Finance | Zhu Ning

Chinese regulatory commission faces balance between change and stability

The Chinese Banking Regulatory Commission held a key meeting on Jan 6 to propel reform in the Chinese financial and banking system. Given that this is the first commission national conference since the Party's Third Plenum in November and the Central Economic Work Conference in December, the meeting attracted considerable interest, domestically and internationally.

Of particular importance to the meeting is that, with the lion's share of assets in the Chinese financial system, the banking sector has enjoyed record growth, accumulating risks while facing mounting pressure for reform.

The timing of the conference was significant. The recent credit crunch in December, although not as devastating or unexpected as the first one in June 2013, raised increasing concerns about the liquidity and asset quality of the Chinese financial system. At the same time, the rapid growth of trust companies and Internet financing has absorbed a large fraction of shadow banking in its own system. The shadow banking system is not only taking away the market share of traditional banks, but also fundamentally challenging how traditional banks carry out their businesses.

Beyond business considerations, the commission is expected to communicate clearly how it plans to balance its mission to further reform the Chinese financial system and to maintain prudential regulation and systemic stability. Shadow banking, on the one hand, can facilitate the reform of interest rate liberalization and encourage market competition. On the other, if the pace of the reform is too quick and dramatic, it may expose the existing banking sector to risks and problems.

Among the many important topics discussed at the meeting, a few specific messages were conveyed.

First, the commission announced that the Chinese banking system welcomes the participation of both domestic and international players. Financial services, in particular banking, remain one of the most regulated areas of the economy. Consequently, banking has remained largely closed to domestic capital and foreign banks. Of course, part of the reason can be attributed to the banks' special social role and the potential impact on the systemic stability of the Chinese economy.

In addition, many argue that allowing more competition in banking should not only help Chinese banking become more competitive, but also provide much needed capital to small and medium-sized enterprises and diversity in the provision of financial services.

In particular, the commission announced that it would allow three to five privately capitalized banks to be established. This is certainly encouraging. Banking is one of the most coveted areas for private capital for several reasons. First, many private companies believe that financial services, banks in general, provide much better investment returns than industrial sectors. Furthermore, many private companies wish to obtain bank financing by setting up banks of their own. Given that bank loans remain one of the cheapest ways to finance private enterprises and are available to a select number of private enterprises, many private companies intend to take the problem into their own hands and operate their own banks.

Second, the commission reiterated its emphasis on maintaining prudential regulation and ensuring systemic stability. In particular, the commission made it clear that it will look into not only banks, but semi-bank financial institutions, in particular trust companies. Although it remains unclear how the central bank and the banking regulator will divide their responsibility in regulating such semi-banking institutions, it is important that regulatory authorities pay close attention to them now rather than later.

Many high-yield-paying trust products and wealth management products in China have grown tremendously in the past few years. On the one hand, such a phenomenon is welcome because it provides a large increment of financing not only for small and medium-sized enterprises, but also for local government financing vehicles.

On the other hand, such products bring potentially catastrophic risks to the financial system. Many investors in shadow banking products believe such products are safe because they understand that despite there being clear stipulations in the prospectus that there is no guarantee of the security of the principal, trust companies and related commercial banks will guarantee the safety of their investment, both because of regulatory and reputation concerns.

This is particularly alarming to the commission because many shadow banking products are indeed structured, packaged or distributed by banks. If anything, it is the commercial banks' creditworthiness that makes the trust products and wealth management products "safe" and "attractive". To sever such contingent liabilities, the commission has vowed to guard off potential risks within the banking sector or contagion from the semi-banking sector. Such precaution is critical in controlling the risks that may jeopardize the financial system and economic growth.

Finally, the commission encourages further financial innovation. It stresses that financial innovation is important for banks to better manage risks, better serve their customers and better diversify their assets, domestically and internationally.

Specifically, the commission underlines facilitating the liberalization of interest rates as an important area for banking reforms. While all Chinese banks enjoy generous savings-loan interest rates and derive close to one-half of earnings from such "regulatory dividends", the commission meeting made it clear that such a situation is not going to last and banks will have to diversify their businesses and seek alternative growth engines to propel their next stage of growth.

Further, banks are encouraged to review their asset quality and risk management. As the commission cautions, things will be very different once interest rates are fully liberalized and banks have to prepare for slow growth or even a drop in the size of their deposits and resulting liquidity and asset shock.

Finally, one path that the commission points out that would lead to interest rate liberalization is further reform and openness in the newly established Shanghai Free Trade Zone. The commission is believed to be committed to providing further support to financial reforms in the zone. Be it lower requirements to establish banks, the scope of businesses that private and foreign banks would be allowed to operate, or the permission to foreign banks to issue renminbi-denominated bonds, the commission seems to have a few plans to help further boost the reforms in Shanghai.

If they can help Chinese financial and banking reform and the development of the Shanghai Free Trade Zone, all the better.

The author is a faculty fellow at the International Center for Finance, Yale University, and deputy dean of the Shanghai Advanced Institute of Finance, Shanghai Jiaotong University. The views do not necessarily reflect those of China Daily.