Last year, a series of financial crises forced the Chinese authorities to take a closer look at the current regulatory setup of the financial system. Not only were many of these crises due to regulatory failures, significant losses were also inflicted on investors. As such, the capability of the authorities to handle the increasingly complex financial challenges under the current economic restructuring was put into question. In China, criticisms of government financial policies are typically not considered a public issue and are usually haggled behind closed doors. The unusual public admissions this year of the shortcomings from the Prime Minister to Central Bank Governor shows their realization of the gravity of the problem. Of course, the abrupt replacement of the chairman of China Securities Regulatory Commission (CSRC), Xiao Gang, on Feb 19 is a tacit admission that the present setup is not working.
In the National People's Congress (NPC) and Chinese People's Political Consultative Conference (CPPCC) session this year, respected analysts like Chi Fulin of the China Institute for Reform & Development have openly called for changes in the current regulatory framework. People's Bank of China (PBoC) Vice Governor, Yi Gang, admitted that studies are underway and hopes that a decision can be reached this year.
In light of the crisis, the issue on hand would be on how to put up the new regulatory framework to replace the current setup. Aside from addressing the problems on hand, it should also attend to the looming challenges the financial system will face in the "New Normal" of China. The most popular replacement strategy suggested is to form a super central bank to take over all functions of the existing agencies.
Current Financial Sector Regulatory Framework
The current regulatory framework was set up in the 1990s and early 2000s as the country progressively adopted the Western financial system. The guiding principles followed the US model of regulation by sectors (分业监管). As a result, the China Securities Regulatory Commission (CSRC) was set up in 1992 to supervise and regulate securities industry; the China Insurance Regulatory Commission (CIRC) was set up in 1998 to overlook the insurance sector; and the China Banking Regulatory Commission (CBRC) was spun off from the PBoC bank supervision department in 2003 to take care of bank supervision and regulation. This diamond shaped structure with one central bank at the apex and three commissions forming the base has a short-cut name in Chinese: "one bank and three commissions" (一行三会). The financial sector counts as one of the most sensitive and regulated sectors in any economy. The deep professional knowledge required for the job means outsiders cannot just be assigned into senior positions and be expected to perform. The chairmanships of the three commissions are often Vice Governors of the PBoC at their time of appointment. Even if the PBoC is the prima donna in the structure, all four agencies still work under the State Council and are parallel in the administrative hierarchy of the Chinese government.
The issue of inter departmental policy coordination was actually noticed much earlier on. There were attempts in 2003, 2008 and 2013 to form a working committee among heads of the four agencies to improve overall financial system supervision and the last attempt in 2013 was initiated by the State Council. Unfortunately, the coordination committee system suffered all along from its lack of legal status, undefined lines of function and its decisions not being binding on the agencies which ultimately doomed its performance. Various financial crises in 2015 further exposed the weakness of the current system and calls for change are getting louder and louder.
Financial Crises of 2015
There were three well-known crises in 2015. The first was the stock market crash; the second was the poorly executed Renminbi (RMB) trading reforms; and the third was the collapse of numerous players in the Internet Finance space.
Stock Market Crash of 2015
The first crisis was the summer stock market meltdown and the botched market rescue attempt in July. The Chinese stock market got into a bull run from November 2014 to June 2015 with the Shanghai stock composite index rising 120 percent from the vicinity of 2400 to almost 5200. Additionally, there was a widespread misconception among public investors at that time - they believed that the government was underwriting the boom as the People's Daily had published an article in April that declared the index at 4000 was just the starting point of a new bull run under China’s reforms. Further cuts in the PBoC interest rate and Reserve Requirement Ratio (RRR) reinforced belief in the stock market in the first half of 2015. Such moves of the PBoC were reminiscent of the famous “Greenspan put” in the years prior to the global financial crisis of 2008, and the bull run continued.
After the market peak of 5177.35 closing on June 12, it went all the way downhill. A third of the value of A-shares on the Shanghai Stock Exchange was lost within one month of the crash. The government announced a market rescue in early July and asked the China Securities Finance Corporation to act in concert with the leading brokerage houses to intervene in the market. This move remains controversial today as the stated goal of holding shares until the index hit 4500 is uncommon. It is unusual for a public fund-initiated market stabilization program to explicitly state an open target. Furthermore, the wisdom of supporting the market when it experienced such a run up in a short amount of time was also controversial. In any case, the market ended the year at 3500, almost the same level when the rescue move was announced. Today, the market trades below the 3000 level and the participating government agencies are sitting on a huge paper loss.
A third of the value of A-shares on the Shanghai Stock Exchange was lost within one month of the crash.
Subsequent analysis of the liquidity driven stock market bubble revealed several unsettling facts:
First, aside from the official stockbroker margin loan of RMB 2.3 trillion at the time of the crash, the banks had close to RMB 2 trillion in funds financing stock margin investment unnoticed by the authorities at that time. These mysterious funds often run on a leverage of 5-10 times and were built up in a few months. The banks were thus creating products taking advantage of the regulatory vacuum between the CBRC and the CSRC.
Second, the senior vice chairman and assistant of the CSRC was arrested officially on corruption charges and 4 out of the 8 executive committee members of Citic Securities were detained for improper market behavior together with several senior executives of other brokerage houses. Citic Securities is the leading securities house in China and it was the major implementing entity in the market rescue. The arrest of so many senior figures in government regulatory agencies and industry validates many investors' suspicion that the Chinese stock market is dominated by insiders who are rigging the market for their private gain in the publicly funded rescue. This seriously dented the credibility of the CSRC.
Third, the market collapse emboldened some insurance companies to buy stocks at their bottom. The surprise takeover bid of Vanke in November by a small insurance company in Shenzhen revealed the practice of many small insurance companies of selling investment linked policies with little insurance features to raise funds for investment in the stock market. Again, industry players were creating products to take advantage of the regulatory vacuum, denting the credibility of the CIRC.
RMB Turmoil of 2015
One of the black swan events of 2015 was definitely the RMB turmoil started in August that has subsided recently. Though the market knew that the RMB had an unwarranted sharp appreciation due to its de facto linkage to the USD, especially in a time when the economy is slowing, everyone still expected the PBoC to engineer an orderly transition to a lower exchange rate with its huge arsenal. The announcement in late July that the RMB daily trading band had been widened to 3 percent from 2 percent was thus taken in stride.
The unexpected 1.8 percent drop on August 11 and 1.2 percent on the following day alerted the market that China might resort to devaluation to restore its export competitiveness. Such a move could trigger competitive devaluation pressures on its neighbors. Emerging market currencies thus tanked globally, with shockwaves felt across the world. Even the Chinese government came out to deny such intentions. However, the damage was done and the market believed that due to the possibility of capital flight, China might accede to the demand of greater capital market opening in the IMF’s forthcoming November review of RMB joining the Special Drawing Rights (SDR) basket. This led to large amounts of capital flight. Even as the IMF acknowledged that the RMB would be freely usable under the current setup in mid-November, the market belief of capital flight persisted and RMB volatility remained elevated until February this year after the PBoC came out to address the issue more openly. Due to the massive capital outflows, China spent hundreds of billions of USD of forex reserves in between August 2015 and January 2016 to support RMB.
Additionally, the second circuit breaker induced stock market meltdown on January 7 was partly triggered by the depreciation of RMB at that time, highlighting the coordination issue between the PBoC and the CSRS.
Implosions of Internet Finance Players
Yu'ebao, which is sponsored by Alibaba, generated close to RMB 600 billion in deposit balances within a year after it started in mid-2013. Its enormous success created a huge wave of internet finance ventures and the public were lulled into the promise of higher returns by the various internet funding vehicles. They believed that big data had solved the credit risk problem and that they were helping to build an inclusive financial system by extending loans to small & medium-sized businesses. Unfortunately, the ease of raising funds also attracted a lot of swindlers and credit risk amateurs to set up shop under the internet finance banner.
With all poorly run finance ventures or outright Ponzi schemes, the music stops when the kiting chain breaks after a few rounds of funding. The second half of 2015 saw a surge of bankruptcies among these internet finance entities with sizes larger than previous Ponzi schemes. The celebrated Ezubao carried an investment balance of RMB 50 billion from 900 thousand investors under 18 months of operation. Along the way, the company ran advertisements in China Central Television (CCTV) and executives won accolades from the popular press on its innovative approach.
Based on records available as of January 2016, out of 3917 Peer to Peer (P2P) internet finance companies, a staggering 1/3 or 1351 had closed down. Out of industry balance of more than RMB 400 billion outstanding, many shops are expected to close by the middle of the year as their funding cycle matures. With regard to crowd funding companies, industry data revealed that as of September 2015, 43 had gone bankrupt with 288 remaining open. P2P is lending to proponents and crowd funding is investing in proponents. It is inherently more risky as an investment than a loan. Crowd funding platforms are higher risk investments than P2P and all indications point ultimately to a higher loss ratio.
Internet finance has been in the market for several years yet regulators only began looking at its regulation late last year. The public's perception of regulatory failure and the shirking of duties of all the regulators is understandable. Depending on the loss recovery, it is probable that the losses run into hundreds of billions of RMB and millions of people have been hurt. What is more shocking is that all of this happened in the last two to three years.
Present Challenges Facing the Financial Regulators
First, there is a regulatory vacuum. The first chairman of the CBRC (2003-2011), Liu Mingkang, aptly stated that Chinese regulators are risk averse in reverse, they will rush in to regulate familiar regulatory targets and avoid regulating unfamiliar areas. Unfortunately, new financial products invented by financial sector players to circumvent regulations often cut across traditional sector boundaries and are unfamiliar to regulators. The regulators' hands-off attitude simply created too many regulatory loopholes, ending up hurting the public.
Second, the rise of derivatives further link players in different sectors in unexpected ways; insurance companies selling policies that are investment in nature; banks' creation of tranches of wealth management products that rest their value on stock market performance. Turf issues among regulators make everyone unaware of the implications of the products in the firm under their watch. The system urgently needs to develop an integrated supervisory capacity.
How to set up a regulatory framework for different business models of different players to ensure financial system viability and safety is not only a challenge, it is also trailblazing.
Third, the challenge posed by the rise of internet finance innovation. Yu'ebao designated the investment company Tianhong to run its fund of RMB 580 billion at the end of January. Tianhong ran the 103 million accounts operation with just 60 staff. A new bank requires approximately 500 branches and 8700 staffs to reach similar size according to industry experts. The disparity in running cost is clear. In some areas, banks just cannot compete with internet finance platforms. Yet the high default rate of P2P firms also shows the downside of internet finance. The economy needs banks to perform their role as the gatekeepers of credit. How to set up a regulatory framework for different business models of different players to ensure financial system viability and safety is not only a challenge, it is also trailblazing.
Fourth, new technology has increased the volatility of the market. The globalization of capital markets and improving internet based technology has sped up fund movement and volatility. Integrating the new market reality with the regulatory structure, while ensuring the smooth operation of the system, is a challenge.
Fifth, the emergence of non-conventional transmission mechanisms in the financial market. Few people expected the high interaction between the Chinese stock market and the exchange market of the last few months. Nobody can say for sure how the financial market will evolve in the future but one can be sure that increasing volatility and interlinking of sectors in crisis will be a constant threat to the system. This uncertainty is perhaps the most important reason to break down the current institutional turfs.
China seems to have reached a consensus on what problems to take on. The current debate centres on what new setup will be better to take on the problems. The institutional setup of the financial system in any country is always a political decision. Different countries should look for systems that suit their economic development goals.
The current economic situation in China presents two additional roles for its forthcoming financial regulators.
The first additional role for the forthcoming regulators is positioning themselves in the forthcoming deleveraging exercise in the sectors of the economy where overcapacity is rampant. Earlier deleveraging of overcapacity in the 1990s essentially was a government takeover of state owned enterprises’ (SOEs) bad loans of the state banking sector with little involvement of the financial system. However, the situation now is more complicated as the scale of operation is much larger and the handling of bad loans needs a more systematic approach to prevent the spillover effects of loan restructuring. Besides, not all bad loans are SOE loans and most of the banks now are not state banks.
Another new role for regulators is to change their regulatory philosophy to include consumer protection. The traditional role of regulators is the promotion of system stability, and meeting economic growth and inflation targets. Now with increasingly complicated financial products in the market, the need to protect innocent investors is increasingly urgent. This should not just be a simple technical monitoring of products in an ex-post basis. The regulatory philosophy must be changed to put consumer protection in an ex-ante basis.
Potential Problems Facing the Super Central Bank Model
The super central bank concept is not new but it is not a popular setup in developed countries. As we noted earlier, the financial sector regulatory framework reflects the political choice of the government. While the model of independent central banks is preferred among academics, most developing countries have overwhelmingly rejected that model in favor of one featuring closer cooperation of the central bank function with that of finance, as that better suits their respective economic objectives.
The super central bank model run by the Monetary Authority of Singapore (MAS) and the Hong Kong Monetary Authority (HKMA) are quite successful in their respective jurisdictions. The single integrated agency approach is more responsive to rapid market shifts and eliminates the regulatory arbitrage opportunities of financial sector players. There is not much literature on the super central bank model and China must develop its own system and working pattern.
One of the important challenges in adopting the super central bank setup lies on the bureaucratic setup. There are 4 ministerial rank officials running the current setup, and the enormous power vested in the new super central bank calls for a more senior official to lead the organization. This calls for a new structure in the State Council. Historically, MAS is led by a senior minister and that point has been cited as an important element in its success. Then Executive Vice Premier Zhu Rongji's governorship of the PBoC was often cited as one of the main reasons behind the successful financial sector setup in the 1990s.