China set to bolster regulatory oversight

From incubator to supervisor

When China’s financial markets were still at an inchoate stage the operations of financial institutions were very basic and their product offerings relatively small. At the time, curbing financial bubbles was hardly a priority for policymakers.

"We believe China’s financial regulatory environment will become even more supervisory oriented, integrated and centralised in the future."  - Raymond Yeung 

Instead Chinese authorities considered the financial services industry to be an enabler for economic development. Authorities played the role of industry incubator as they were aiming to expand the financial industry. Financial deregulation was a common theme. 

The incubatory role gained some tangible outcomes. The breadth and depth of China’s financial markets has expanded dramatically over the years.

Nowadays, China’s financial industry has evolved to do much more than meeting the credit needs of the real economy as reflected by the rising debt exposure within the financial industry, notably between banks and non-bank financial institutions. Likewise, the risks faced by the financial markets have also increased.

These risks could stem from the irregular activities of individual financial institutions, such as aggressive trading, leveraging through regulatory arbitrage, and excessive risk-taking.

In this context, Chinese policymakers see a pressing need to review the mandates of the authorities and focus on their supervisory roles professionally. This will certainly challenge the technical abilities as well as the mindset of regulators.

Shift

The NFWC reiterated the need to supervise financial activities using a functional and behavioural approach. The aim is to align regulatory standards with the nature of business activities carried out by the different types of financial institutions.

The rise of cross-sectoral, cross-market activities in the past three decades has necessitated an evolutionary change in regulatory model.

In China, regulators are now facing the same challenges as their global peers. On the surface, the different segments of the financial services industry seem to operate separately and independently.

In reality, conglomerates are emerging via the establishments of subsidiaries and affiliated companies through acquisitions and complex shareholding structures.

The blossoming of financial products and services in China reflects structural changes in the country’s financial industry.

After the NFWC, we believe Chinese authorities will need to re-define the various categories of financial activities and develop behavioural standards for each to enhance the scope and efficiency of different regulatory bodies.

Centralised framework

The NFWC said "financial regulation is mainly the central government’s authority" in an attempt to dissolve existing ambiguities between the functions of provincial governments and the central government.

In the past when China was still a heavily planned economy the provincial governments would regard financial institutions in their locales as part of their jurisdiction and treated related institutions as their ‘secondary fiscal firepower’, providing them with preferential access to credit on demand.

Even after years of reform this mindset still prevails and the degree of influence of provincial governments over the local branches of financial institutions remains strong.

While the local bank branches were encouraged to support the economic development of lower-tier cities through lending, a potential moral hazard problem has emerged.

Provincial government bodies could become ‘free riders’ as they have not been made fully accountable for the financial risks they take on, as the loans are perceived to be backed at the national level, further encouraging credit expansion without prudent risk management.

The existing incentive structure hardly aligns the mandates of financial responsibility and accountability between the central and provincial governments.

The NFWC also stated clearly local governments should "strengthen the management of domestic risk in accordance with the unified rules prescribed by the central government.”

By emphasising that the power of financial regulation lies with the central government, it implies senior Chinese policymakers are attempting to adjust the rights and responsibilities of provincial government with regard to the financial system.

Looking ahead, we will watch closely how smoothly the policy coordination initiatives launched at the State Council level are passed through to the provincial government level.

There is no perfect system in the world. After three decades of rapid economic development, China’s financial services industry has become more consolidated and market-oriented. Cross-sector business, shadow banking, and even Internet finance are all irreversible trends as financial products and services converge.

At the same time, the opening up of the financial markets has posed unprecedented challenges to existing interest rate and exchange rate policies. As the markets evolve continuously, it will be an ongoing process for the Chinese government to refine the country’s regulatory framework.

Raymond Yeung is Chief Economist, Greater China, ANZ