China’s celebrated One Belt, One Road initiative aims to overhaul the nation’s trading infrastructure, and connect China more efficiently with its neighbours. Financial market participants might be wishing for a One Regulator initiative to help solve years of different and sometimes conflicting decrees issued by China’s panoply of financial regulatory agencies.
The creation of a single new body to tackle financial risk, announced last November, seems to have prompted a new spirit of co-operation, evidenced by January’s announcement of new bond rules spanning all four main agencies. While participants welcome this new drive, questions remain about whether it goes far enough to guarantee financial stability and facilitate market development.
Greater co-ordination among regulators is central to tackling threats to financial stability in the country posed by record levels of credit and a bloated shadow banking sector.
“When you have unco-ordinated regulation and everyone tries to do a bit of something, then the compounded effects of this can have serious unintended consequences,” says one Shanghai-based head of markets for an international bank. “The government is taking a positive step towards looking at things in a more market-driven way and addressing those aspects of unhealthy market behaviour that have caused problems in the past.”
The effort centres on the new Financial Stability and Development Committee, set up at the behest of president Xi Jinping to tackle financial risk. The committee, which has its offices in the People’s Bank of China and is headed by vice-premier Ma Kai, operates above the current assortment of regulators and is expected to have the power to set new rules if necessary.
“With the committee operating at such a high level – higher even than the central bank – it will hopefully be a decision-making body and not just a co-ordinating one,” says Moody’s analyst Nicholas Zhu.
Market participants are hopeful the new committee can help provide progress on long-standing questions around derivatives netting and securitisation, which have foundered on the existing fragmented approach to rulemaking.
Qu Hongbin, co-head of Asian economic research at HSBC, is starting “to see some co-ordination in new policies in asset management for instance. Now we need to see [the authorities] deliver a more co-ordinated policy action and that in my view is what we are going to see this year and the next year.”
And then there were four
The debate over co-ordination has been raging since 2003, when the PBoC span off the responsibility for supervising deposit-taking institutions to the newly formed China Banking Regulatory Commission. At the time, the government promised to establish a new “co-ordination mechanism” between the two regulators and their existing counterparts, the China Securities Regulatory Commission (founded in 1992), and China Insurance Regulatory Commission (1998).
The mechanism has been unsuccessful, with each of the four regulators accused of focusing too much on building up their own industries in order to justify their existence rather than working for the good of the market.
Innovation departments within each regulator have served as forums for looking at how each of the respective industries can be promoted, which has led to the various markets being regulated in noticeably different ways, Zhu says.
The country’s wealth management sector is a good example: here, regulatory arbitrage has paved the way for the surge of shadow banking. While the CBRC imposes limits on the types of instrument that banks’ wealth management businesses can invest in – including the equity of unlisted companies and certain types of investment fund – the CSRC takes a less restrictive approach.
This has given rise to concerns that some banks may be channelling wealth management products through their securities subsidiaries to avoid the tougher oversight of the banking regulator – a practice that regulators are keen to put an end to.
“There is a very murky line between how different types of financial products are regulated and better regulatory co-ordination will definitely limit the systemic transmission of risk [between banks and securities companies],” says Zhu.
As part of their push to tighten up these regulatory loopholes, the four agencies acted in concert to issue rules formalising certain types of bond trading in January. In addition, the CBRC barred banks from providing guarantees or making decisions for companies arranging entrusted loans. These loans are made from one company to another in what has come to resemble banking activity but without the same level of risk controls that licensed lenders exercise when making credit decisions. Meanwhile, the insurance regulator moved to block insurance companies from issuing equity loans via share buy-back arrangements.
This block of rulemaking served as a contrast to a previous push in 2016 that consisted of unilateral rulings by separate agencies that panicked markets into a widespread sell-off (see box: Lessons learnt).
Hold the line
But for all the benefits of greater regulatory collaboration under China’s new Financial Stability and Development Committee, market sources feel the catch lies in the implementation.
“It’s all very well for the authorities to say ‘shadow banking is a big problem’ or ‘short selling is a big problem’. Well yes it is. But where I am getting frustrated is all the micro-level stuff – and that is going to be much harder to resolve,” says a senior director at an asset management company with interests in the country.
Many of the required changes may also lie outside the purview of the four main regulators. For example, tax law is the responsibility of the Ministry of Finance, not the sector regulators – and so far the authorities have not given any indication that reforming tax law will be a part of the latest co-ordination effort.
The PBoC’s research head, Xu Zhong, bemoaned the limitations of the central bank’s supervisory powers in a February article in Caixin, a Chinese financial magazine. He wrote that while the PBoC assumes bailout responsibilities for failing institutions, it lacks sufficient power to guard against bank collapse.
There is also the question of whether the regulatory agencies can demonstrate unity of purpose if economic conditions change.
“Fundamentally, the top focus of the new committee is to improve the management of systemic risks in the country so that we don’t have a crisis that spirals out of control. But at the same time the authorities have stated that they want to ensure social stability and a certain level of growth. The two objectives conflict,” says the head of markets at the international bank. “If you want to squeeze the leverage out of the system you are going to slow growth, but you don’t want to slow growth so much that it affects the stability of the country.”
Data showed China’s economy advanced 6.9% last year, higher than the government target of 6.5%. While that gives authorities the room to push ahead with rules to purge excessive borrowing, there could be limits.
As near neighbour Japan has shown, aggressive deleveraging can have damaging effects on an economy. Tokyo embarked on its own deleveraging strategy in the early 1990s, after an asset bubble caused by unchecked credit expansion burst. The result was dramatic deflation that dogs Japan to this day.
Even if China’s regulatory agencies succeed in greater co-operation, certain voices warn against travelling too far in this direction.
“If the government were to merge the three regulatory commissions into a separate body, this might make the effort to tackle the irregularities in the financial industry a little more difficult,” says the head of sales for an international bank based in Shanghai. “The segregation of duties, with the relevant expertise in each body and a good level of co-ordination between them, is the best way to improve regulatory efficiency.”
Market sources suggest that one clear beneficiary of greater co-ordination is likely to be the introduction of a new legal framework that would allow close-out netting between derivatives traders. Without such a framework in place, international dealers face higher margining costs when transacting in China as their positions cannot be netted off.
“The CBRC is trying very hard to resolve the netting issue, but it is not just the banks who are derivatives users – securities firms, currently under supervision of the CSRC, also need to be on board with netting rules,” says a regulatory expert who recently left a US bank. “Until there is more co-ordination between regulators, it will be very difficult to develop a legal framework that can guarantee certainty in netting.”
Netting in China has become a hot topic since the introduction of new variation margining rules last March. While international banks were the first to raise concerns over the lack of a netting framework in China, the country’s large domestic banks – some of which are facing potentially higher costs or other hurdles when transacting with their global counterparts – are now understood to have taken up the baton.
In July, the CBRC published a statement in support of close-out netting and highlighted the problems that still need to be overcome before law firms will be comfortable issuing a clean netting opinion for Chinese institutions. The CSRC, on the other hand, has so far remained silent on the issue.
Streamlining regulation will also help lower costs, says Shengzhe Wang, Shanghai-based legal counsel for Hogan Lovells, citing the securitisation market as a prime candidate for greater efficiency.
In advance of any securitisation transaction in China, parties must first identify which authority they need to apply to. It could be the CBRC or PBoC for credit or CIRC for insurance or CSRC for corporate-related assets. That compares with seeking the nod of a single regulator in Europe, she says.
As a result, a securitisation deal in Germany takes on average between three to five months to complete, while the timeframe in China could be twice as long, especially for new issuers, says Shengzhe.
The CBRC is trying very hard to resolve the netting issue, but it is not just the banks who are derivatives users
But not all parties are set to benefit from harmonisation; one constituent that may miss out is foreign asset managers in China. Currently, buy-siders tend to set up two separate entities: one to gather funds from qualified Chinese investors to place their money overseas under the Qualified Domestic Limited Partnership scheme, and the other to manage funds onshore. This issue has become particularly relevant following a 2016 decision to allow foreigners into the onshore fund management space in China.
The Asset Management Association of China, a self-regulatory body authorised by the CSRC, favours a single regulatory structure that it would be responsible for overseeing. But the Shanghai Financial Office, a municipal government department set up in 2002 to oversee rules pertaining to the running of Shanghai as an international financial hub, says the two activities should be kept separate in order to prevent bad financial management from one part of a firm creeping into other areas.
This area of uncertainty illustrates the difficulties facing the new boss of the financial stability committee when existing head Ma Kai retires in March. Ma’s likely successor, Liu He, speaking at the World Economic Forum’s annual meeting in Davos this year, said that China intends to “bring the overall leverage ratio under effective control, make the financial system more adaptable and better able to serve the real economy, prevent systemic risks and facilitate better flow of economic activities”. It is an ambitious agenda, but at least the new committee should provide the tools for the job.
At the end of 2016, China’s disparate regulators pushed through a slew of new rules and guidance intended to curb excessive shadow banking on the market.
The CSRC introduced tougher capital requirements for fund management companies and imposed new restrictions on who can raise finance from the capital markets. The CIRC restricted the sale of risky high-yield wealth management products. The CBRC drafted rules to limit the amount of wealth management products banks could write as a proportion of their balance sheet. Even the PBoC weighed in by adjusting the way in which macroprudential risks are assessed.
But none of the regulators appeared to have talked to one another about their intentions, with the consequence that this deluge of regulation disrupted trading in the bond markets. Bond yields surged in April and then again in October, hitting a three-year high by mid-November. The disruption forced the PBoC to inject 300 billion yuan ($45 billion) of liquidity into the financial system. The country’s policy banks, which are tasked with financing economic and trade growth, also had to postpone their capital-raising via the debt markets.
“Regulation against financial institutions should certainly not be interrupting the issuance of bonds from these quasi-government policy banks,” says Ivan Shi, head of research at Shanghai-based consultancy Z-Ben Advisors. “The offering rate of these might go high, but it is a rare case in which a policy bank has to reschedule its bond issuance altogether.”
The head of markets at an international bank believes the right lessons have now been learnt from this bond market sell-off.
“In the past different regulators came out with their own supervision updates on particular issues that concerned their market without considering how this might spill over and impact other areas. But we are now seeing much better co-ordination among regulators, at least at the very top level, so hopefully this kind of problem can be avoided in the future,” he says.
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