January 14,2008

Financial Regulatory Reform Spurred by Subprime Crisis

By Ma Wenluo
Chinese financial supervisors are busy learning a lesson from America’s subprime mortgage crisis as they realize that increasingly open financial markets and a proliferation of complicated trading products bring new challenges to their work.

Liu Mingkang, director of the

China Banking Regulatory Commission (CBRC), commenting on this crisis, said recently that financial innovation has boosted demands for effectiveness in regulating financial markets.  He pointed out that financial derivatives, such as securitized subprime mortgage loans, are transferring credit risk to the capital market, and serious information asymmetry is leading to market failure. Meanwhile, major defects exist in financial supervision systems, e.g. failure to prevent financial institutions from loosening credit standards and a lack of effective supervision of investment banks, intermediate institutions like credit rating agencies and of major investors such as hedge funds. 

Adding to the problem in China is that its financial authorities have failed to establish unified supervisory standards. 

Due to the increasing wealth of Chinese citizens and a lack of investment channels, a variety of financial products are being introduced by different domestic financial institutions, and a many of these products under the name of "financial innovation" are on the edge of law and lack proper supervision. China’s financial authorities, such as CBRC, the People’s Bank of China (PBoC), the China Securities Regulatory Commission (CSRC) and the China Insurance Regulatory Commission are issuing differing policies at different times.

CSRC used to smother securities companies with over-supervision. Consequently in a bear market a number of securities companies not allowed to diversify their business models have been bankrupted or gobbled up by other firms. From 2004, CSRC began to identify a selection of solidly performing securities firms as "innovative", and allow these firms to undertake measures in their business, operations and organization to improve their profit-making ability and development space, so long as those measures were not specifically forbidden or limited by laws and regulations. They also gave them permission to issue stocks and bonds. After 2006, and benefiting from the flourishing stock market, these companies?share prices have risen significantly and they are now readying to compete with international investment banks.

However, China’s accession to the WTO means that financial institutions are facing heavier competitive pressures. The Beijing government is encouraging innovation, such as asset securitization, by all financial institutes in their business. Financial authorities are trying to develop other new products, e.g. asset-backed securities, mortgage-backed securities, bad asset securities, and auto loan securities, but they’re facing limited or even a lack of legal grounding, such as in the governing of special purpose vehicles (SPV), the majority of asset securitization products sold through trust investment companies.

It is the trust investment companies who are most greatly affected through financial supervision and innovation. Unlike banks, securities companies and insurance companies, each of which are separated sectors and have a definite business scope set out by law, Chinese trust investment companies find it hard to find living space, and it is inevitable that they might push the limits on product innovation. In China the convention is that "nothing is allowed which is not expressly permitted," and the basic business of trust investment companies, "commissioned by people, finance for people", faces competition and challenges from the banks, funds and insurance companies. When the trusts invade these sectors?space they are rebuked by regulators.

In an effort to curb abuses, CBRC, at the beginning of 2007, raised the required minimum investment into trust products to RMB 1 million from half a million to restrain many resident investors, but this is a hard choice between financial supervision and financial innovation.

The legal environment of financial supervision and innovation in China is underdeveloped and differs from those in western countries. Xia Bin, ex-official of People’s Bank of China (PBoC) and current director of the Financial Institute of the Development Research Center of the State Council, believes that the authority needs to properly address the problem and set up a mechanism as soon as possible to bring into line the relationship between supervision and innovation.

Lack of coordination among the regulators leads to differences in supervision policies. For instance the National Development and Reform Commission (NDRC) has been criticized for "controlling" the issuing of company bonds, i.e. dictating who can and can’t as well as credit ratings and prices, while PBoC has expanded the inter-bank money market and encouraged companies to issue short-term,i.e. one year, bonds.  Meanwhile, CSRC has issued its own regulations for issuing company bonds under a "granted and registered" system. As a result the NDRC must reexamine methods to issue bonds according to market principles.

The national financial authorities of most developed countries early followed a rule of strict separation of the various sectors under their control, but later grew to allow diversification. The integration of global finance will force China to allow companies to take on diversified financial operation as they are developing more and more innovative products.  But to do so, China’s regulatory system needs integration also.

Wu Xiaoling, recently retired PBoC vice-president, warned earlier that in order to improve administrative efficiency and avoid scattered management, China must set up unified functional regulation as soon as possible so that businesses with similar scope and function would be managed by a single department.

Currently the State Council is considering whether to set up a super ministry for financial supervision. The 17th CPC National Congress raised the idea of a super ministry, and a financial supervision coordination commission, with functions similar to those of the Hong Kong Monetary Authority, is expected to be established during the March 5th session of National People’s Congress.


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