Closer Look: China Expresses Zero Tolerance for Predators in Financial Markets

China’s top securities regulator, Liu Shiyu, lashed out on Friday at unscrupulous investors who have recently been disturbing the financial markets, vowing to catch a number of “capital crocodiles” in order to prevent them from “sucking the blood of the retail investors.”

This is the first public gesture from authorities after reports last week that mysterious tycoon Xiao Jianhua was being investigated. Liu’s rhetoric is clear and resolute; apparently, he is well-poised for action.

Through a number of directly or indirectly controlled banks, insurers, securities firms and listed companies, Xiao and his business conglomerate, Tomorrow Holding Group, have participated in many high-profile acquisitions in recent years. But some of the deals have sparked concern over their legality and the risks involved due to their widespread use of shell companies and complicated transactions among interconnected companies.

Xiao is a good example of a financial tycoon who has quietly gained control of multiple financial institutions through affiliated parties or proxies, dodging regulatory rules that restrict single-shareholder control of financial institutions.

Powerful shareholders are bending the rules to gain absolute control of financial institutions so that they can turn them into financing platforms to support their own ambitious expansion plans. Financial institutions under a single shareholder’s control are often plagued by weak corporate governance and fall outside necessary supervision. They may easily become the vehicle to transfer funds and facilitate transactions among connected parties for the narrow interests of a handful of influential shareholders while putting small shareholders and the market at risk.

The problems become even more worrisome when leveraged funds are used to finance some of the ambitious but risky deals.

Over the past few years, China’s financial markets have been constantly rocked by highly leveraged and risky investments. Speculators have channeled borrowed money into the stock market, bank wealth management plans, insurance policies, trust products and internet-based financial platforms for quick gains through risky trading activities. Such practices are often carried out in the name of innovation and take advantage of regulatory loopholes.

Financial innovation can be a double-edged sword. While the right kind of innovation spurs the development of financial markets, improper use of innovative financial tools can have serious consequence as it pushes up market leverage and diverts capital away from the real economy to seek speculative gains.

Mounting risk concerns in the financial sector have forced policymakers to make deleveraging the top priority on the country’s economic agenda this year, shifting focus from last year’s fight against industrial overcapacity.

Unlike industrial and commercial enterprises, financial institutions are closely linked to a large number of investors and consumers. So they must be strictly regulated in a transparent manner. Koh Beng Seng, former deputy managing director of the Monetary Authority of Singapore, wrote in an article recently published on Caixin that only shareholders with good reputations and no criminal records should be allowed to hold majority stakes in a financial institution. Meanwhile, institutional arrangements must be in place to constraint majority shareholder power and prevent conflicts of interest. He argued that shareholding through proxies in financial institutions should be strictly prohibited.

China’s financial regulators have sent strong signals that they are tightening their scrutiny on financial markets. On Feb. 9, Chen Wenhui, chairman of the China Insurance Regulatory Commission, warned about risks related to weak governance and a single shareholder’s control of some insurance companies. Last month, Liu Shiyu, head of the China Securities Regulatory Commission, vowed to punish financial violations and called for the healthy development of the capital market. In December, Liu denounced companies that used unauthorized funds to finance leverage buyouts as “barbarians” and “robbers.”

Since late last year, the central bank has also issued a series of policies targeting internet finance, online payments and wealth management products to step up supervision on the financial market.

While most private entrepreneurs deserve support and protection for their contribution to the economy, financial predators seeking illicit gains through murky business operations and regulatory arbitrage should not be allowed because they harm the markets.

Some analysts have said that a major factor triggering the 1997 Asian financial crisis — in addition to problems in various countries’ economic structures and monetary systems — was the control that powerful families had over the financial sector. A mature and stable economy needs to set up an effective financial supervisory system, with balance between innovation and risk control, which leaves no room for financial predators to manipulate the market with measures outside the law.

Wang Yong is a financial editor at Caixin Media