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China's Road to Greater Financial Stability

Chapter 3. Strengthening the Financial Stability Framework in China

Udaibir Das, Jonathan Fiechter, and Tao Sun
Published Date:
August 2013
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Over the past decade, China has maintained a stable financial system during a period of rapid economic expansion and significant structural change and reform. This commendable performance reflects the great strides made by the Chinese authorities in deepening financial reform, mitigating financial risks, and strengthening supervisory capabilities. But, until recently, it has also reflected a willingness by government to periodically draw on the public purse to relieve the banking system of bad debts and inject sizable amounts of capital. The authorities are fully aware of the moral hazard involved in these types of state intervention and are keen to promote a financial system that is better prepared to contain its own risks. The urgency for doing so is heightened by the knowledge that both domestic and cross-border systemic linkages in China are intensifying as the size and complexity of the financial sector expands, and as the authorities encourage further financial innovation to better service the needs of a dynamic economy.

The ultimate responsibility for promoting and maintaining financial stability in China resides with the State Council, the highest executive authority. From an operational perspective, however, this responsibility is very largely discharged by the following four agencies:

  • The People’s Bank of China (PBC), which as the central bank is specifically charged with guarding against financial risks and maintaining financial stability;
  • China Banking Regulatory Commission, which is the prudential regulator of banks;
  • China Securities Regulatory Commission, which regulates the securities market and futures markets; and
  • China Insurance Regulatory Commission, which regulates the insurance industry.

Of the other government agencies, the most important from a financial stability perspective are the Ministry of Finance, whose responsibilities as fiscal agent include debt issuance and the management of state-owned assets, and the State Administration of Foreign Exchange, which has custody of foreign exchange reserves. Together these two agencies provide the government with a very substantial backstop for the financial system—the resources to intervene in times of financial stress.

The work that these agencies need to undertake jointly to promote financial stability can be broken down into three broad streams:

  • Surveillance—the early identification of potential threats to financial stability;
  • Mitigation—the measures that need to be taken to make the financial system more resilient to shocks; and
  • Crisis management—the principles and procedures for responding to distress or failures in the financial system.

Each of these streams represents a significant body of work in its own right and requires a high level of interagency cooperation and coordination to be fully effective.

On surveillance, the main challenge is to identify the macroeconomic and financial variables that provide the most insight into the potential risks and vulnerabilities facing the financial system. This information obviously varies from country to country depending on the scope of national statistical collection and the availability of market-based information. The challenge in China, as elsewhere, is to identify the data set that is most likely to provide the authorities with some early warning of systemic risks and thus provide an opportunity to respond preemptively.

The central bank and the regulatory agencies share responsibility for the mitigation of risk within the financial system. Much of the central bank’s contribution to these efforts will come from fulfillment of its other core policy objectives, which are to maintain a sound monetary policy to promote a low-inflation environment and to develop a robust payments infrastructure, including a reliable real-time gross settlement system. The central bank’s support for system liquidity through financial market operations is also vital to financial stability. For the regulatory agencies, risk mitigation requires that they pursue the types of best prudential practices identified in the various international standards and codes, tailored where appropriate to national circumstances. History also tells us that progress around issues such as corporate governance, insolvency, creditor protection, and implementation of suitable accounting and auditing standards plays a vital role in promoting financial stability.

However, the global financial crisis has also highlighted the importance of adopting a comprehensive macroprudential framework to help mitigate risks. Success in achieving financial stability will depend critically on complementing microprudential regulations, which aim to enhance the resilience of individual institutions, with effective macroprudential regulation to strengthen the resilience of the financial system as a whole.

The need for crisis management arrangements is an acknowledgement that the risk of failure within the financial system is never eliminated, notwithstanding the best efforts in terms of surveillance and mitigation. The authorities need to have contingency plans to respond promptly to a crisis that may involve one or more financial institutions. In most countries, the toolkit for crisis management provides for both “open resolution” outcomes, in which distressed financial institutions are restored to health and remain in business, and “closed resolution” outcomes, in which provision is made for the wind-up and orderly exit of such institutions. Striking the right balance between these open and closed resolution outcomes is critical if financial stability is to be preserved at the least cost to public finances and without an unwelcome and, ultimately, damaging increase in moral hazard. To date in China, the authorities have displayed a strong preference for open resolution outcomes.

Ultimately, the key to an effective financial stability framework is cooperation and coordination between the various agencies, both during the good times when the financial system is in robust health and also in times of crisis. An important question in China is whether coordination arrangements, which appear to be extremely effective in times of crisis, are equally well suited to normal operating conditions.


Surveillance is a difficult task, not least because the term “systemic risk,” while widely used, is actually quite difficult to define and quantify. It’s easy to identify once we see it in the form of a broad-based breakdown in the functioning of the financial system, which is normally realized ex post as a large number of financial failures. However, policymakers cannot afford to wait until systemic risk crystallizes into disaster, and so surveillance needs to function, to the extent that it can, in an ex ante mode. That is, it should help the authorities identify sources of systemic risk and the various channels through which these risks are propagated. Accordingly, an effective surveillance framework is one that is predicated on a good understanding of systemic linkages—those interactions that transmit and sometimes amplify risks between the real economy and the financial system and also within the financial system itself. Many of these linkages are intensifying in China as integration into the world economy proceeds apace, and as the financial sector grows in size and complexity.

Cross-sector linkages—those that exist between the financial and nonfinancial sectors—are being gradually reshaped by the evolution of the domestic capital markets and also by the drive to provide better access to finance by the household, small business, and rural sectors in support of domestic consumption.

Cross-border linkages—those between the financial system and the world economy—reflect the need to fund a vibrant manufacturing export sector. But direct linkages are also increasing as financial institutions expand their overseas presence in line with a surge in foreign investment more generally.

Financial linkages—those that transmit risk within the financial system—exist at three levels: (1) cross-market linkages between the domestic money, bond, foreign exchange, and equity markets; (2) cross-institution linkages between bank and nonbank financial institutions; and (3) external linkages between global and local financial institutions and markets.

In China, the transmission of systemic risk through financial linkages is largely contained through the use of administrative controls both on cross-border flows of capital and the deployment of capital domestically. There are, for example, strict controls on cross-investments between bank and nonbank financial institutions, although the government has sanctioned a number of (significant) exemptions as part of a pilot study. In addition, bond markets are divided—with retail trading restricted to the exchanges and wholesale trading channeled through the interbank market—and there are a range of restrictions on equity trading, particularly for foreigners. Nonetheless, there is evidence that financial linkages are intensifying as the traded markets in China expand, providing participants with more liquidity and greater hedging opportunities. External linkages are also deepening as some capital movements are liberalized.

There are two dimensions to systemic risk arising from these various interlinkages. The first relates to the way in which aggregate risk evolves over time. In particular, there is a procyclical bias to risk, with financial institutions tending to take on excessive amounts in the upswing of an economic cycle only to become overly risk-averse in a downswing. This characteristic amplifies the boom-andbust cycle in the supply of credit and liquidity—and by extension in asset prices—that is so damaging to the real economy. The second dimension is cross-sectional or network risk due to the common exposures and interconnectedness that exist within the financial system—relationships that work to amplify and rapidly transmit shocks between financial institutions. As a result, the failure of one institution, particularly one of significant size or market share, can threaten the system as a whole.

The challenge in China, as in other countries, is to develop a surveillance system that will provide the authorities with some guidance about the amount of risk occurring within the financial system and some early warning of potential problems. In taking the lead on this work, the PBC needs to set itself three key objectives.

The first is to build a comprehensive statistical database, including a broadbased set of financial soundness indicators, so that the authorities can monitor the condition of the financial system on a timely basis.1 In China, financial soundness indicators are readily available for the largest commercial banks, but coverage is very limited for other key depository and nonbank financial institutions, which together account for around 40 percent of total financial assets. This seems to reflect a number of factors, including the incomplete transition of many smaller financial institutions and nonbank activities to internationally accepted accounting and disclosure standards; methodological and interagency coordination difficulties; and the failure of existing data collection services to keep pace with financial sector growth and innovation. To achieve this first objective, the PBC will need to collaborate closely with the other prudential regulators, which also have a vested interest in enhanced statistical collection.

The second objective is to identify the economic and financial indicators that can act as an early warning system of potential threats to the financial system. Inevitably, a crisis will reflect the collision of several vulnerabilities of an economic or financial nature. There are often common factors at work: excessive credit growth, particularly associated with a rapid run-up in asset prices; volatile cross-border capital flows; and increased corporate and/or household sector balance sheet leverage. In China, there are also important structural considerations to be taken into account, such as whether the current model of investmentdriven growth is sustainable without an accompanying increase in systemic risk.

There is no precise set of economic or financial indicators that will form the basis of an early warning system. A parsimonious but useful set is commonly derived from the behavior of credit and asset prices (Borio and Drehmann, 2009). In particular, there is evidence that sustained rapid credit growth combined with large increases in property prices increases the probability of an episode of financial instability. The challenge in emerging markets like China is to differentiate between an expansion in credit that is the corollary of a successful financial deepening program spurred on by government and an expansion of credit that is suggestive of imprudent borrowing. A good understanding of credit—who is borrowing, how much, and why—is a basic building block of macroprudential surveillance. Similarly, an understanding of the conditionality of credit—both in aggregate and by industry—can provide some valuable insights into the evolving risk environment.

Even more useful, but more data intensive, are leading indicators obtained from the analysis of sectoral balance sheets of the household, corporate, and public sectors. By tracking debt and debt-servicing requirements over time, balance sheet analysis aims to anticipate the potential for higher levels of default should economic growth falter. Similarly, the analysis of state and local government balance sheets may be rewarding if any doubts exist regarding their debt servicing capabilities and whether the central government stands behind them.

Finally, there is always demand for a “snapshot” of systemic risk that provides a sense of whether risks in the financial system are rising or falling. This usually takes the form of an index—a single quantitative measure of financial conditions derived from a weighted sum of variables drawn from foreign exchange, debt, equity markets, and the banking sector (Illing and Liu, 2003; IMF, 2007). A different approach is to separate out the various dimensions of risk and present them in a “map” or “cobweb” form. In each case, the value of these methodologies is heavily dependent on the liquidity and transparency of the financial markets from which the various measures of risks are drawn (IMF, 2007). This means that as financial markets in China deepen and mature, the information content of financial pricing will improve and so will the value that can be derived from the quantitative modeling of systemic risk in China.

The PBC already devotes considerable resources to financial stability and publishes its efforts annually in a comprehensive annual Financial Stability Report.2 Continuing to enhance its systemic risk monitoring and measuring capabilities will be an important priority for the central bank as it seeks to keep pace with the expanding size and complexity of China’s financial system.


Once an increase in systemic risk has been identified, the challenge is to agree on the policy response that will best address it. What the global financial crisis has taught policymakers is that prudential regulation that ensures the safety and soundness of individual institutions, though vitally important, is not sufficient for this task. What is required is a strengthened set of microprudential regulations targeted at individual institutions but complemented by macroprudential policies that focus on the system as a whole.

In terms of microprudential regulations, it is now clear that leading into the global financial crisis too many financial institutions in too many countries lacked the capital and liquidity needed to absorb sizable economic and financial shocks. Hence, the Basel Committee on Banking Supervision (BCBS), of which China is a member, has undertaken actions to:

  • Improve the quantity and quality of capital within the global financial system so that it can more easily absorb losses;
  • Adjust capital requirements so that they are more closely aligned with the risks they are meant to protect against and, in particular, more fully capture market risk, counterparty credit risk, risk in securitized portfolios, and the state of the business cycle;
  • Apply a gross leverage ratio as a backstop against excessive leverage; and
  • Introduce measures to protect against liquidity shortages by requiring larger liquidity buffers and lowering the dependency on less secure forms of funding.

What is also better recognized today is the importance of singling out the largest and most complex financial institutions, that is, those institutions with the potential to do the most damage to the financial system should they fail. There is now global consensus that these systemically important financial institutions (SIFIs), particularly those with a significant cross-border presence, should be subject to more intense supervisory oversight and should hold a capital surcharge. Many countries are considering the addition of a similar surcharge to those SIFIs that have a more limited domestic presence. While these initiatives will help reduce the probability of failures among SIFIs, they will certainly not eliminate them altogether. And as the experience of a number of G20 countries has demonstrated only too well, when SIFIs get into difficulties, the default response is usually to bail them out—an outcome that has been very expensive for the taxpayer and that has perpetuated the underlying problem of moral hazard within the global financial system.

Another reform initiative is the “bail-in” to protect taxpayers from exposure to SIFIs’ losses. Bail-in is a statutory power of a resolution authority to restructure the liabilities of a distressed financial institution by writing down its unsecured debt and/or converting it to equity. The statutory bail-in power is intended to achieve prompt recapitalization and restructuring of the distressed institution (Zhou and others, 2012). Of course, bail-in is not a panacea—it is simply one element of a comprehensive solution to the SIFI problem.

The debate about how best to deal with SIFIs is very relevant to China. Reflecting a high degree of concentration in the financial system, the major Chinese banks have a substantial market share and are systemic in size and interconnectedness. While the largest Chinese banks today have relatively simple operations, at least in comparison with the largest U.S. and European banks, this is changing. As noted earlier, cross-investments between banks and nonbank financial institutions have been approved as part of a pilot study. However, nonfinancial companies and industrial houses are able to take up significant stakes in financial institutions and there are no legal impediments to them setting up complex holding company structures that can be very challenging to supervise on a consolidated basis. Ultimately, this all makes for an increasing risk over time of the major banks becoming too large to effectively manage, supervise, or resolve in an orderly fashion. This, in turn, reinforces the importance of identifying a combination of approaches, including bail-ins, to address the systemic risks associated with SIFIs.

However, effective supervision is not just about intensity; it is also about scope. The global financial crisis was propagated in part by institutions outside the regulated sector, that is, in the so-called “shadow” banking system. These institutions—including investment banks, structured investment vehicles, and money market mutual funds—were typically subject to less regulation than the core of the financial system. Events revealed that a number of these institutions were not holding sufficient capital or liquid assets for the risks they were taking, and their weakness soon spread more widely through the financial system. Other shadow institutions, including firms whose activities may not be well defined (such as hedge funds, private equity funds, and commodity trading accounts), were not especially implicated in the crisis. Nonetheless, they can be highly leveraged and closely interconnected with the rest of the financial system, and therefore have the potential to amplify and propagate stresses.

In a regulated banking sector such as China’s, strong incentives exist for both borrowers and lenders to shift their activities to markets that are subject to “lighttouch” regulation or in some cases to those parts of the financial system that are unregulated altogether. One area of concern over the past few years, for example, has been the rapid increase in the off-balance-sheet activities of Chinese banks as they promoted wealth management products in cooperation with trust companies.

A far broader challenge relates to the “informal” financial markets in China. Efforts to regulate the supply of credit through the banking system have been associated with the growth of a flourishing informal financial sector—part of which provides credit to small and medium-sized enterprises (SMEs), with another part linked to cross-border capital flows into China. The exact size of this market is unknown, but it is clearly sizable, prompting periodic government crackdowns. The existence of a large informal banking system is not without systemic consequences. From a monetary perspective, it will dilute the efficacy of policy actions and thus frustrate efforts to contain the buildup of systemic risks through tighter monetary conditions. Also, where this unregulated market is large, there is always the potential for contagion to the “official” market if the failure of informal institutions—particularly illegal ones—undermines confidence in the financial system more generally. It is likely that there are also significant financial linkages between the two sectors that will transmit risk in times of stress. There would appear to be no quick fix to this problem, which will only be addressed by further deregulating the banking sector and developing financial markets so that they are better able to meet the needs of the retail and SME sectors. Moreover, further efforts to promote banking services to the underserved SMEs would be helpful to prevent risks arising from the informal financial markets.

In terms of macroprudential oversight, the main challenge in China as in other countries is to design a policy framework that will help mitigate the procyclical bias of the financial system and also allow the authorities to respond preemptively to the emergence of systemic risks. Monetary policy will have an important role to play in this regard, but there will be limits to this support as long as the primary objective of monetary policy is price stability. There are also some attractions to identifying policy measures that have an element of “automaticity” about them, so that the burden of deciding exactly when to act, and how much to act, is partly lifted from policymakers. The search for policy measures that might complement the role of monetary policy has so far concentrated on the following:

  • Countercyclical capital requirements, which would add a buffer to capital requirements based on the current cyclical position of the economy;
  • Variable risk weights to capital requirements for specific types of lending, such as real estate;
  • Forward-looking provisioning to link loss provisions to the credit cycle, so banks are forced to put money aside for their potential losses when credit is growing strongly;
  • Collateral requirements that impose higher collateral restrictions on some activities (examples include loan-to-value limits on secured lending and minimum haircuts or margins on securities financing transactions); and
  • Quantitative credit controls and reserve requirements that either limit lending directly or indirectly by increasing short-term liquidity requirements.

The choice of instrument depends on the circumstances of individual countries, from the stage of economic development to the structure of the economy. Countries with fixed exchange rate regimes, for example, tend to make greater use of such instruments, given that such an exchange rate arrangement limits the room for interest rate policy.

Although a macroprudential approach is still evolving in tandem with international efforts, China has already made good use of a number of policy measures in its efforts to contain systemic risks. For example, China experienced an unprecedented surge in credit in 2010 as a by-product of the government’s successful policy response to the global financial crisis. To help contain this, the authorities tightened monetary policy but also modified a range of prudential regulations directly targeted at reducing exuberance in the economy. These measures included the imposition of a capital surcharge on systemically important banks, the use of dynamic provisioning, the modification of capital requirements, higher reserve requirements, higher loan-to-value ratios, and guidance on loan growth.

The risks posed by overheated real estate markets also prompted the State Council to deploy a range of policies specifically aimed at dampening real estate speculation. These extended to increasing the minimum down payment requirements and loan rates for second homes, temporarily banning loans for third homes, and strengthening property tax collection. These measures were supplemented by actions to increase the supply of housing, particularly low-cost dwellings. Collectively, these measures represent an admirable deployment of macroprudential tools in response to an identified rise in the procyclical dimension of systemic risk. However, there is no indication yet of how these various buffers and requirements will be adjusted as conditions change, suggesting that the macroprudential framework is still a work in progress.

Crisis Management

Notwithstanding the best efforts to identify and mitigate threats to a financial system, there will still be episodes of financial crisis. These may be idiosyncratic episodes where a single financial institution is in difficulty through mismanagement, but they can also be systemic crises involving multiple institutions. How the authorities respond to these events has an important bearing on the overall stability of the financial system, since failure to quickly contain and resolve problems can rapidly undermine confidence in the financial sector more generally.

Crisis management arrangements vary from country to country, but they tend to share the following key characteristics:

  • A clear understanding of the limits to emergency liquidity support from the central bank;
  • The existence of adequate powers to ensure that the authorities are able to resolve and restructure a distressed institution to keep it operating—an “open resolution” outcome; and
  • The existence of sufficient powers and resources to close a distressed institution in an orderly way—a “closed resolution” outcome.

An effective crisis management framework will be one that combines these options so that problems in the financial system are resolved at minimum cost in terms of both moral hazard and fiscal support.

By their very nature, effective crisis management arrangements require a very high degree of interagency cooperation involving government, the central bank, and financial regulators. Each will have a specific role and each will need to have well-documented contingency arrangements so that it knows how to respond promptly to emerging problems. A crisis itself is no time for developing the protocol and procedures for a speedy and effective resolution of problems.

China’s crisis management arrangements fall under the purview of the State Council. Traditionally, the State Council has displayed a strong preference for responding to episodes of financial distress with “open resolution” outcomes in order to avoid any loss of savings that could lead to runs on other institutions and to social discontent. As a result, only a few banks have been closed in the last 10 years and only a small number of rural credit cooperatives have had their licenses revoked in the last five years. These open resolutions have resulted in significant injections of equity to undercapitalized banks and the de-risking of balance sheets through the transfer of poorly performing assets to asset management companies. The restructuring program has also gone hand in hand with an overhaul of governance, which has been somewhat strengthened in the case of the largest banks by their conversion to joint stock companies and listing on the exchanges. This open resolution approach may have helped alleviate social discontent, but it has been expensive for government and has come at the expense of an increase in moral hazard in the financial system.

Like other countries following the recent crisis, China needs to make sure that closed resolution outcomes are also a viable option for dealing with distressed financial institutions, including SIFIs. The toolkit for facilitating both open and closed resolutions includes the legal authority to intervene promptly in a nonviable financial institution; the resources to close, recapitalize, or sell such an institution; and the capacity to manage the intervened institution, including its assets.3

However, closed resolutions will only be feasible if there is a financial safety net to protect depositors from loss (a deposit insurance system) and if resources are available to continue to fund the operations of systemically important but nonviable institutions while a resolution strategy is developed. The authorities have given considerable thought to how such a deposit insurance system might operate in China and recognize the importance of this work.4 Early progress toward implementation of such a system would be a major step toward equipping China with all of the tools needed to manage a modern and dynamic financial system—one in which periodic failures are inevitable.

A related issue is how to organize the resolution function. Again, there is no best practice. In some countries, the deposit insurance, resolution, and asset management functions are combined in a single entity, such as the Federal Deposit Insurance Corporation in the United States. In other countries, the resolution authority is carried out by the supervisors, while deposit insurance is either a stand-alone entity, such as in Canada, or a pay-box function, as in some European countries. Typically, the asset management function and the interim operation of the intervened financial institution are part of the resolution function, once the supervisor has decided it is necessary to intervene in the bank.

Institutional Set-Up

Strengthening the financial stability framework so that surveillance, mitigation, and crisis management arrangements are effective is obviously a major undertaking that requires the regulatory authorities and the government to collaborate closely. In most countries this cooperation is underpinned by a series of memoranda of understanding that set out the respective responsibilities of financial regulators, particularly with regard to information sharing. Most countries also have protocols and procedures in place to ensure that they coordinate their actions in a financial crisis, usually involving the establishment of a dedicated crisis management committee.

In China, the overarching responsibility for financial stability resides with the State Council, which exercised that responsibility during the global financial crisis by establishing and chairing a high-level committee of key financial agencies that met regularly to assess conditions and consult on policy actions. Each of the agencies also has contingency plans in place for responding to a crisis, including memoranda of understanding to promote cooperation. However, one of the vital lessons of the crisis is that interagency cooperation must be equally effective outside crisis periods so that any buildup of risks can be identified and addressed well before it crystallizes as a systemic event. In other words, an effective macroprudential framework is one in which financial agencies not only share their concerns on emerging risks but also work closely together to resolve them. The general question about China’s institutional approach is whether it also needs to be reoriented to give more weight to systemic risks.

There is no single or right set of institutional arrangements for promoting a macroprudential perspective of the financial system. Institutional arrangements need to address country-specific circumstances, including the legal and political environment. One way to do this in China would be to establish a permanent Financial Stability Committee chaired by a very senior official with a clear mandate to monitor systemic risks and make recommendations on the actions needed to address them. Membership of the committee would need to include the PBC, the three supervisory agencies, the Ministry of Finance, and any other relevant macroeconomic agencies. Consistent with its financial stability mandate, there would also be a strong case for the PBC to serve as secretariat of the committee. Having such a permanent committee in place would be broadly consistent with the initiatives undertaken by many other G20 countries to find ways to improve the resilience of their own financial systems and, by doing so, the resilience of the global financial system.


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The financial soundness indicators were developed by the IMF, together with the international community, in order to support macroprudential analysis and assess the strengths and vulnerabilities of financial systems.


Financial Stability Board (2011) outlines the broad principles that have been developed by the G20 countries following the global financial crisis.


IADI and BCBS (2009) outlines the broad principles to be incorporated in such a scheme.

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