabilities in the following 5 areas:

• Improving the credit risk management decision making system, and actively promoting within the Bank the reforms to its credit evaluation system
• Improving rating models and strengthening credit risk measurement capabilities
• Strengthening risk management capabilities of branches, including establishing independent on-site risk management visits
• Establishing cooperation with loan assistance agencies
• Establishing a multi-dimensional credit administration system to support enhanced post-approval loan management

Improving the credit risk management decision making system, and actively promoting within the Bank the reforms to its credit evaluation system

CDB has carried out reforms and adjustment to the organizational structure and decision-making process of the Credit Risk Management Committee. The Bank included the Head of International Finance Department as a standing member of its Credit Risk Management Committee; it established a Credit Rating Committee and International Business Risk Management Committee under the leadership of the Credit Risk Management Committee; enhanced the approval authority of branch-level Credit Rating Committees, and gradually diverted the responsibilities for individual risk control to branches.

Throughout 2007, CDB actively promoted reforms that were made to the credit evaluation system by strengthening the coordination and operation of the Loan Committee, adding members with relevant and focused credit expertise, enhancing the segregation of duties of independent road-show members, installing a comprehensive question & answer mechanism, facilitating branch-level Loan Committee reforms and formulating a series of policies and guidelines to document the changes and regulate the credit evaluation activities.

Improving rating models and strengthening credit risk measurement capabilities

The Bank implemented the new version of a customer rating scorecard, a more prudent and objective rating method, which is more sensitive to risks, improves the transparency of rating models and duplicability of the results, and refines the quality of its internal rating system. The Bank has also invited internationally reputable consulting firms to carry out evaluation and provide consulting advice to enhance its credit risk measurement methodology, to categorize its asset portfolio according to Basel requirements, to conduct in-depth research on the rating method especially for project finance customers, and to further refine the risk measurement methodology for this type of assets.

Strengthening risk management capabilities of branches including establishing independent on-site risk management visits

CDB has been continuously enhancing its risk management structure. In 2007, CDB established Risk Management Committees at branch levels, which are responsible for the coordination, approval and decision making for enterprise-wide risk management in branches. The Credit Management Division was renamed as Risk Management Division. As the department with the function of enterprise-wide risk management at the branch level, it is responsible for managing branch-wide risks.

CDB has also been enhancing the delegation hierarchy of risk management structure in head office and branches. In line with the gradual diversification of its business activities and the increasing need for county-level business development, the Bank has progressively shifted the risk management function to its branches to assist in the transformation of those branches from operational bodies into overall management units. During 2007, the Bank has conducted on-site visits to review risk management practices at each of its 34 branches. The on-site visit mechanism has significantly reinforced the enterprise-wide risk management at all of the Bank's branches.

Establishing cooperation with loan assistance agencies

The Bank has realized that the absence of a comprehensive branch network could limit its ability to execute its strategy consistently across the country. As a result the Bank has worked closely with local governments and various loan assistance agencies, established a business mode that is "based on government cooperation, by means of loan assistance agencies and platform construction, and guaranteed by risk sharing and compensation", balanced the sharing of risk and the distribution of risk-based compensation. This has proven to be very effective in terms of both controlling risk and developing the business related to the well being of the people. In 2007, loans of a total value amounting to RMB 22.75 billion was through democratic appraisal of loan assistance agencies and approved and disbursed by CDB branches.

Establishing a multi-dimensional credit administration system to support enhanced post-approval loan management

CDB has established a multi-dimensional credit administration system that has provided the basis for significant enhancement in the efficiency and effectiveness of post-approval loan management and overall risk management. The function includes the ability to monitor loan usage, monitor and project loan cash flow, oversee project progress, manage borrower risks, track guarantee and various other areas of risk and loan management leading to a comprehensive early-warning process. The Bank has effectively enhanced its capability for managing the recovery of loan interest and principal and to adopt flexible management approaches to ensure that the level of recoveries is consistently in line with the top performance of leading international banks.

Market risk

Market risk is the risk of loss caused by changes in prices of financial instruments, principally influenced by interest and foreign exchange ("FX") rates or a change in available liquidity. Market risks faced by the Bank mainly include interest rate risks within the banking and trading books, currency risks and liquidity risks.

During 2007, the Bank appointed a reputable international consulting firm to carry out a market risk measurement project to clearly identify the gaps between its existing practices and the measurement requirements of the Basel II Accord. Building on the work completed in the previous year, the Bank has established an integrated treasury management system that fully supports requirements for straight-through processing between the front, middle and back offices.

The Bank has established a comprehensive transaction and position based limit framework for the management and control of market risk within the trading and banking books including risk exposure limits, stop-loss limits, overnight and intraday exposure limits in terms of nominal FX, PVBP, NII and EV measures for interest rate risk.

The Bank has established a rating mechanism for counterparty credit risks, which have been incorporated into the Bank's credit limit framework. During 2007, the Bank conducted its businesses activities and executed treasury related transactions strictly in accordance with these limits.

On a periodic basis, the Bank prepares market risk monitoring reports for its management in order to gain a timely and accurate understanding of the market risk to which the Bank is exposed.

Interest Rate Risk

Interest rate risk is the risk of loss arising from changes in the level of interest rates or changes in the shape of yield curves that could adversely affect the market value of financial instruments or future earnings of CDB. The interest rate risk that the Bank is exposed to is assessed from both net interest income and the economic value of equity perspectives using a number of methods, including interest rate re-pricing gap analysis, duration gap analysis, net interest income sensitivity ratio, and economic value of equity sensitivity ratio etc. The management of interest rate risk of the trading book is achieved through mark-to-market, limit analysis, exposure analysis, sensitivity analysis and profit & loss analysis.

During 2007, the Bank established an internal coordination mechanism specially aimed at anticipation of interest rate adjustments by the PBOC and the adjustment of interest rates in other currencies. The Bank adopted interest rate trend contingency planning and analysis mechanisms covering the impact of interest rate adjustments, carried out analysis under scenarios of different interest rate volatility and created reference points for making appropriate management decisions.

Currency Risk

Currency risk is the risk of loss arising from the fluctuation of exchange rates. The Bank controls its currency risk primarily by adopting a matched funding policy. For mismatched exposures and exposures not fully hedged, the Bank will, within authorized and approved limits, proactively use available market instruments, including foreign exchange forwards and swaps, to effectively hedge and control its overall exposure to currency risk.

Liquidity Risk

Liquidity risk is the risk that the Bank is unable to fund its current obligations and operations in the most cost efficient manner. The Bank's primary funding source is the domestic bond market. Changes in the government's monetary policies and market expectations of movements in interest rates are all important factors that could adversely affect the Bank's key funding sources. Efficient and accurate planning plays a critical role in the Bank's liquidity management. The Bank has established a set of liquidity management policies and models, including periodic cash flow projection and monitoring, interest rate sensitivity analysis and emergency funding mechanisms. The Bank's excellent credit ratings, innovative bond types, and bond issuing capabilities also provide support in the control of liquidity risks.

Operational risk

Operational risk is the risk of loss arising from failed internal control process on systems, people and/or external events. In recent years, the Bank has focused its efforts in operational risk management on the following four elements:

• Policy & process risk factors, including: process execution, outsourcing activities, internal reporting, customer service and communications, product deficiency control, external reporting and financial management;
• Organization & employee risk factors, including: employee skills and training, key employee retention, internal fraud and unauthorized activities;
• IT system risk factors, including: system development, system function, system effectiveness, data integrity and internal IT security;
• Other external risk factors, including: business continuity and external fraud.

Operational risk management has been continuously strengthened at the Bank through various means and methods, including strengthening internal controls, recruitment of qualified and competent individuals, focusing on operational compliance, regular assessment and process improvement. In 2007, with the commencement of operational risk management consulting project, the Bank carried out a self-assessment of operational risk throughout the Head Office and branches, analyzed the degree of impact and probability distribution of key operational risks.

Under the principle of "managing the Bank according to the law", the Bank has established a comprehensive legal risk prevention process, covering all business processes including credit origination, project development, loan approval, contract review and loan collection. In 2007, the Bank established Legal Affairs Offices in its branches and set up a two-tier legal risk management framework covering both Head Office operations and Branch operations. In addition, the Bank has strengthened the legal support provided to the Head Office Loan Committee's loan review process, the process for international cooperation and the county-level business development process.