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China's Road to Greater Financial Stability
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Chapter 9. Seeking the Middle Ground for Supervision

Author(s):
Udaibir Das, Jonathan Fiechter, and Tao Sun
Published Date:
August 2013
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As China moves to strengthen its supervisory system, it is faced with a choice. Should it follow the supervisory model adopted by many Western countries of allowing a fair degree of independence on the part of bank management to determine the bank’s business strategy? Or should China continue with its current approach of a relatively comprehensive and heavy-handed approach to regulation and supervision, which grants less discretion to bank management?

The Western supervisory model, which is being questioned following the global financial crisis, is characterized by a high degree of reliance on financial institutions’ own systems, policies, and management incentives to align risks with supervisory expectations. Supervision and regulation are less intrusive and supervisors permit banks viewed as having sophisticated risk management approaches and good corporate governance the freedom to determine their business strategy (e.g., pricing of products, management of the balance sheet, and a range of financial services) within the parameters of the statutory framework. This model assumes that financial market innovation is normally benign, and great reliance is placed on market discipline to give banks the incentive to avoid taking on excessive risk. In some cases, this approach to supervision has been characterized as a “light-touch,” with a reliance on the market to act as a governor to limit excessive risk-taking.

While this model appears to have worked very well during the early part of the last decade, the experience from the crisis includes significant failures in the risk management practices of banks along with weak corporate governance. Because of the systemic importance of many of these banks, governments were unwilling to permit the weaker ones to fail (particularly following the failure of Lehman Brothers) because of the risk that such failures might cause system-wide financial instability. As a consequence, since the start of the crisis, there has been a rethinking of the reliance on market discipline and bank management to manage and control the risk assumed by banks—that is, a questioning of the philosophy underlying the regulatory paradigm in the major financial markets in the advanced economies. Consideration is being given to more prescriptive regulation, more intrusive supervision, and less faith in the accuracy and timeliness of market-based indicators of soundness such as ratings produced by credit rating agencies. In an effort to restore the application of market discipline, policies are being discussed to reduce the complexity and interconnectedness of large banks so that potential failures pose less of a threat to financial stability. This is part of an overall supervisory theme of returning to the basics.

In contrast to the model in the West, the supervisory model for emerging markets in Asia such as China has taken a more paternalistic approach, characterized by a rules-based prudential framework that is heavily prescriptive and conservative, backed by intrusive supervision and a focus on compliance with rules that may go beyond prudential standards. Financial institutions are often viewed like public utilities, with an obligation to serve the economic development needs of the domestic economy even when such services do not always meet a market test. Such regimes may include controls on interest rates paid on deposits and lending rates, a focus on ensuring that banks provide infrastructure finance, and an expectation of bank funding of major state-owned entities (SOEs). The result may be that domestic banks act in a way that is more akin to that of a development bank.

While such regimes may work well initially in underdeveloped financial systems, they need to evolve as the real sector becomes more developed. As the demand for credit by private companies and consumers grows, financial systems geared to meeting the needs of major corporations and project finance will need to evolve to meet the disparate demands of households and smaller businesses that lack government backing. A rules-based and conservative prudential regime that discourages innovation and change may unintentionally serve as an impediment to the development of a more robust and diversified financial system. Moreover, the primary focus of the major banks on government-oriented lending with an implicit government backstop may prevent a risk culture from emerging within the banks.

While it is recognized by many officials that China needs a more dynamic and innovative banking system that will require a change in the approach to supervision and regulation, the decision for the Chinese leadership is where to position the regime in the spectrum defined by the two extremes. This chapter draws on the findings of the IMF’s 2010 Financial Sector Assessment Program (FSAP) of China to take a look at the strengths of the current system and the challenges that are to be navigated. It then recommends priorities for the authorities as they transition to a supervisory regime that may be better suited to overseeing a financial system that can meet the needs of the evolving Chinese economy.

China’s Financial System

The modern Chinese financial system is very young, mirroring the developments in the real economy. The reform of the banking system began in the 1980s, when commercial banking was separated from the People’s Bank of China (PBC). At the outset, the commercial banks were expected to operate as direct lending arms of the government. In the following decade, however, initiatives were undertaken to develop a dual system of policy banks and commercial banks, with the intention that government-oriented policy lending would be shifted into specialized policy banks and out of the commercial banks. This goal has not yet been achieved.

The Chinese financial system is dominated by the rapidly growing banking sector, with nonbank financial institutions accounting for only a fraction of the system. The banking system accounts for nearly 80 percent of net new lending every year. In the past two decades, the banking sector has become extraordinarily large, with assets of over 200 percent of GDP. Two Chinese banks are in the top three globally by market capitalization.

By contrast, China’s capital markets, which date to the 1990s, remain relatively shallow. Over 60 percent of outstanding bonds were issued by the government, with the majority of the remaining bonds issued by either the large commercial banks or the policy banks (which are state-owned and provide a range of development finance services in support of infrastructure, agricultural development, export insurance, etc.)

Not unexpectedly, given the relatively young age of the financial markets, there has been a lot of change since the 1980s. The banking system has undergone an extraordinary evolution, with the number of banking entities reduced from more than 40,000 to less than 5,000 through a series of restructurings and mergers of credit cooperatives into commercial banks. The Chinese government has on two separate occasions rescued the large state banks by making massive capital injections and transferring the banks’ nonperforming loans (NPLs) to state-sponsored asset-management companies. To reduce the likelihood of this happening again, the government has emphasized improving corporate governance in these institutions through the introduction of experienced outside directors, and has become more cautious in using the nonpolicy banks to carry out government policy objectives.

The regulated financial markets in China are subject to strict government controls. Key financial prices remain regulated, which distorts the incentives to save and invest, limits the ability of institutions to price for risk, and constrains the conduct of monetary policy. Despite gradual interest rate liberalization over more than a decade, retail interest rates remain partly regulated, with deposit rates subject to a cap and lending rates to a floor. Banks can price lending above the floor to a degree, and do so in practice.

Expanding access to financial services has been a priority of the government. Efforts are being made to improve access to bank finance by small and mediumsized enterprises and households, and, at the local level, to find alternatives to bank funding of projects sponsored by local governments. These initiatives are in response to a system of bank financing that has been largely limited to large corporate entities (which are typically owned or controlled by the state) and projects supported by the local governments.

In the past five years, as the Chinese economy has experienced the adverse impact of the global slowdown, the government has again encouraged high levels of commercial bank lending as a way to stimulate the economy. The heavy involvement of the state in the financial system has done more to influence the strategic direction of the financial system than market forces.

Current Status of Supervision

Regulation and supervision of China’s banking system has made very impressive progress in the past few years, led by a forward-looking regulator (the China Banking Regulatory Commission–CBRC) with a clear safety and soundness mandate. The CBRC was spun off from the PBC in 2003 as a stand-alone prudential authority and is widely credited with having made significant achievements in its short existence. It has played a key role in driving professionalism, risk management, corporate governance, internal control, and disclosure in the major banks, as well as in enhancing international recognition of the Chinese banking system. This task has been helped by the fact that the objectives and responsibilities of authorities involved in banking supervision are clear. The CBRC’s mandate has enabled it to focus primarily on the mission of safety and soundness, and that has helped it become a high-quality organization, although it has also been used to enforce the meeting of the government’s policy goals by the banks. Under this mandate, the CBRC has been very successful in articulating to banks and the public the need to balance both safety and soundness objectives with the need to achieve economic and social progress.

The legal framework has been very supportive. Laws, rules, and guidance that the CBRC operates under generally establish a benchmark of prudential standards that is of high quality and was drawn extensively from international standards. The CBRC has the authority to take a wide range of corrective and remedial actions, and the large numbers of enforcement actions it has taken and disclosed demonstrates its willingness to use them. CBRC staff is legally protected from the consequences of acts committed in good faith. The CBRC also has the legal authority to share information with other regulators, domestically and internationally, and does so through networks of Memoranda of Understandings.

The CBRC has the necessary building blocks for effective onsite and offsite supervision, but in common with a number of supervisory agencies in other countries, it needs to continue to build its cadre of experienced supervisors. There is a system to capture frequent and periodic information from banks and an acknowledgment that with the evolving risks, even more data need to be collected. Supervisory approaches are increasingly risk-focused, reflecting the need to carefully assign scarce resources to areas of the highest risk. Credit risk is viewed as the most important risk facing Chinese banks and will remain so for some time. It has received the most focus from banks and the CBRC and, with some exceptions, is generally well controlled, particularly in the large banks. Not surprisingly, the risk management policies and credit underwriting standards are weaker in the rural institutions. The rules and practices for problem assets and related provisioning for the listed banks are generally adequate. They are based on the equivalent of the accounting rules and regulatory requirements for classifying loans of the International Financial Reporting Standards (IFRS).

The CBRC does regular, extensive, and in-depth reviews of asset quality and the provisioning system. Major audit firms audit the majority of listed banks. The regulatory system has encouraged robust provisioning and requires capital buffers to be held as part of a firm’s equity. Traded market risk in the Chinese banking system is generally low. China’s implementation of the capital adequacy framework, which is a key component of the prudential regime, has generally been conservative. The result is that Chinese banks uniformly have capital ratios above the Basel minimums. The quality of bank capital is also strong and is composed primarily of high-quality core capital, in keeping with the current focus on capital quality in international discussions. The CBRC has required banks to hold more capital and higher provisions as a safeguard against a possible deterioration in loan quality following the rapid loan growth of recent years.

Risk management systems in Chinese banks are evolving. The CBRC has encouraged banks to improve their risk management systems in conjunction with their efforts to deliver on the government’s economic and social objectives. Following its mandate, and as a result of observed and potential deficiencies in risk management practices, the CBRC has introduced a range of prudential measures, including more stringent credit risk management of loans to local government platforms and real estate lending. Most major banks have developed risk management systems for each of the major individual risks they face, although the systems are of mixed quality.

An extensive approval regime spanning products, activities, and businesses underlies the supervisory framework. China defines the permissible activities of banks and operates an extensive bank licensing and approval process. Considerable resources are devoted to approving the licensing of new institutions, new branches or sub-branches of existing institutions, new products, and changes in ownership. Fit and proper criteria apply not only to board members and senior management but also extend to other positions in banks. The use of the term “bank” is appropriately controlled and shell banks are not permitted. Minimum capital requirements to start a new bank are based on the type of bank and are in line with or higher than international norms. The CBRC implements an appropriate approval process for changes in ownership and major acquisitions. Investments by banks, including in overseas branches, require approval as part of the general approval system.

Innovation has lagged in Chinese banks, perhaps an unavoidable consequence of the comprehensive regulatory regime and the absence of market pressures to produce high earnings faced by banks with extensive public shareholders. Banks are generally prohibited from investing in nonbank activities, although in the recent past exceptions have been permitted for investment in financial leasing and asset management. Bank-insurance and bank-securities cross-investments have not been allowed until recently, with four cross-ownership pilots currently under way. In those cases the CBRC imposes firewalls between the banks and the other entity. Among other considerations, there are also explicit provisions that these pilots must earn at least average industry returns or they are to be dissolved.

Overall, consolidated supervision within the banking system is effective and the CBRC has developed a wide network of formal and informal home-host information sharing arrangements and has used these effectively as both a home and host.

Major Supervisory Challenges that Need to be Addressed

Compared to the more advanced economies, the Chinese banking system undertakes more conventional banking business and is exposed to less complexity. As markets further open and China’s banks expand, complexity and risks will increase. Both supervisors and banks must evolve in the short term to be ready to meet those challenges.

Although the framework of laws and guidance is generally of high quality and modeled on international standards, much of the framework guidance is relatively recent and untested. Experience is still being gained in its application in the local context. A period of settling in is required for effectiveness to be enhanced, for banks that are not advanced to catch up, and for the CBRC to ensure that all banks have risk management systems commensurate with the risks they are assuming. Supervisory capacity to effectively evaluate the risk management capacity of banks is also developing, but it typically takes years to build a critical mass of experienced supervisors.

The funding and governance of the CBRC raises the risk of potential constraints to its ability to build its capacity and effectiveness. This in turn could hamper its ability to provide world-class supervision, particularly as Chinese banks become more complex and innovative and expand abroad. The role and authority of the State Council vis-à-vis the CBRC needs to be clarified and refined to ensure that the CBRC has the ability to take decisions free from any political interference. While the CBRC reports that no interference has occurred since its creation, the existing arrangements do not comply with international best practice and could be problematic in the future.

A related challenge facing supervisors is responding to the predominant role of the state in the financial system, both in day-to-day operations and in crafting their policy framework. While heavy state involvement in the banking system may contribute to perceptions that the state provides a financial backstop for the banks (which may in turn promote financial stability), it can also override soundness concerns, contribute to the misallocation of bank credit, and lead banks to be less responsive to supervisory advice that may conflict with advice from state officials. This potential conflict between safety and soundness objectives versus other objectives exists in many countries but may be more acute in China because of the predominant reliance on the banking system to achieve economic and social goals. Credit intermediation is thwarted to the extent that lending to SOEs and local governments squeezes out the fledgling private sector. More than one-third of bank assets continue to be in exposures to the government or central bank, and even more if local government-related vehicles are taken into account.

The focus of the major commercial banks in making large infrastructure loans and extending credit to SOEs has led to a shortfall in bank lending to the private sector and households. The state has sought to address this problem by setting policy lending goals for banks to increase financial access to underserved segments such as small businesses. Implementing this policy has been left to the bank supervisors, given their extensive knowledge of the banking systems and their regular interaction with the banks during their examinations. But this is an example of one distortion leading to another, and the growth of the large underground banking system suggests that the banks are unable to fully meet the credit needs of the private sector and households.

Together with the differently aligned incentives promoted by bank ownership by the state, banks have reduced incentives to focus on developing risk management. The new risk governance, measurement, and management systems have not been tested under stress and some areas for material improvement are clearly evident. Board-approved strategies are often too focused on target loan growth in various sectors and regulatory-determined key performance indicators rather than on targeted risk measures linked to the banks’ own risk systems.

Comprehensive, enterprise-wide risk management that takes account of interactions between risks in measuring, managing, and stress testing, and that relates capital to risk, is at an early stage in many banks. For these banks, the priority is to ensure that a sound risk management framework is fully in place, imbedded in their culture and group-wide operations, and sustainable. While much of banking in China is deposit-taking and lending, the Chinese lending market is complex by virtue of its scope and diversity, and banks are getting into new areas of lending and other activities. The quality and sophistication of risk management needs to be commensurate with these realities.

As evidenced in the approach to credit risk management, there is an intense focus by all parties in the system on minimizing the level of NPLs. This is understandable given the serious bad loan experience in the early part of the decade. But this may divert attention away from other early, forward-looking measures of credit risk that need to be addressed. It also runs the risk that by making the level of NPLs a key performance indicator, NPLs will be written off or restructured regardless of cost, to the detriment of banks developing more robust risk cultures and enjoying long-term profitability.

Market risks may increase as market liberalization occurs. Exchange rate liberalization will increase foreign exchange risk for banks and their customers. Risk management tools, information technology, and the data infrastructure to support the tools are generally commensurate with the current level of risk, but the level of sophistication will need to increase over time as liberalization continues.

The relative newness of the supervisory methodology means that supervisory assessments are not as forward-looking as they need to be. Heavy reliance on a few basic simple ratios, though advantageous from the perspective of implementation, should not be permitted to discourage more judgment-based assessments of inherent risk and the quality of banks’ risk management and governance. Optimally, the benefits of simple basic indictors would be maintained, supplemented by banks’ compliance with CBRC guidance to develop more sophisticated supervisory approaches. This would encourage more of a risk culture in banks and should reduce the risk that banks will rely excessively on regulatory compliance rather than their own risk assessments.

The CBRC has the authority and has demonstrated a willingness to act to resolve nonviable institutions. Dealing with problem banks has been on the basis of “going-concern” solutions, and the capability to close an institution may need to be enhanced going forward.

Consolidated supervision of banks and their direct subsidiaries and branches on the mainland or offshore is of high quality. However, existing laws may permit more complex structures, and presently there is not a framework for consolidated supervision of financial conglomerates. The PBC is developing a proposal to have a lead supervisor in charge of multisector conglomerates. As the Chinese system evolves toward a system of less state ownership and more private ownership, it will be important that supervisory capacity be enhanced to be able to deal with more complex ownership structures. The mixed conglomerate structure that has proven itself to be difficult to regulate in other markets is beginning to take root in China. A system of effectively supervising these entities is a challenge, and current legal authority needs to be amended to facilitate conglomerate supervision—for example, the laws do not allow supervisory review of beneficial ownership or indirect changes of control. Other rules that also involve potentially more complex bank ownership structures (e.g., related-party rules) should also be reviewed to ensure that they are sufficiently comprehensive.

Reliance by one supervisor on the work of other supervisory agencies in examining mixed corporate groups (bank/insurance/securities pilots) has not always worked well in practice globally and will need to be carefully monitored and considered as the PBC develops its framework for consolidated supervision of conglomerates.

Recommendations

Given the environment in China, which is slowly evolving to a more market-oriented configuration, and the desire to accommodate the G20 international regulatory reform agenda, which is moving rapidly to conclusion, what should the Chinese supervisors aim for? The Chinese system already has some of the features that are now deemed desirable for supervisors, such as intensive and intrusive supervision. But there are other features that make it difficult to achieve the tenets of good supervision. Although it is likely is that the economy will be dominated by SOEs in the foreseeable future, households and the private sector may play an increasingly important role. Therefore, over the medium term, the authorities should aim for a supervisory system that promotes development of a financial system that can meet the varied needs of Chinese savers and borrowers of all sizes, both state and private. It is assumed that the Chinese financial system will continue to be comprised of both private and state-owned commercial banks and state-run policy banks.

The first objective should be to foster increased transparency, which will enable market discipline and government accountability to play a role in supplementing supervisory efforts. The CBRC already collects a lot of data from institutions, but disclosure both by banks and the CBRC could be significantly enhanced through quarterly release of at least aggregate data together with key financial ratios and peer group indicators. The CBRC has also developed a strong analytical capacity and should take on the task of providing both information and analysis on a regular basis. Continued attention will need to be given to the development of the private accounting and audit profession in China to ensure that financial statements are professionally prepared and audited. The CBRC should be empowered to reject and rescind the appointment of an external auditor who is deemed unfit to perform a reliable and independent audit.

The second objective should be to place greater emphasis on improving the governance and management of banks. The state will likely continue to play a major role in the sector via ownership, and the supervisors should aim to strengthen the ability of the boards of banks to provide strong strategic guidance and better understand and then articulate meaningful policies for risk tolerance and appetite. This will require supervisory involvement that goes beyond the fit and proper regime to the laying out of stronger expectations of the role of both supervisors and banks’ management and boards. Further developing plans for continuing board education (as has been successfully done in some other countries in the region) will be helpful.

The third objective should be to gradually relax the prescriptive and approval-based regime. Bank management needs to be held more accountable for setting the strategic direction of the bank and for maintaining robust balance sheets and prudent risk levels. The CBRC needs to place less reliance on rules, punishment, and prohibition and gradually shift toward placing more reliance on the principles underlying the approaches that it expects banks to follow. Weaning banks off their dependence on the sanctity and safety of state ownership and their lending to state-determined priority sectors and projects is a necessary first step to building the risk management capacity of banks. This is easier said than done, especially given the lessons of the global financial crisis. Some of the advanced economies had clearly gone too far in relying on banks’ own risk management systems. So what is needed is a balance between the two approaches.

The fourth objective should be to enhance supervisory effectiveness by developing a strong cadre of bank supervisors across all segments of the banking system. While there have been impressive gains in quality, there is a need to develop greater numbers of skilled and trained banking supervisors across the system. China has both global and domestic systemically important banks as well as thousands of small banks, and though the supervisory focus has been on the former, much more attention may need to be placed on midsize and smaller banks to ensure that they upgrade their risk management and governance performance.

The fifth objective should be to strengthen both the mechanisms and the actual coordination and cooperation among supervisors in the system. As of now, the State Council has played the key role in bringing the supervisors together, but as the system moves to greater integration across the different sectors, the introduction of more cross-sector products, and the rise of conglomerate businesses, coordination among the different sector supervisors will have to become a way of life and transcend the turf issues that prevail in most countries. This should also be the case for interagency coordination with the PBC, which has a key role to play in the macroprudential agenda.

The sixth objective should be for China to play a greater role in the international standard-setting process by providing inputs based on its own experience to reinforce the impetus in ongoing international discussions of the value of simple approaches. While several emerging market economies have become members of international policy setting fora such as the Basel Committee and the Financial Stability Board, the discussions continue to be dominated by the experiences of the more advanced economies. In searching for longer-term solutions to the problems exposed by the crisis, the inputs that could be provided by China and other emerging market economies could make an important contribution to shaping the reform agenda.

The seventh and probably the most important objective should be to retain both the willingness and ability of supervisors to play an intrusive role in the operations of banks and to be skeptical and pose the right questions to bank management, while at the same time not substituting supervisory judgment in areas that are more appropriately left to bank management. This requires a delicate balancing act by supervisors.

Conclusions

Despite being an ancient country, China has a relatively young financial supervisory system. Given the tremendous growth of its economy, it has the ability to deal with issues of resources and capacity that have plagued other countries. It has used a policy of gradualism, for example, to temper the effects of opening up to foreign bank entry. This has allowed supervisors to keep pace with their more complex products and activities. Both the PBC and CBRC are widely respected inside and outside of China. The CBRC, in particular, has demonstrated its willingness to act in pursuit of its safety and soundness mandate. It needs to continue to work on developing a plan to enhance its capacity and expertise and to ensure that progress made so far is sustainable. Accomplishing this objective requires the continued support of the government. Enhanced vigilance is required by banks and the regulatory community to keep risks under control in China’s financial system.

In many ways, the strength of bank regulation to date lies in the deliberately simple, conservative approach taken, often relying on specific prudential ratios that banks must meet. The challenge going forward is that this approach, by itself, will not be sufficient as markets and banks evolve. The CBRC is well governed within the constraints it faces and has steadily and materially increased its transparency. There is a need for more forward resource planning and an urgent government-supported strategy for material upgrading and retention of experienced supervisors, especially those with specialist skills. In its evolution, the government should aim to meet the Western model halfway, retaining some of the elements of its current regime, including the focus on simplicity and conservatism, while at the same time embracing the lessons that came out of the crisis regarding the importance of holding management accountable for building an effective and forward-looking risk management capacity.

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