This year’s crash has forced the government to address the cracks in its financial regulatory system. These legal and policy considerations will shape a new regime
In the year leading up to China's crash beginning on June 12 2015, state-owned media actively encouraged investment in the stock market. Investors responded enthusiastically, and many piled in with money borrowed from various unlicensed internet-based brokers. When the China Securities Regulatory Commission (CSRC) investigated and stopped these illegal lending activities, it caused a sweeping sell-off and under-margin forced sales. And so began a vicious downward cycle of price decreases and margin calls, leading to the protracted crash that lasted until July 9 2015. During that time, the Shanghai stock index fell 30%.
Despite government rescue efforts, the market remained volatile and vulnerable until the middle of September. The crash and ineffective bailout sparked a national debate on how to effectively regulate and develop capital markets in China. The central government has realised that, on account of the markets' sheer size and complexity, a complete overhaul of its traditional regulatory system is needed to meet fast-changing market needs.
Increased leverage trading contributed to the market bubble and crash. Leverage trading includes:
- securities lending and margin trading businesses of securities companies under CSRC supervision;
- commercial bank and trust company structured products under China Banking Regulatory Commission (CBRC) supervision; and
- unlicensed internet-based brokers financing margin trading under no supervision in the unregulated grey market.
The CSRC believes its limited regulatory scope over the leveraged trading system slowed its response to the unusual market trends. It's a symptom of China's fragmented financial regulatory system. Although Article 9 of the amended People's Bank of China Law (2003) called for the State Council to establish a mechanism to coordinate the financial regulatory system, all attempts failed because the coordination mechanisms, unlike permanent institutions, lacked decision-making and implementation powers.
"Are there ways to improve financial regulation without undergoing costly regulatory reorganisation?"
On November 3, in his proposals for China's next five-year plan, President Xi Jinping proposed establishing a coordinated, powerful and effective modern financial regulatory system to solve the problems caused by regulatory fragmentation, and to prevent systemic risks.
President Xi's plan has reignited debate on which agency should lead the coordination effort and spawned three leading proposals. The first proposal suggests the People's Bank of China (PBOC) should lead because – as China's central bank – it is the lender of last resort. PBOC supporters even recommend bringing all other regulatory agencies under the PBOC, including the CSRC, CBRC and China Insurance Regulatory Commission (CIRC).
The second proposal opposes consolidation under the PBOC because it would create a conflict between the Bank's supervisory role and monetary policy role. Instead, the second proposal suggests a 'separation plus coordination' model, which would establish a financial coordination committee at the State Council level to oversee and coordinate all financial regulators. The third proposal suggests that, with market evolution towards mixed operation, the CSRC, CBRC and CIRC should integrate into a new consolidated mega-ministry.
China may need a year or two to start reorganising the financial regulatory system. During this time, a few fundamental questions must be answered. Can reorganising regulatory agencies actually solve regulatory problems? Does the separate operation principle necessarily require separate supervision; and does mixed operation require integrated supervision? Most importantly, are there other options to improve financial regulation without undergoing costly regulatory reorganisation?
Independence and professionalism
China's financial regulators suffer from the same lack of institutional independence as all Chinese ministries and local governments. They lack sufficient resources, professional capability and the legal protections necessary for true institutional independence. As a result, regulators cannot discharge their duties upon their own discretion but must constantly report to their superiors for approval and further instruction. This creates dependent and unprofessional regulators who, compared to their counterparts in mature markets, feel less responsible and motivated to enforce rules. Without more institutional independence, simply reorganising regulatory agencies will not establish a truly effective regulatory system.
Under the prevailing structure, financial regulators lack credibility and respect in the market. This unfavourable impression was confirmed during and after the crash, when the CSRC shifted its efforts from aggressively propping up the market, to abruptly seeking enforcement actions against illegal margin trading, to indiscriminately introducing market rescue measures. As a ministry under the State Council, the market crash made clear that the CSRC had only two options in how to respond to a market bubble or crisis: act first while speculating about the State Council's ultimate intentions, or do nothing until instructed by the State Council. As a result, the CSRC had to choose an option first and then had to change course frequently during the market crash.
The separation principle
The Securities Law and the Insurance Law enshrine the 'separate operation and separate supervision' principle, which separates the operation and the administration of the securities, banking, trust and insurance industries. Under the separation principle, the CSRC, CIRC and CBRC were spun off from the PBOC in 1992, 1998 and 2003, respectively. The resulting financial regulatory structure reflected the US's financial regulatory system during the Glass-Steagall regime. Although the final structures were similar, the historical reasons and purposes giving rise to the two systems were different. In the US, Glass-Steagall was a reaction to the conflict of interest in banks engaged in both commercial and investment banking. Glass-Steagall protected commercial banks from capital market risks. In China, separation and specialisation was a preemptive measure thought necessary during the formative years of China's financial institutions and markets. The separation principle was implemented to protect against institutional or market failure arising from both the regulators' and market participants' incompetence in trying to be all things to all people.
In contrast to the separate supervision trend taking hold at the government level, the behaviour of participants in all four financial industries increasingly straddles multiple lines and markets. Initially, financial groups such as Ping An, CITIC and Everbright appeared, which owned entities across the four industries. Then other barriers started to dissolve. For example, a qualified insurance company can now invest directly in the stock markets, a qualified securities company or mutual fund manager can raise funds from the interbank market, and a qualified commercial bank can establish its own mutual fund management company. Although the mixed operation has started to become reality at market level, serious policy concerns should caution against moving too far from the separate supervision system.
First, China's financial markets have developed to roughly the level of sophistication (and occasional chaos) as the US pre-Glass-Steagall. To avoid systemic risks, China must still block market contagion between different industries. But during the year leading to the market crash, commercial banks and trust companies channeled a staggering amount of bank loan proceeds into the stock market through shadow bank vehicles such as their asset management plans. The deregulation of shadow banking broke the barrier between the industries and destabilised the stock market.
Second, greater integration among regulatory agencies could potentially disrupt or distract from market-oriented reforms that are already underway and have reached critical junctures; the success or failure of which will play a decisive role in China's overall financial reform. These individual reform schemes include the PBOC's liberalisation of interest and exchange rates, and the CSRC's transformation from a merit-based to pure disclosure-based system for approving initial public offerings (IPO).
Third, if the primary public policy goal is to prevent systemic financial stress in the wake of the global financial crisis and in the face of China's slowing economy, it can be achieved more efficiently by improving financial regulation within each regulatory body rather than through time-consuming and costly structural reorganisation.
As China's financial markets have developed, its regulators have been in a relentless and uncoordinated race to develop and expand their respective jurisdictions. The result is fragmented and competing regulations, all vying to regulate the same business activities differently. Debt capital markets and asset management business notably suffer under this fragmentation as both operate in an environment where market participants engage in arbitrage under multiple regulatory layers. For example, a market participant can often cherry-pick the least restrictive scheme for product distribution, disclosures and qualified investor criteria.
Since the stock market crash, however, a new consensus has emerged among financial regulators that the status quo cannot continue. No matter who takes the lead, the fragmented regulatory system must give way to a unified set of market-based conduct rules. This functional approach will see a market participant's conduct governed according to the kind of activities it participates in rather than according to the kind of entity it is. This approach will uniformly apply rules (at least at a general level) to the same conduct and encourage greater coherence of the more specific regulations overseen by different regulators.
Despite the goodwill among financial regulators to adopt this approach, it's not yet known which will formulate and implement the unified rules. And without total acquiescence to the coordinating authority, competing desires among the different financial regulators would render any system that emerges highly ineffective.
Unification under the Securities Law
An alternative solution might be found by amending the definition of 'securities' in the Securities Law. Article 2 lists only stocks, corporate bonds, treasury bonds, securities investment funds' shares, and the derivatives of these instruments as 'securities'. As most jurisdictional overlap occurs in regulating capital market products and conduct, an expanded definition in the Securities Law could easily eliminate much of the overlap by allowing CSRC to become the regulatory body.
Inside China, written by FenXun Partners' Xusheng Yang and Sue Liu, is an insight into aspects of the China market that often elude the naked eye.
Yang is a specialist in China's financial markets and institutions, having started his career at the China Securities Regulatory Commission and then co-founding FenXun in 2009. Liu's practice focuses primarily on the asset management industry, and has previously worked as an associate at Skadden Arps Slate Meagher & Flom in New York.
The CSRC's expanded power would come at the expense of other agencies, which enjoy residual power over securities market transactions based on having jurisdiction over an entity involved in the transaction. Today, the CBRC has jurisdiction over commercial banks and non-banking financial institutions; and as a result, also over their wealth management products, bonds and investment banking business. While the CIRC has jurisdiction over insurance companies, and their wealth management products and certain investment business. Both the CBRC and CIRC would likely see their power over these products curbed with an expanded definition of 'securities'. And the PBOC's regulatory power over the interbank bond market might also be eroded if the definition is broadened.
These changes appeared to be on the near horizon before the stock market crash. The National People's Congress had added to the legislative agenda the revision of the Securities Law, and had finished its first review of the bill in April 2015. The working committee had recommended an overhaul of the statute to address the developments and challenges in China's capital markets. And the bill included a broadly expanded definition of 'securities'.
But the revision to the Securities Law was postponed after the crash, while the debate rages on regulatory coordination. Apparently, the legislature would like to carefully examine the financial regulatory system's existing holes to ensure its response not only shores up the system, but also includes an effective coping mechanism for future financial crises. As the consensus builds towards market-based rules and a uniform approach, China is sure to embrace its own big bang in its financial markets with the much anticipated revised Securities Law, if not a completely new Financial Services Act.
By Xusheng Yang, partner at FenXun Partners in Beijing
© 2021 Euromoney Institutional Investor PLC. For help please see our FAQs.