May 16, 2017 02:23 PM

Editorial: Regulatory Reform Needed as First Defense Against Financial Risks

In recent months, financial regulators in China have taken bold steps to root out irregularities and plug potential legal loopholes as the country strives to tighten oversight and rein in risks in the financial sector, which is plagued by excessive debt and ballooning shadow-lending activities.

Last year, the central bank introduced the Macro Prudential Assessment system to gauge financial institutions’ risk exposure, hoping to put a lid on fast-growing, off-the-books credit offerings. The China Banking Regulatory Commission stepped on the gas in late March this year, issuing seven policy documents in 10 days to increase scrutiny over the banking sector. The securities watchdog, the China Securities Regulatory Commission, also lashed its whip, imposing 5.5 billion yuan ($797 million) in penalties on companies found to be issuing fraudulent data or engaging in other malpractices in April alone. This sum is higher than the total amount of fines collected in all of 2016. The China Insurance Regulatory Commission, which saw its former chairman, Xiang Junbo, fall from grace over an alleged corruption scandal in April, has issued a slew of fresh regulations and carried out inspections to uncover irregularities in insurers’ investment activities. Several insurance giants, including Foresea Life Insurance, Evergrande Life Insurance and Anbang Life Insurance, have been punished for selling high-risk products known as “universal life insurance” — a type of short-term policy that combines minimal protection benefits with a high return on investment.

These and other measures are part of a wider net being cast by policymakers to catch violators and improve financial stability. At a recent Politburo meeting, President Xi Jinping highlighted financial security as a strategic and fundamental issue affecting China’s social and economic growth.

The Chinese economy is now under pressure as growth in “the real economy,” made up of construction, manufacturing and trade in other tangible products and services, continues to slow. While financial-sector reforms gather momentum, efforts to restructure China’s economy have lagged behind, and this gap has flustered the overall transformation of the country’s growth model. Meanwhile, regulators are struggling to keep pace with the rapidly evolving financial market, raising concerns over potential risks.

Over the past decade, the boundary lines that demarcated different subsectors of the financial market have blurred, as banks, insurers, brokerages and other institutions have started to step out of their traditional domains and invest in each others’ businesses. The complexity of financial products has increased, and now they involve funds and investors from different parts of the market.

China established its financial regulatory system in 2003, which consists of the central bank and three commissions that oversee banking, securities and insurance. But this arrangement, which carves out terrain to be supervised by different agencies, isn’t suitable to oversee a fast-growing piece of the financial pie — cross-market financial products. Under the current system, regulators lack incentives to supervise market activities that fall outside their traditional domain, and also lack the capacity to identify emerging risks. This allows investors to dodge regulations and add excessive leverage when trading.

This cat-and-mouse game is threatening to wreak havoc on the financial order of the country. Since 2012, shadow-banking assets have ballooned, with more small and midsize banks funneling money into this thinly regulated sector, and it’s now threatening to poison the larger financial system.

Pushing forward regulatory reform is the need of the hour, and the market is eagerly waiting to see what policymakers will do next. However, the pace of change has been slow due to its complexity and resistance from groups with vested interests. Given such circumstances, it is more feasible to start the regulatory overhaul with moderate steps to enhance coordination and by clarifying which supervisory body should take the lead when tackling problems affecting multiple sectors.

Supervising the banking sector is the most important task for any regulatory system as it is crucial to implement monetary policy. Putting banks under proper oversight is essential to control financial risks and push the financial industry to better serve the real economy.

Enhancing financial supervision also requires institutional arrangements that can weed out corruption and encourage regulators to follow a strong ethical framework. This would prevent regulatory agencies from being manipulated by groups with vested interests. Over the past few years, several senior regulatory officials have been investigated for allegedly colluding with market players to block certain policies or for using their powers in a way that benefits certain parties. Continued efforts to root out corruption in the financial regulatory system and reflecting on previous cases are essential if China is to build a healthy ecosystem for the financial market.

Enhancing financial supervision benefits the market in the long run, but it requires a firm determination because persistent efforts to crack down on irregularities will cause market fluctuations and hurt some parties’ interests. Reform measures can easily be hindered by groups lobbying to “protect investors’ interest.” But the financial market needs a sound oversight system for it to operate in an open and fair manner.

Change makers also need to be nimble as China’s financial market is massive and highly connected, and any abrupt risks could have a domino effect. Changes can’t be made in a rush but should be carried out gradually. But it’s important for regulators to show clear determination to push the reforms forward. Any hesitation may send out the wrong signal, encouraging the market to misbehave.

China’s economy is reaching a pivotal point in its transition, and it is facing challenges from both external and domestic markets, and needs support from a healthy and prosperous financial system. Regulators must act now to firmly guard the financial sector against systemic risks and strengthen the country’s financial security.

A previous version of this story incorrectly stated when the PBOC introduced the Macro-Prudential Assessment. It was in 2016.

Hu Shuli is the editor-in-chief of Caixin Media.

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