Dec 20, 2016 03:09 PM

Editorial: Government Must Act Fast to Stop Insurance Companies from Turning into Corporate Raiders

Insurance companies are at the center of a storm after the head of China's securities regulator, Liu Shiyu, pointed an angry finger at some players who had dipped into "improperly sourced funds" to raise their stakes in publicly traded blue-chip companies. Over the past year, some insurers have made aggressive equity investments, at times using highly leveraged funds borrowed from the public. The usually low-key regulatory czar recently took a biting swipe at such "robber barons," saying such actions have raised concerns about insurers' losing sight of their main mission, which is to build an investment portfolio that offers long-term stable returns and not exposing ordinary investors to grave financial risks. Such practices have also increased the risks of financial institutions — a vast majority of which are controlled by a single shareholder and plagued by weak corporate governance — of being hijacked to finance the expansion plans of their principal stakeholder.

In recent years, some of China's better-run companies have seen outsiders with deep pockets swoop in to amass sizable stakes, at times in preparation for a hostile takeover. This trend seems to be an echo from the past. In 2003, private manufacturing and investment conglomerate Delong Group quietly took control of several city commercial banks by buying shares in the open market. Earnings and assets from the banks and other financial institutions controlled by Delong were then channeled to fund its aggressive expansion drive, which quickly collapsed as it relied on highly leveraged debt. The fall of Delong in April 2014 hurt its creditors, and the state had to intervene to clean up the mess.

One feels a sense of déjà vu when examining the risks to the financial system from the latest attempts at leveraged buyouts. It is important to prevent a single shareholder from gaining a controlling stake in banks and insurance companies because these institutions manage funds directly raised from the public such as depositors and insurance-policy holders. They should also be told to adhere to stricter corporate governance standards and be subjected to closer supervision to protect the interests of small investors. When one player holds disproportionate sway over the decision-making process, this easily creates room for flaws in governance and allows the dominant player to hijack the institution to serve its narrow goals. This may even create systemic risks that can destabilize the country's financial system as a whole.

In China, over 80% of the total social financing is currently raised through financial intermediaries, mainly banks and insurance companies. Their assets have grown rapidly in recent years, and there is an increasing demand for a fresh capital injection into these two sectors. It usually falls beyond a single shareholder's financing capacity to support such expansion. But some shareholders have tried to gain control of institutions by massaging the books to show fake capital injections, violating rules.

Prudent risk assessment and control is vital for the survival of financial institutions. When a company's accounts do not reflect its actual financial health, regulators cannot accurately gauge their payment capacity or whether they meet their capital-adequacy requirements. This increase risks for depositors and small investors.

The reason why powerful shareholders are bending the rules to gain absolute control of a financial institution is clear: to turn it into a financing platform to support their own ambitious expansion plans. Corporate governance and risk control systems in banks and insurance companies fully controlled by a single shareholder exist only in name. The dominant stakeholder can promote its own agenda unfettered, while ignoring operation risks and reactions of the market. In many cases, takeover bids are funded using bank loans or money from trust funds, and these investments are withdrawn after gaining control of an institution by transferring funds out to another related subsidiary of the controlling shareholder. Such practices make the deals compliant with regulatory rules on the surface but leave financial institutions hollowed out, passing the risks to the central bank and the public once they collapse.

China's financial regulatory framework has set strict rules governing the ownership structure of financial institutions. The China Banking Regulatory Commission had long restricted a single shareholder from holding over a 20% stake in a bank. Since 2014, the limit has been gradually increased to 30% to encourage private investment in the banking sector. The insurance regulator has banned investors from using bank loans or other borrowed money to buy stakes in insurance companies, and has limited a single private investor from holding no more than a 51% stake in an insurance company.

But in practice, these requirements have often been ignored. A single shareholder owns over a 90% stake in some private insurance companies, sometimes through several affiliated parties. Small and midsize banks share a similar fate. The insurance regulator recently stated that the 51% shareholding cap will be gradually lowered. But without a careful examination of the relationships between shareholders and their proxies, a lower shareholding cap will not work as regulators expect.

China's financial industry should open its doors to private investors, but the precondition should be to maintain a diversified shareholding structure and set up sound corporate governance systems. The board of directors should be tasked with designing the strategic blueprint for a company and supervising its implementation, prioritizing long-term growth over the narrow interests of a handful of influential shareholders. Meanwhile, a professional management team should be allowed to operate the business independently. The board must prevent financial institutions from being controlled by insiders and the sacrificing of smaller shareholders' interests. And regulators must make sure that financial institutions' resources are allocated fairly and effectively, without being turned into the family silver for a few influential stakeholders.

It is easy to fire warning shots, but it's much harder to follow that through with concrete actions to shake up the regulatory system, especially at a time when the banking and insurance industries are growing rapidly. But industry supervisors must quickly catch up with this evolving industry, and there is no excuse for regulators to drag their feet anymore. Gaps in the current financial supervision system make it difficult to detect complex shareholding structures in financial institutions. A better-coordinated and unified regulatory system, which helps to close these loopholes, is urgently needed to rein in financial risks.

Hu Shuli is the chief editor of Caixin Media.

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