Introduction: Comment solicitation on the “Financial Stability Law of the People’s Republic of China (Draft for Comment)” (hereinafter referred to as the “draft law”) is about to end by May 6. Recently, Liu Xiaochun, Vice President of Shanghai Finance Institute, was invited by CF40 Research Department to share his views on the draft’s provisions on financial risk disposal.
Whether from the current practice of preventing and defusing financial risks or from the chapter distribution of the draft law (a total of 6 chapters and 48 articles, of which Chapter 4 on financial risk disposal contains 16 articles, way more than other chapters), orderly disposal of financial risks has become a major challenge in the process of establishing a long-term mechanism for financial stability. To set up and improve a market-oriented and law-based financial risk disposal mechanism, sources of funds for risk disposal must be specified.
Based on the draft law, some controversial issues have been clarified, but there are some new questions to be answered.
For example, the Financial Stability Fund (hereinafter referred to as “stability fund”) that has caught the market's attention is mentioned by the draft law only in the part of the “sources of disposal funds” of the “risk disposal” section; and in terms of the order of using the disposal funds, the stability fund is put in the last place. Article 29 makes it clear that the stability fund serves as the “backup” fund to cope with major financial risks. From relevant expressions, the stability fund only serves its role as a pool of funds in the stage of risk disposal without having any other functions and tools for disposal, let alone participating in the early stages of preventing and defusing risks.
As for the role of local governments and the use of local public resources to manage risks, the draft law provides that “the provincial-level governments are responsible for the disposal of financial risks caused by rural cooperative financial institutions and non-financial enterprises within their jurisdiction, and leading the disposal of other financial risks in accordance with the requirements of the national financial stability development and coordination mechanism.” In terms of the order of use of disposal funds, the draft law states that “for those risks that threaten regional stability and cannot be defused after exhausting all the market-based measures for asset recovery and loss reduction, the provincial-level governments should resort to local public resources according to law while the provincial-level finance departments should oversee the use of local government funds”, in which the use of local public resources comes before the stability fund.
However, whether local governments can lead the disposal of financial risks is still debated within the financial sector. Some argue that local governments lack the decision-making capacity and incentive mechanism for risk disposal, and localized financial risk disposal might also lead to destructive competition due to loosened regulatory standards.
In addition, in Article 30 regarding disposal measures of financial authorities, the draft law clarifies that when the financial authorities under the State Council implement risk disposal, with the approval of the main person in charge, they can take different measures based on specific circumstances in accordance with the law, including “exercising the management rights of the disposed financial institution” and “ transferring part or all of the businesses, assets, and liabilities of the disposed financial institution to a third-party institution”. In this process, how should we address the possible moral hazard and conflict of interest?
In this interview, Liu Xiaochun shared his thoughts on the issues above. The following is the transcript of the interview.
Q1: Based on the draft law, what functions do you think the Financial Stability Fund should have? Is it necessary to extend its role to the stage of preventing and defusing risks?
Liu Xiaochun: There is a view that with the Financial Stability Fund, we can invest in the market without any concern. In other words, we don’t need to worry about the risks now that the stability fund serves as a guarantee to cover losses. This brings about a question: what is the stability fund for?
In my opinion, based on the draft law, the Financial Stability Fund is not used to cover losses caused by financial risks, nor is it used to guard against risks, because if the risks can be prevented, there is no need to resort to the stability fund. Meanwhile, the stability fund is not used to protect the rights of investors. As the draft law puts it, only in cases where major financial risks threaten financial stability can the stability fund be utilized. The “risks” here do not mean market volatility like the stock market decline; instead, here risks refer to circumstances that might affect the whole financial system or lead to financial and economic meltdown. Therefore, the stability fund should neither take on the role of preventing and defusing risks nor be used to dispose regular risks. Rather, the fund should only be used as a non-standardized tool in special situations.
Q2: Does the Financial Stability Fund only serve as a pool of funds? Should it have any specific disposal functions and instruments？
Liu Xiaochun: This is a question worth discussing. Take deposit insurance as an example. Its purpose is clear, which is to protect the interests of depositors instead of bailing out banks. At the same time, the insurance also covers the loss of depositors by guaranteeing full withdrawal of up to 500,000 RMB personal deposits and partial withdrawal of deposits beyond 500,000 RMB. There is no moral hazard here because the boundary is very clear.
The stability fund, nevertheless, raises a more complex issue. People tend to believe that European and the US experience are more advanced and mature. But I think they are not that mature at least in this respect. Setting up a stability fund was actually their last resort.
From my perspective, there is no problem if the Financial Stability Fund only serves as a pool of funds without having any other functions. Moreover, if risks can be prevented and defused in the early stage, we might never use this fund.
Q3: What are your suggestions as to how to use the stability fund including the conditionality? For example, the draft law mentions that “for major financial risks that threaten financial stability, the stability fund can be used in accordance with the rules.” How to decide whether a situation can be deemed as the so-called “major financial risks that threaten financial stability”?
Liu Xiaochun: The key is to understand that the stability fund is not used to cover losses. On this premise, we can further specify its functions.
I think the stability fund is the last resort but it may not be the one to really solve the problem. It is only an emergency fund. When risks threaten the whole economic and financial system and all the available measures fail, the stability fund then can step in. After restoring the stability of the economic and financial system temporarily, we need other instruments to mitigate and dispose risks. Meanwhile, the financial risk disposal mechanism should be market- and law-based. The intervention of the fund is conditional and should be withdrawn in the end. For example, if an institution is liquidated, the earnings left after the disposal of residual value should be used for repayment of the stability fund.
For instance, if a commercial bank is exposed to risks, while deposit insurance can protect the interests of depositors, there are still large-scale interbank liabilities, which might imperil the whole financial system if not handled properly. At this point, if there is a financial stability fund, we can consider at which point and in what way to use the fund for risk disposal. For example, the fund can temporarily take a stake in the bank and improve the capital adequacy ratio to stabilize other banks’ assessment of its risks and avoid panic. When risk disposal is completed through other measures, new shareholders can be introduced and the equity of the stability fund can exit. After the exit, the stability fund might even gain some profits. In short, we should not regard the participation of the stability fund as a support for the commercial bank to pay off its debts or bail it out. The fund might bail out the institution in such a way, but this is not the purpose of the fund.
Therefore, it is not appropriate to set very specific standards for the use of the stability fund. A better approach is to highlight the flexibility of the fund usage to cope with unexpected and unconventional risks. Whether to use and how to use the fund should be on a case-by-case basis. Overly specific standards might cause perverse incentive, making some institutions and enterprises take excessive risks on purpose to escape debts. Many people hope that the financial stability law can specify the conditions and procedure for the use of the stability fund. I think their intention is good, but in reality it will backfire. If there were any specific standards, it would be certain that once an institution is exposed to risks, some people, institutions, and local governments would try every means to enlarge the risks to meet the “standards”.
Why do many large private firms encounter such a problem when risks occur — scaling up instead of scaling down operation when they are aware of the risks? In part, it is because they believe that as long as they increase the risks to a certain level, the government will try to bail them out. The government gives them resources while they hold the profits as they are private enterprises. Therefore, in the end, they take advantage of the bail-out.
From the bailout experience of Hong Kong of China, Europe, and the US, although the move was at any cost during the crisis, it also came with conditions including bailout conditions and exit mechanism to avoid moral hazard and prevent institutions concerned from turning the stability fund into a relief fund regardless of the cost. After the bailout, the fund must exit to let those who cause the trouble bear the responsibility and cost.
The stability fund is not a lucrative subsidy to be taken advantage of. We should not let the market anticipate and count on it, otherwise, the fund might be seized upon by the market.
For example, Hong Kong’s response to the Asian financial crisis was successful in a certain sense. To stabilize the financial market, Hong Kong used the Exchange Fund to buy a large number of stocks. After the market restored stability, as these assets were generally profitable, the government of the Hong Kong Special Administrative Region set up the Tracker Fund of Hong Kong and made it goes public. In this way, the exchange fund exited in a market-based manner while Hong Kong investors were able to share the earnings of the Tracker Fund. During the 2008 financial crisis, the Fed’s bailout of large investment banks was also conditional and restrictive. For instance, the Fed approved the conversion of Goldman Sachs and Morgan Stanley from investment banks to bank holding companies on condition that they are subject to the same regulation as commercial banks and the Fed would withdraw their capital to let the institutions repay the money. As for the capital structure of the European Stability Mechanism (ESM), the largest component is “callable” capital that member states are committed to pay whenever necessary. This way of ad-hoc capital raising can also help avoid the stability fund being used as a guarantee to cover losses.
Q4: In terms of the use of public funds, the draft law provides that “when necessary, central bank lending and other public funds can be used to provide liquidity support for the financial stability funds. The stability fund should repay the loans with the proceeds from asset disposal, earnings, industry fees, etc.” Combined with Article 28 that puts the use of the stability fund in the last place, does it mean that public funds like those of the central bank will not be directly involved in risk disposal, but instead indirectly step in through the stability funds?
Liu Xiaochun: The draft law doesn’t affect the direct involvement of the central bank’s funds. When the early-stage risks are still within the scope of its responsibility, the central bank can play its role as the lender of last resort. Part of the reason why we need indirect involvement of the central bank lending into risk disposal through the stability fund is that the use of the stability fund is more flexible. For example, if there is a need to replenish the capital base of an financial institution to bring the debt ratio back to a normal range, we can use the stability fund to provide the capital; after the stability fund gains earnings, it can repay the central bank lending, while the lending itself cannot directly serve as equity funds.
Q5: What is your advice on the capital raising and management of the fund? Is it necessary to set up an independent fund management agency?
Liu Xiaochun: I don’t think it is necessary to establish a separate management agency and it is best not to run the stability fund, because running a fund requires a team and a set of management methods as well as consideration of the costs, system, evaluation, and profitability. Setting up a large agency might create other problems, as running and managing a stability fund itself poses great risks.
What’s important is to establish a mechanism and rules for raising and using the fund. For example, financial institutions like banks, insurance companies, and securities companies can give a capital contribution in proportion to their overall assets or capital; the Financial Stability and Development Committee under the State Council can designate a department to be in charge of the capital raising and open a special account in the central bank to put the money. The capital cannot be used under normal circumstances and does not need to generate profits through active investing as long as it suffers no loss; the fund is used only when necessary.
The capital can be raised beforehand or afterward, or the “callable” approach can be borrowed by designating a specific department to raise funds from financial institutions ad hoc when necessary. If, as I said, the stability fund mainly serves as emergency assistance amid crisis instead of covering the risks, even if the fund needs to be raised in advance, its usual size does not need to be too large. Rather, in terms of institutional design, the fund might as well let the designated department raise funds from other institutions according to certain rules and standards when it is necessary to use the fund for risk disposal; after the disposal, if it gains any profits, the money can be repaid to the financial institution. This might be a better way.
If the fund becomes considerately large, given China’s current conditions, many government departments and people will certainly want the fund to play a bigger role, such as putting it in the stock market just like the social security fund. That would be a problem.
Q6: The draft law stipulates that local governments are responsible for the disposal of financial risks caused by rural cooperative financial institutions and non-financial enterprises. As for the order of using funds, local public resources come before the stability fund. But some argue that local governments lack the decision-making capacity and incentive mechanism for risk disposal, and localized financial risk disposal might also lead to destructive competition due to loosened regulatory standards. Do you think whether local governments should have the power to lead risk disposal? Why the use of local public resources is put before the stability fund?
Liu Xiaochun: I think risk management is a practical issue rather than a theoretical one.
First, in the case of China, the power game between the central and local governments has always existed. It is reasonable to hand over the right to the local governments to take the lead in treating risks of rural cooperative financial institutions and financial risks caused by non-financial institutions, so that the local governments can use local public resources to bear the burden. It is the current special social reality in China that requires such a mechanism.
Second, in a certain sense, a considerable part of the non-performing assets of many local financial institutions and even national financial institutions is the result of local government intervention in the past. There are two situations. One is that some local governments do not understand the rules of bank operation, holding that a bank’s job is to support local development by lending, the more the better. But they fail to realize that bank's liabilities are savings deposits made by the local people. The second situation is that although the local government is clear about the rules, it also believes that the central government will be the lender of the last resort. Whenever a risk breaks out, it is always left to the central government. Therefore, clarifying local responsibilities is beneficial for local governments to manage the financial industry in accordance with the laws of finance and avoid excessive interference with the normal operation of financial institutions.
Furthermore, most businesses of rural credit cooperatives and local non-financial enterprises are basically localized, and are not likely to cause holistic and systemic risks, so there is no need to use the stability fund which is aimed at systemic dangers.
Some people have worries over whether it will cause the concentration of power if the power of leading risk treatment is handed over to local governments. I believe that only when the power is delegated to the local governments can they really take the responsibility and have the determination and motivation to utilize all available resources to defuse risks. This will also encourage the local regulatory departments to do their work well on a daily basis to prevent risks before they occur.
Of course, institutional building should be the first priority. A binding mechanism to prevent the abuse of power by local governments must be established and constantly improved to ensure they act in accordance with market principles and in accordance with the law.
Q7: The seventh question is about the relationship between different insurance funds. The drafting instructions of the Financial Stability Law mentioned that "the stability fund and the existing deposit insurance fund and industry guarantee fund will operate in two layers and coordinate with each other". How to understand this? How to distinguish the boundaries of responsibility?
Liu Xiaochun: In a certain sense, they are different things. The stability fund will only be used at the last moment. The deposit insurance fund and the industry guarantee fund, as I have just mentioned, already have clear responsibility boundaries.
The deposit insurance funds and industry guarantee funds have different goals and would not exceed the scope of one’s own responsibility, so I think cooperation is not involved here. According to my understanding, cooperation would be needed at a time when a bank sees large-scale crowding out and the deposit insurance funds cannot cope with the situation, then the stability fund can provide funds for deposit insurance to ensure the payment of savings deposits. It is not to have all kinds of funds to underwrite losses together during the process of risk treatment.
A much discussed issue today is that the deposit insurance fund should be allowed to “grow its teeth” and assume certain regulatory functions. It can carry out early correction from its special dimension, such as risk identification, and can provide risk warning and regulatory advice to banks and regulators. From the perspective of the deposit insurance fund itself, insurance has to bear losses and should be allowed to assume regulatory function, which is also a powerful supplement to the regulatory agencies such as the China Banking and Insurance Regulatory Commission.
Q8: Article 30 of the draft stipulates that the financial regulatory department can exercise the operation and management rights of the institution taken over and transfer business assets and liabilities to third-party institutions. Are takeovers by regulatory departments suitable as a means of normalized risk treatment? How do you consider the possible conflicts of interest and moral hazard that may exist in the direct exercise of the operation and management rights?
Liu Xiaochun: Are there any moral hazard or a conflict of interest? The answer is yes from the theoretical sense. But there is a premise here, that is, when a financial institution has a risk and the regulator comes to take over, the role of the regulator is very clear. It is only a temporary takeover, not that the regulator will become a shareholder, so the regulator won’t have any interest in this process. From this perspective, there is no moral hazard. Of course, there are personal factors, but that's not what we're discussing here.
But in general, first, takeover by regulatory departments must have basic preconditions, that is, it must be clearly stated in advance under what circumstances the takeover is required, and when the takeover needs to be withdrawn. Second, regulatory departments have the right to take over the institution and what method is used to take over are two issues. Takeover can be done by entrustment, and it is not necessary that a regulatory department must directly participate in the operation. For example, other banks or third-party companies can be entrusted to take over the failed institution, and professional managers can manage the financial expenses and other issues.
One thing is certain, during the process of risk treatment, when an institution is taken over and its owners and managers still participate in the operation and management, there will be problems such as conflict of interest and moral hazard.
This article is compiled from an interview with the author, and was published on CF40 WeChat blog on April 30, 2022. The views expressed herein are the author’s own and do not represent those of CF40 or other organizations.
