Top 5 Priorities in China s Financial Regulation Xie Ping (China Investment Corporation) China s financial sector has improved remarkably in the past decade, especially in the banking sector. It plays an important role in China s coping with the global financial crisis and receives high marks in IMF s recent Financial Sector Assessment for China. Currently China s financial institutions are well capitalized, highly profitable and among the world s largest by market capitalization. However, serious regulatory challenges remain, which will to a great extent define the development of China s financial sector in the next 5 to 10 years. In this speech, I will briefly discuss top 5 priorities in China s financial regulation, their implications and policy suggestions. I. Improving Financial Sector s Service to the Real Economy Financial sector should serve the need of the real economy. It has three fundamental functions. The first function is to provide payment facilities. The second and also the most important function is to channel 1
funds from savers to borrowers, thus promoting economic growth and employment. The third is to provide risk management tools. Although nowadays financial sector functions quite well in China, there is still much room for improvement and financial regulation should play an instrumental role. First, people around China have complained that fees charged by banks are too high, unjustified by the quality of services and often not transparent enough. To better protect financial consumers, this year China Banking Regulatory Commission (CBRC), People s Bank of China (PBoC) and National Development and Reform Commission (NDRC) have jointly launched a country-wide investigation into banks irregular fee charges. There will be some government guidelines on banks service charges in future. Government should make it clear whether some services are public goods or not. Second, there is massive allocation inefficiency in China s credit market. Loan to small and medium enterprises (SMEs) is not commensurate with their economic contribution. Unfortunately, this situation is aggravated after the 2008-2009 Chinese economic stimulus plan (also called 4 trillion Yuan stimulus package). While credit availability is substantially improved for government related companies and investment projects, SMEs endure credit crunch. Many SMEs have to go to informal credit market for funding needs. In some places, most 2
notably Wenzhou in Zhejiang and Erdos in Inner Mongolia, informal credit market collapses after excessive risk taking and rampant fraud, causing huge loss to local economy and residents. In March, the State Council, or China s cabinet, launches a pilot zone in Wenzhou to regulate private financing activities. Third, many insurance products in China are essentially equity and/or bond investment programs, offering limited protection against risk faced by insurance takers. The most prominent case is investment-linked life insurance policy, which is even sold to migrant workers. These products deviate from the basic goal of risk sharing and behave more like mutual funds. Recently they incur massive redemption after stock market tumbles and pose potential threats to insurance companies liquidity profile. I think regulatory authorities should make improving financial sector s service to the real economy an explicit goal and influence the course of financial sector development, including institution type, business scope and business model. II. Keeping State Ownership in Banks at an Optimal Level Chinese government, through Central Huijin Investment Co., Ministry of Finance and National Social Security Fund, controls all major banks in 3
China. Although state ownership has been diluted a lot since 2003, when China started the latest round of bank reform, they remain high compared to international levels. The question is: should state ownership be above 50%? State ownership in banks has positive effects. During the global financial crisis, many western banks found it hard to raise capital from private sector and had to seek government bailout. Under such circumstances, government becomes capital provider of last resort. Government capital injection has an immediate stabilizing effect on banks depositors, creditors and counterparties, thus promoting financial stability in the short run. Banks such as Royal Bank of Scotland and Citigroup seek bailouts many times and were nationalized in the end. From this perspective, Chinese government s stakes in banks also result from government bailouts. However, in developed countries, state ownership in banks tends to be temporary. When market recovers, governments sell bank shares to private investors. Banks also view government bailouts as a stigma and want to exit bailout programs whenever possible. This is in stark contrast to China s case, where state ownership in banks tends to be persistent and significant. In China, state ownership in banks already has negative effects. First, state ownership in banks is not good for corporate governance. There are lots of empirical evidences that banks controlled by state have poor 4
corporate governance records and lower valuation multiples when other things being equal. Second, banks with state ownership may extend loans on political grounds, not solely on commercial ones. When bank CEOs are also politicians and loan a rare resource, CEOs can trade loans for favorable political opportunities. Chinese banks loan supply under the 4 trillion Yuan stimulus package, to local government funding vehicles (LGFVs) and state owned enterprises (SOEs) demonstrate this point quite vividly. Though loans politically originated generate private benefits for bank CEOs, they tend to have higher NPL ratio. This is a typical principal-agent problem. When all banks engage in political trades, there will be collective moral hazard and regulation will be less effective. Third, banks with state ownership tend to have more monopoly power. In China, state owned banks (SOBs) market share is more than 50% in loan and deposit market, 80% in assets under custodian and 70% in corporate bond underwriting. Government may also find ownership in banks has undesirable effects. The first is the difficulty to meet SOBs capital needs. In 2010, Central Huijin Investment Co. had to issue bond to participate in the rights offerings of SOBs. The second is that countries with higher state ownership in banks tend to grow slower. 5
In the long run, there is a balance between banks capital strength, state ownership and government s fiscal power. When fiscal power is a hard constraint, government should determine which banks to own and at what levels. III. Continuing Separate Operation and Separation Supervision China s financial system is characterized by separate operation and separate supervision. This arrangement dates from the 1995 Central Bank Law. In financial institutions side, there is a firewall among banks, security companies and insurance companies. Though several financial holding companies exist, most notably Ping An Insurance (Group) Company, there is limited overlap among major banks (ICBC, CCB, BOC, ABC, BCOM), security companies (CITICS, CICC) and insurance companies (China Life Insurance Company, China Pacific Insurance, People s Insurance Company of China, Ping An Insurance). In regulatory authorities side, CBRC supervises the banking industry, China Security Regulatory Commission (CSRC) the security market and China Insurance Regulatory Commission (CIRC) the insurance market. Before the global financial crisis, there was a trend toward comprehensive operation in China. Many financial institutions and regulators expressed great interest in US bank holding companies and 6
Europe s universal banks. US experience after the appeal of Glass Steagall Act in 1999 was intensively studied and debated. However, this trend is stalled or even reversed after the global financial crisis. First, in the past 20 years, HSBC, Citigroup, AIG, UBS, Deutsche Bank and Allianz all achieve limited success in comprehensive operation. The synergy among different financial businesses is insignificant. Banks, security companies and insurance companies differ greatly in corporate culture, business mode, risk taking behavior, incentive mechanism and resolution method. It is more appropriate to have separate legal, corporate governance and risk management arrangements. Second, when banks with retail deposit base engage in high risk activities, such as proprietary trading and investment banking, they may be subsidized by deposit insurance and have moral hazard problem. Third, the fundamental activities of commercial banks, such as taking deposit, making loan and payment services, are indispensable parts of modern society and should not be mixed with high risk activities. In other words, we should separate utility banking from casino banking. Forth, when a big and complex financial company is in distress, it may be hard to resolve it orderly via market mechanism, often leading to government bailout, such as AIG. That is why US introduces Volcker s rule and UK Independent 7
Commission on Banking proposes to ringfeng retail banking from investment banking. I think China will learn from these lessons and try comprehensive operation in a more prudent manner. I also think the separate supervision arrangement won t change much though regulatory coordination should be improved. A positive side effect of separate supervision is that it creates a tournament or competition of regulatory authorities, encouraging them to do a good job. IV. Solving the Too Big To Fail Problem In China, too big to fail (TBTF) problem is severe and has unique characteristics. First, In terms of market capitalization, China has several largest banks in the world. Bank of China is identified by Basel Committee on Banking Supervision (BCBS) as one of the 29 Global Systemically Important Financial Institutions (GSIFIs). Second, In US, Volcker s rule requires that no financial institution s liability should be more than 10% of all financial institution liabilities. By contrast, each of ICBC, CCB, BOC and ABC s share in China s deposit market is more than 10%. Third, in China, state ownership in big banks makes TBTF problem very different from developed countries. 8
In developed countries, state ownership in banks is considered as a temporary or side effect of government bailout, not a permanent situation. Regulatory and resolution measures for systemically important financial institutions proposed by developed countries all share one common principle. That is, whenever a financial institution needs to raise capital externally, private sector should be the first choice; whenever a financial institution is in distress or in the resolution process, private shareholders and creditors other than retail depositors should absorb loss first and as much as possible; financial institutions should rely less on public sector. Obviously, this principle is incompatible with state ownership in banks. Besides, in China, bankruptcy rules and procedures for financial institutions are less developed. For example, Guangdong International Trust and Investment Corporation (GITIC) is still in the process of liquidation after declaring bankruptcy in 1999. I think we should devise our own measures to cope with TBTF problem in China and keep the following considerations in mine. First, as just mentioned, state ownership in banks should be kept at an optimal level. Second, state shareholder and regulatory authorities should balance financial institutions profit maximization behavior and TBTF problem caused by their expansion. 9
V. Regulating Shadow Banking System Shadow banking system doesn t have a standard and universally accepted definition at this moment. It usually refers to unregulated and off balance sheet financial activities with maturity and liquidity transformation functions. In US and Europe, shadow banking system means money market funds, securitization market, repo and security lending market. Shadow banking system suffered a bank run after the Reserve Primary money market fund broke the buck in September 2008, causing a liquidity crisis and credit crunch. After that, almost everyone agrees that shadow banking system should be regulated. But how to regulate remains an open question. Financial Stability Board (FSB) will finalize its proposal within this year. In China, the exact meaning of shadow banking system is quite different from US and Europe. In most cases, it involves the cooperation between a bank and a trust company. First, a trust program or wealth management program is set up to raise money from individuals or companies. Then the money is invested in some high return sectors, such as real estate sector, in the form of loan and private equity investment. These activities occur off banks balance sheet. The economic rational of China s shadow banking activities is quite straightforward. From investors point, they offer a higher yield than bank 10
deposit, which suffers negative real interest rate due to high inflation. From borrowers point, they offer an alternative and affordable funding channel when bank loan is unavailable. From banks point, they offer a way to circumvent credit quota control, loan to deposit ratio constraint and capital regulation, yet generating fee income. China s shadow banking activities pose two kind of risk. First they are essentially regulatory arbitrage, lowering the effectiveness of monetary policy and prudential regulation. Second, they create contingent liabilities for banks. When the underlying investments fail, banks may have to take some loss due to reputation consideration. Since 2011, CBRC has used two measures to regulate shadow banking activities. One is to tighten the regulation of trust companies. The other is to require banks to transfer off balance sheet activities into balance sheet. 11