Editorial: Strong Institutions Key to Preventing ‘Regulatory Capture’

Dismantling a system that allows “regulatory capture” has become a major challenge facing financial regulators. As the cover story of last week’s Caixin magazine reported, regulating the financial industry and even controlling graft — which has become systemic — requires fixing flawed institutional structures, not just thwarting corrupt individuals. The financial industry must urgently persist in market-oriented reforms while improving and strengthening supervision. If a correct direction is found, strong supervision will not conflict with reform — it will be a natural part of reform.

Regulatory capture is not a new issue. In 1971, U.S. economist George Stigler argued that while regulatory bodies have greater independence when they are first established, they are ultimately “captured” by the industry they are supposed to regulate, and work to promote the industry’s interests rather than the public’s. This “life-cycle theory” of regulation may seem fatalistic, but reality has unfortunately proved again and again that it is true. In the past two years, China’s financial supervisors have been exposed for falling into the trap of regulatory capture and top officials have been frequently investigated for corruption. Former Assistant Chairman Zhang Yujun of the China Securities Regulatory Commission (CSRC), former CSRC Vice Chairman Yao Gang, former Chairman Xiang Junbo of the China Insurance Regulatory Commission (CIRC), and assistant chairman Yang Jiacai of the China Banking Regulatory Commission have all been investigated. Xiang in particular was the first chief from China’s four largest financial regulators to be investigated. He was sternly condemned in a statement by the Communist Party’s top graft buster, the Central Commission for Discipline Inspection, for “abusing his powers of supervision and approval.”

The fact that regulatory capture and corruption exist has long been widely acknowledged, but the seriousness and pervasiveness of the problem are shocking. The CIRC and CBRC have recently replaced their respective top discipline officials, showing that the central government is strongly concerned about the issue of corruption in the financial system. We hope that, with this as a starting point, the institutional weaknesses allowing regulatory capture in China’s financial system can be eliminated.

To erase Xiang’s negative legacy, we must first have an accurate understanding of his policies. Before his fall, he was seen as one of the more senior officials pushing for financial sector reforms. Some believed the “deregulation” and other reforms he allowed in the insurance industry were necessary, and it was the supervision system that had failed to catch up. This point of view is overly general, and even misleading.

For a long time, China’s insurance industry was excessively regulated and in need of market reform. However, the many policies implemented by Xiang were quite complex, and frequently packaged as “market liberalization” while being tailored to suit specific companies. For example, his “innovation pilot programs” only helped certain companies — acting illegally — to get rich. This kind of “reform” is inherently unfair, creating serious disorder in the industry. It has become common to see many insurance companies plagued with problems like tortuous governance structures, overly dominant shareholders, outrageous nepotism, and fake capital increases — “risk management” exists in name only. The CIRC gave up regulating some insurance businesses that are clearly violating rules, and was instead on intimate terms with these businesses, allowing them to enjoy a phase of “barbaric growth” and “extraordinary ascents.” This places great pressure on insurance enterprises that are trying to operate within the law, and sets negative examples. Some insurance companies have become personal ATMs for “capital predators,” with funds seized through financial insurance products frequently appearing on the capital market, seriously affecting the real economy and disrupting financial order. People have reason to ask with suspicion, “Is insurance still insured?”

At the critical moment, insurance regulators did nothing, with some officials even explaining away the problem. This teaches a profound lesson.

Xiang’s policies have tarnished the name of reform, but we should not throw the baby out with the bathwater. Recently, a CIRC official said the various problems that appeared in the industry in recent years were not caused by excessive reform, but because past reform measures didn’t hit the mark and weren’t thorough enough. This is the correct attitude.

The next steps are for China’s financial industry to continue to head in a market-oriented and liberalized direction, deepen institutional reforms, promote simplification and decentralization, accelerate the opening-up process, and gradually relax barriers to access. Reform does not mean weaker regulation, but rather stronger regulation thanks to clearer boundaries between the market and regulatory authorities. Regulators can vacate gray areas that allow rent-seeking behaviors, and instead concentrate their efforts on safeguarding the public interest and mitigating financial risks. The most urgent task is to clean up the mess left by Xiang, apply the correct solutions to the problem, close loopholes, and prevent regulatory capture by altering institutional structures and systems.

Many cases show that regulatory capture isn’t affecting only the CIRC, but that it also exists in other regulatory organizations. This indicates that blaming regulatory capture on individual problems is a superficial approach. In order to solve the problem of regulatory capture, it is not enough to depend on organizations to police themselves and to punish individuals. The key is to strengthen regulatory bodies’ independence and professionalism, while restraining their discretionary power with the rule of law. Additionally, we need to provide positive incentives through appropriate remuneration and professional pride, and continue unflaggingly to improve the technical capabilities of supervisors. These aspects must all be explored deeply.

In October, the CCDI published a document asking for stronger supervision of discipline department leaders and members. Recalling painful past experiences, the financial regulators have each introduced new rules to avoid regulatory capture. The CIRC, for example, introduced in May a document clamping down on riskier short-term policies. The CBRC in July issued two new policies, including a trial program to prevent staff from evading their duties. The efficacy of the new regulations remains to be seen, but this is a good start. No doubt, this is a little like locking the stable door after the horse has bolted — but it is still important to persevere and be thorough.

How to deal with problematic companies and people involved in regulatory capture is still a matter of debate. Authorities might want to put the issue on ice for now to prevent affecting markets and social stability. Their intentions aren’t bad, but slow, opaque investigations have led the financial industry to expect instability, causing speculation. Openness, fairness, and impartiality are the basic principles the financial industry must not violate at any point. In this respect, the media can always play a positive role.

Months ago, the National Financial Work Conference decided to set up a committee to oversee financial stability, with the four big regulators as its main pillars. This is expected to be a milestone on the path toward better financial regulation. China will soon begin a new five-year-journey, and financial regulators must wash away corruption and meet future challenges with a new face. Preventing regulatory capture is a top priority, and market-oriented reform should likewise not be allowed to slow down.

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