Caixin
Jan 25, 2018 08:18 PM
FINANCE

China’s Financial Crackdown: What You Need to Know

After an eventful 2017 that saw the iron fist of China’s regulators batter a range of risky activities ranging from high-yield, low-protection insurance policies to cryptocurrency trading, all signs point to an even tougher year for the country’s financial sector this year as the government steps up its deleveraging campaign.

Guo Shuqing, chairman of the China Banking Regulatory Commission (CBRC), provided a taste of what’s in store in an interview with the official People’s Daily published on Jan. 17. Describing the authorities’ campaign to prevent and defuse major financial risks as a “tough battle,” Guo said the regulator’s tasks this year will be to lower debt levels in the corporate and household sectors, contain property bubbles and help local governments tackle their hidden liabilities. He also pledged tougher supervision of corporate governance and the shareholding structure of the country’s banks, after shortcomings in these areas were blamed for fostering shady activities and endangering financial stability.

Some analysts say Guo’s comments mark a shift in government policy away from the trend of liberalization that took place following the global financial crisis. Others say they could herald the start of a period of retrenchment for the country’s financial industry after years of loosely regulated expansion.

The government’s determination to rein in financial risks was spelled out most recently by Liu He, a key financial and economic adviser to President Xi Jinping. Speaking at the World Economic Forum in Davos, Switzerland on Wednesday, Liu said that preventing and resolving major risks is one of the three critical battles China is preparing to fight over the next few years.

The authorities will strive to bring the country’s overall leverage “under effective control” within three years, Liu said, with a focus on curbing the growth of debt among local governments and companies. He said the government has “full confidence and a clear plan to get the job done.”

Regulators intend to leave no stone unturned in their drive to stop the reckless and risky practices undertaken by banks, insurance companies, brokerages, and other financial institutions in their quest for profits. Fraud, which has the potential to threaten social stability, is a key area of concern.

The Financial Stability and Development Committee, a cabinet-level body to coordinate the various regulators that oversee China’s sprawling financial industry, started operating last year, while several veteran anti-graft officials have been appointed to senior positions at financial-industry watchdogs to strengthen scrutiny over corruption and abuse of power.

The campaign has, unsurprisingly, sparked resistance from financial institutions, as they are forced to halt the opaque and risky operations they used over the past decade to fuel their profits.

Here are some key questions and answers about the campaign that looks set to change the landscape of China’s financial industry.

Why is the financial crackdown top of the government’s agenda?

The total assets of China’s banking system have quadrupled to 240 trillion yuan ($38 trillion) in a decade, fueled by a lending boom that began in 2008 to cushion the economy from the impact of the global financial crisis. The country’s banking system is now the world’s biggest, having overtaken the Eurozone in 2016.

The growth in bank lending has outpaced the increase in gross domestic product (GDP) for several years, raising the country’s debt to GDP ratio to a level that has prompted warnings by the International Monetary Fund and the big global ratings agencies of the potential for a financial crisis.

The percentage of outstanding credit to the nonfinancial sector in China jumped to just under 260% of GDP at the end of June 2017, according to the Bank for International Settlements, up from 148% at the end of 2007. Although that’s not much higher than the figure for the U.S. and is far lower than Japan’s, it’s the speed of the increase that has caused concern.

In addition, much of the credit found its way into the shadow banking sector as financial institutions and companies used their bank loans to speculate and invest in riskier products that offered higher returns. New channels for lending and investment sprang up, notably via asset management products that were issued by banks, trust firms, brokerages, fund management companies and insurers.

Trillions of yuan have found their way into the lightly regulated asset management sector, which had assets under management of $15 trillion at the end of 2016, according to government figures.

Rather than being ploughed into the so-called “real economy” which involves the production of goods and services and investment in fixed assets, the money was used by financial institutions to buy other financial investments that were riskier but offered higher returns. That created a complex web of investments outside the formal banking system that regulators found difficult to oversee and which led to a dangerous mix of asset-liability mismatch, leveraged investment and liquidity risks.

Much of the credit also found its way to local governments, providing them with a ready supply of money to finance their investment and spending and allowing them to skirt central government debt controls and supervision.

With risk in the financial system accumulating and the threat of defaults causing a domino effect that might trigger instability, President Xi decided enough was enough and that it was time to rein in the freewheeling financial sector.

Who’s in the firing line?

The short answer is: everyone. Securities companies, banks, insurance firms, non-bank financial institutions, traders, trust companies, peer-to-peer and micro-lenders, asset managers — the list is extensive.

The People’s Bank of China (PBOC) and the three financial watchdogs — the China Banking Regulatory Commission (CBRC), the China Securities Regulatory Commission (CSRC), and the China Insurance Regulatory Commission (CIRC) — have all released new regulations, policy documents and directives over the past 18 months to curb risky activity by companies under their supervision.

The main aims so far have been forcing financial institutions to stop using borrowed money to invest in financial products, reducing risks from the mismatch of liabilities and assets — where firms borrow cheaper short-term money to make more lucrative but illiquid longer-term investments, and preventing regulatory arbitrage ­which involves companies taking advantage of uncoordinated regulation between the various financial watchdogs to skirt rules and undertake risky activities. Improving corporate governance has also been high on the agenda.

Banks, the source of many of the problems facing the financial sector, have been in the eye of the regulatory storm that was unleashed early last year and have faced a crackdown on a range of activities including curbs on their involvement in entrusted loans.

Insurance companies have faced a virtual ban on issuing universal life insurance policies, short-term policies that came with minimal life insurance benefits but attracted policy holders with high yields and no-penalty early cancellations.

What’s next?

This year, regulators have signaled they will pay more attention to corporate governance and financial conglomerates, companies that built themselves into large diverse financial institutions through complex ownership structures and fraudulent capital injections.

Last year, the heads of two financial groups — Tomorrow Holding Co. and Anbang Insurance Group Co. — were detained for investigation. The complex structure of the two companies allowed them to “capture” the financial watchdogs charged with regulating them, secretly gain control over other companies and shuffle money between them, and promote their own interests.

In his People’s Daily interview, Guo criticized some shareholders who used banks as “ATM machines” and “recklessly conducted unfair connected transactions to line their own pockets.” Guo said some financial conglomerates had become “a severe obstacle to the country’s financial reforms and a threat to the security of the banking system,” warning that “stern treatment is needed.”

The insurance and securities watchdogs have also stated their intention to strengthen the corporate governance of financial institutions under their supervision to prevent shareholders from abusing their power.

Another top priority is putting a further squeeze on the interbank market, the main source of short-term funding for banks and nonbank financial institutions that borrow money to invest in higher-yielding assets.

Regulators have already had some success in reining institutions’ dependence on the interbank market, where much of the money used for shadow-banking activities originates. Commercial banks’ interbank assets and liabilities fell by 2.8 trillion yuan and 830 billion yuan respectively by the end of November from the beginning of the year, and the growth in wealth management products sold between financial institutions has also fallen back.

The country’s anti-corruption authorities are also increasing their focus on the financial sector. The Central Commission for Discipline Inspection (CCDI) signaled its intention to target banks in a communique dated Jan. 14 that highlighted four key areas of investigation, including “financial credit,” a reference to loans that fund loosely regulated trust, insurance or other asset management products that carry higher risks.

Beijing, the country’s capital, and Shanghai, the country’s financial center, have also recently appointed two former financial regulators as vice mayors, tightening supervision on the financial sector at the municipal government level.

What will be the impact on the financial sector and the economy?

Local government financing vehicles and property firms, who rely heavily on the shadow banking system as major funding channels, will find it harder to raise funds. Banks and trust companies that have made money from arranging, selling and investing in the products and services now being curbed, such as wealth management products and entrusted loans, are likely to see their profits from these activities take a hit, especially when new regulations to curb the issuance of asset management products go into effect in mid-2019.

The prospect of harsh fines and penalties may also make financial institutions think twice before breaking or avoiding rules in the new tougher environment. The Chengdu branch of Shanghai Pudong Development Bank was fined 462 million yuan earlier this month for illegal lending activities, including falsifying loan deals and hiding nonperforming assets, marking one of the stiffest penalties handed out so far in the crackdown on financial wrongdoing.

Tianjin-based China Bohai Bank was recently strongly criticized by the anti-corruption watchdog for sending a batch of gifts card worth just 168 yuan each.

Contact reporter Leng Cheng (chengleng@caixin.com)

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