Abstract: When formulating policies regarding financial stability and financial risk control, policymakers should take into account the impact of various dimensions of the human society on the financial sector. All policies and measures should respect market rules and leverage the market’s role in spontaneously preventing and resolving risks, and avoid undue tolerance of risks.
Most discussions of the cause of financial risks have focused on either market factors or financial institutions. The first include factors such as credit risks as a result of business failures and liquidity risks from fund supply and demand fluctuations. The latter include risks arising from financial institutions’ failures in asset/liability management, risk management, and operations. In other words, we used to talk about financial risks only in the financial context.
The pure market assumed by theories does not exist in the real world. The real-world market consists not only of parties of transactions. It needs rules, and rules need to be formulated and maintained, and so laws, regulations and policies are all constituent parts of a market. Rules and regulations are made based on the market’s circumstances, but they can also reshape the market.
But markets and the financial sector are not isolated from other parts of the human society. They are closely connected with politics, military affairs, culture and various other social activities. That makes it necessary to consider non-financial factors when discussing financial risks and stability. Likewise, the key to maintaining financial stability may be found beyond the financial territory.
Yet, at the same time, all policies and measures implemented to prevent financial risks and protect financial stability should respect the rules of the market and financial activities and bring out their spontaneous roles. Hence, with improper institutional design and implementation, actions aimed at managing and preventing financial risks could turn out to be self-defeating.
I. ECONOMIC POLICIES AND FINANCIAL RISKS
Systematic risks from business credit defaults that lead to a surge of non-performing loans at banks are caused by a variety of reasons, including operational failures of the businesses, market changes and policy adjustments.
Most risks arising from bad operation or market changes are formed in a gradual manner and unconcentrated, allowing time for banks to react and apply mitigation moves. Even cyclical risks wouldn’t break out massively across regions and businesses, and so wouldn’t generate immediate impacts on banks.
But policymaking is different. Any policy is introduced with defined and consistent requirement and time and mode of implementation, and that means policy-triggered risks would break out simultaneously, leaving little time or room for adjustment. It is impossible for bank credit risk management to prevent or mitigate these risks. Previous policy moves in China aimed at closing unqualified small cement plants, cotton mills, steel factories, coal pits and car manufacturers are case in points.
Undoubtedly, these policies have been highly targeted and effective in eliminating economic risks, but they have also caused financial risks at the same time. Most importantly, they do not respect market and financial rules, as they determine the life and death of a company only by its scale. Many of the businesses were not weeded out by the market, but by policy. Policies including industrial standards on environmental protection and quality can reduce disruptions caused by excessive investment, overcapacity, and fake and inferior products, so as to boost orderly competition. Incompetent businesses would have to keep contracting until they fail. Banks would also choose customers and allocate resources in accordance with policies until risks are mitigated. Some of the small businesses would stand out from competition, while some of the big firms would fail before becoming zombies.
Some of the policies, while weakening the role of the market and finance, runs against the market rules when executed. For example, firms are asked to rectify their previously legitimate business operations straight away in accordance with new policies; banks are told to recover their lending ahead of time without delay, which is impossible because firms now have no cash flow after being forced to shut down. Neither firms nor banks had any time window even to cushion the blow. But risks would be much lower if policies can provide such a time window.
II. MACRO REGULATION AND FINANCIAL RISKS
The fundamental purpose of macro regulation is to prevent and resolve market risks, and the modern central banking system has a lot to with that. However, macro regulation itself is highly risky and could cause even bigger dangers if poorly managed. Improper monetary policies implemented by the Federal Reserve was one of the reasons researchers believe to have triggered the 1929-33 Great Depression, for example.
Modern economy is relying more on macro regulation by central banks. But the problem at stake is whether excessive protection of the market will strangle its spontaneous roles. For an analogy, human bodies are vulnerable to some of the viruses, and so we inject hormones to improve immunity; but excessive and prolonged intake could actually weaken the human body’s immunity system and increase its reliance on drugs.
Stabilizing and managing expectations have been a focus of attention. But the issue is, when it comes to macro regulations such as monetary policy, which could produce better results, predictable policy or unpredictable policy?
Market participants are always looking for chances of profitability amid patterned market fluctuations. If monetary policy is predictable with a pattern, then market participants will establish business strategies accordingly, and market operations will be more concentrated. That could result in a monetary policy-oriented market, where the central bank becomes a market counterparty, not the regulator, with a more passive role to play. In this case, the central bank is actually pushing things toward the direction it least wants them to go.
That then plunges the central bank into a dilemma. If it intervenes in accordance with market expectations, it would temporarily relieve market tensions but further inflate the bubble and push up the risks, forcing itself into a new round of game with the market. But if it doesn’t intervene, the market would be unsatisfied and tend to believe that the bubble will inflate and it’s only a matter of time for the central bank to step in, and so it keeps blowing the bubble until the prophecy fulfills itself. But if the central bank operates reversely, the market would panic at its determination to pop the bubble and flee, leading to the burst of the bubble and the collapse of market confidence. The central bank would have no choice but to release liquidity to save the market. This process keeps repeating, and that’s why we always hear the market calling for cuts to the interest rate and the required reserve rate (RRR) and inject liquidity. This happens across major economies with almost no opposite voices except for a few from real experts.
But different markets could have different voices. The part of the financial market which is transaction-oriented and the part that provides financing for the real economy are different. They are associated but separated, more so under today’s financial system.
Voices on macro regulation usually come from the transaction-oriented part of the financial market. When the economy goes downward, policymakers would try to boost it up by injecting liquidity and cutting rates and the RRR to increase the financing demand of the real economy. However, in addition to fund supply and price, market expectations and confidence with regard to future consumption also play a part driving real economy investment. If the real economy expects consumption growth to be gloomy, no business would risk aggressive investment no matter how cheap the funds are.
That said, the financial market would keep calling on the central bank to inject liquidity citing statistics and saying it’s the market’s voice. If the central bank does so, the liquidity it provides will not be absorbed by the real economy at all as the latter has no financing demand, thus leading to no improvement in the real economy, a larger asset price bubble, and the piling up of systemic risks in the financial system.
From this point of view, macro regulation could also be a grey rhino, which is logical: just as bacteria and viruses can develop drug resistance, life is highly adaptable to the environment, and so are human society as well as individuals to rewards and punishments of all kinds.
There are no best approaches or systems for management, but only the most suitable ones. And they must keep adapting or their efficacy would keep declining. As a matter of fact, central banks across the globe have kept updating their theories and strategies with an increasingly rich toolbox, but the underlying logic has not changed. Now could be the time for more disruptive reforms.
In recent years, the People’s Bank of China (PBC) has made meaningful explorations of macro regulation policies based on China’s own situation rather than blindly copying foreign models. It has clearly distinguished between the two parts of the financial market, properly utilized both quantitative and price-based tools, adopted structural policy while maintaining a reasonable amount of liquidity, in order to create a smooth channel for policy transmission to the real economy. The long-term result remains to be seen, but it is a commendable innovation.
III. REGULATORY POLICY AND FINANCIAL RISKS
Financial regulation is also evolving. Early requirements on the level of asset reserves for commercial banks to issue currencies and later systems on deposit reserves and loan-to-deposit ratio management were mainly targeted at preventing liquidity risks of commercial banks.
Such a regulatory system was elevated to a new height with the introduction of the Basel Capital Accords, which placed a greater emphasis on capital constraints and prevention of the risk of loss including that from credit risks, market risks and operation risks, etc. Its underlying logic is that the minimum capital reserve of commercial banks must cover their unexpected losses, so that there is a 99.99% probability that insolvency can be prevented. To this end, the Accords have calculated a capital occupancy coefficient for all types of assets. The regulatory indicators and the three pillars this series has defined is a summary of lessons learnt over the hundreds of years of banking history, playing an important role in steering robust management of banks and providing regulators across the world with useful tools and methodologies.
First introduced in 1988, Basel Accords is now a series of three agreements (Basel I, II and III). The Basel Committee on Bank Supervision (BCBS) put some patches on Basel III soon after its release in 2010 in view of financial market changes. The development of the series and the patches seemed to be owed to the fact that continuous innovation in the financial market and banking sector had induced new risks. But from another point of view, ever since the Basel Accords were in place, banks began to pursue mixed operation and adjust their income structure by increasing non-interest or intermediate business income with various financial innovations. But at the same time, shadow banking was also growing with more complicated products and business models. While these phenomena can be regarded as financial innovation over the course of economic development, they also manifest efforts of banks and other financial institutions to break through the constraints posed by the Basel Accords and explore new possibilities for profit.
The Basel Accords prevent financial risks mainly by increasing the capital adequacy ratio. Each revision of it was mostly about strengthening capital constraints while adding and improving regulatory indicators. The underlying logic, again, is that banks’ capital must cover its unexpected loss.
Such regulation could lead to two problems. First, banks would always plan their balance sheets assuming the worst could happen, but in reality, the extremes of various risks are unlikely to break out at the same time, and that leaves some of the assets useless or idle. Second, strict capital adequacy ratio means that banks would find it impossible to achieve an average profit ratio unless they can find new profit opportunities. That’s probably why over the recent decades many financial innovations were about off-balance sheet assets. When lending procedures become so tedious that previous business and management logics no longer apply, it adds to both the banks’ credit risks and market risks with wider influence, and regulators then need to further raise the capital adequacy ratio to cover these risks.
The above is not to say that the Basel Accords are useless for improving the security of bank operations, or that the banks and the market are intentionally going against the Basel Accords, but to show that all systems will have side effects and loopholes that will always be exploited by capital seeking to maximize profits.
The key questions are: Is it necessary to block all the gaps to prevent market and financial risks? Should the market play a better role in risk management? When market participants know that someone will come and deal with the risks, a considerable number of them will try to outsmart the regulators. Market competition could have offset most of the risks, but now all risks are hedged with the regulators. Over-protected market and finance will not be strong.
Market and finance should be regulated to avoid risks caused by capital expansion, but it is also necessary to give full play to the functions of the market and finance, that is, by leveraging their profit motives, to guide the positive role of the market and finance and restrain their negative side. Risky behaviors must be prohibited, but rigid containment and blockade may also cause risks. A better approach is to let the market digest risk phenomena that are normal to market and financial activities.
However, some matters must be explicitly prohibited, and there should be no room for accommodation. For example, a financial business must be licensed to operate, and environmental requirements shouldn’t be relaxed just because some industries or enterprises need support. The government could provide them with environmental protection subsidies, but not exempt them from environmental protection requirements.
Government should provide more profit opportunities and guide the financial sector toward areas they want the latter to enter, and reduce administrative intervention. For example, to support environmental, social, and governance (ESG) practices, there should be legal and regulatory requirements, and, more importantly, interest mechanisms, such as tax preference and low-cost relending.
The Chinese economy is under downward pressure, which requires banks to increase credit supply, especially to support small and micro enterprises and the real economy. The government could consider targeted RRR cuts and central bank relending. In this case, compared with morally requiring commercial banks to increase their risk tolerance, it may be more effective to take the following measures: reduce the provision coverage ratio gradually, limit the maximum provision coverage ratio in stages, and require the provision to be used to replenish core capital and give full tax exemption. Banks will be more motivated in this way to increase credit under certain risk strategies.
The idea of financial risk management and prevention shouldn’t be limited to finance. The government will need to examine how each aspect of human society impacts the financial world. Risk management and prevention efforts may themselves lead to financial risks. Building a solid firewall against risks is a right move, but it is more important to respect, utilize, and guide the market force, and avoid undue tolerance of risks.
This article is published on CHINA FINANCE (Vol. 14, 2022). The views expressed herewith are the author’s own and do not represent those of CF40 or other organizations.
