Editorial: Ending ‘Chaotic’ Investment in Financial Institutions to Bring Order to Industry

China’s regulators have strengthened their supervision of nonfinancial enterprises investing in financial institutions, even while unveiling their hotly anticipated new asset management regulations.

On April 27, the People’s Bank of China, the China Banking and Insurance Regulatory Commission and the China Securities Regulatory Commission unveiled their jointly formulated guidance document relating to this type of investment. The fact that the document was deliberated by the Central Comprehensively Deepening Reforms Commission shows its importance. The guidance document requires enterprises to use only their own funds to invest in financial institutions and clearly narrows the scope for becoming a qualified shareholder, while prohibiting the control of financial institution shares through holdings and other illegal relationships. Compared with the new asset management regulations, the April 27 guidance document will play a more-fundamental role in establishing and maintaining order in the financial industry. After years of running unbridled and causing extensive damage, the “chaotic” use of equity holdings is expected to now end.

Chaotic manipulation of equity holdings has long plagued corporate governance in China. As the pursuit of profit has become more convenient and more direct, chaotic behavior in China’s financial sector has become increasingly undisguised to the extent that perpetrators have become completely unscrupulous. Whether the actions come in the form of fake or circular capital increases, or secretly holding equity in financial institutions through holding companies or other noncompliant arrangements, they are all attempts to escape regulatory constraints. Ultimately, these actions weaken the financial institutions’ resistance to risk while hurting China’s campaign against financial risk.

These actions are by no means “financial innovation,” and no responsible regulator would condone them. This chaotic behavior is actually an old problem that everyone is familiar with. However, in the past, it was often difficult to investigate and punish such behavior due to the fractured regulatory system. After the recent reform of the financial supervision system, there is now greater coordination of financial committees under the State Council; regulatory authorities have been restructured; and there has been a surge of new regulations. The market is eagerly waiting to see if thorough supervision can now finally be achieved. The guidance document is an important milestone in the reform of the financial supervision system. Its ability to curb chaos in the financial sector will become an important indicator of whether institutional reforms have succeeded.

An important focus of the guidance document is effectively preventing and controlling financial risk. It clearly states its intention to tackle problems like companies not suited to finance investing in finacial institutions; the use of external funds to conduct false or circular capital injections; improper intervention in the operation of financial institutions; and the achievement of personal gain through connected transactions. The document wants to address the problems of financial institutions becoming “distracted from their intended purpose” and turning to finance, and the “cross-contamination of industrial and financial risk.” As a series of financial scandals has demonstrated, if China cannot strictly regulate nonfinancial companies’ investments in financial institutions, financial institutions will be reduced to acting as shareholders’ ATMs — in a situation where the causes of risk are isolated. If there is mutual contagion, it will extend indefinitely, leading to systemic financial risk, damaging the financial system from within.

Chaotic, opaque share ownership structures and fake capital increases not only introduce major external risk into financial institutions, resulting in the extreme concentration of financial risk, but they also open the door to illegal activity and abuses of share ownership rights, gradually creating a twisted chain of intertwined interests. Regulators have long made it clear that fake capital increases are a crime, but the problem lies in how to quantify, prove, and investigate this crime.

Shareholders, especially majority shareholders, are prone to engaging in illegal transactions, posing widespread problems for corporate governance. Shareholders of financial institutions are no exception. Misappropriation, illegal solicitation of funds, and improper intervention in the operation of financial institutions are frequent problems. Cases investigated by regulators show that some banks have issued loans to their shareholders at interest rates 20% lower than the ones they offer to other borrowers with similar loans. This shows poor compliance with banking regulations. The guidance document reiterates that it is necessary to construct firewalls between companies’ employees and regulate the overlap of directors between financial institutions and the companies that invest in them to prevent senior executives from holding multiple positions at the same time.

The insurance industry has seen a concentrated outbreak of “chaotic” behavior in recent years. The case of Anbang Insurance Group is a prime example of this. As Caixin has reported previously, and as confirmed by a court case, Anbang’s shareholding structure appears on the surface to be a complicated maze, but in reality the group is controlled almost exclusively by one person, Wu Xiaohui. Problems including controlling shareholders misappropriating insurance funds, false capital increases, and self-injection of funds have become the core targets of insurance regulators this year.

The release of the guidance document is an important step. However, the implementation of supervision is even more important. In fact, at the beginning of the year, the former banking and insurance regulatory bodies, as well as the securities regulator, issued multiple regulatory solutions for managing share ownership of banks, insurers, and securities companies. On May 3, the newly formed China Banking and Insurance Regulatory Commission issued draft regulations for related transactions by insurance companies, adding to the gradually tightening regulatory net. However, we should consider how financial chaos has not gone away despite many years of regulation and supervision. We hope that the April 27 guidance document, as a higher-level, unified set of rules, will promote the actual implementation of supervision.

Regulatory bodies must return to their essential role of supervision. Take the insurance industry as an example. As a result of regulatory capture and the support from policymakers, insurance products have seriously deteriorated and become a springboard for capital operation by companies looking to obtain improper benefits. The hostile takeovers by Baoneng Group and the aggressive acquisitions of Anbang stem from a lack of supervision — not to mention the corruption of former top insurance regulator Xiang Junbo. At the time of the intense controversy surrounding Baoneng’s takeover, for example, the China Insurance Regulatory Commission failed to act, and even spoke in defense of the company. Some key regulators even openly admired now-disgraced Anbang leader Wu Xiaohui’s deal-making “skills.” Now, they have learned a painful lesson. Regulators must learn to deliver tangible results — an area that has been their major weakness so far.

With the introduction of the guidance document, we must remember that it is not necessary to reject all capital from nonfinancial sources. After all, there is currently too little, rather than too much, private investment in financial institutions. The intention of the guidance document is to establish rules and strengthen the foundation of the system. If capital from stronger and better companies can be introduced, beneficial interactions between the financial industry and the real economy will surely grow. However, financial institutions must never become tools for speculators. This is a red line that must not be crossed.

Translated by Teng Jing Xuan (jingxuanteng@caixin.com)