Abstract: In this paper, the authors offer eight policy suggestions on how to systemically improve the effectiveness of China’s financial regulation: 1) step up the legislative and institutional development of financial regulation; 2) improve the standards of micro-prudential regulation; 3) establish a regulatory accountability system; 4) improve the "dual-pillar" macro-control framework; 5) unify the standards and policies of local financial supervision and strengthen the coordination between the central and local governments; 6) support responsible financial innovation with financial regulatory innovation; 7) the central bank, regulatory and financial departments should work together to build a national financial safety net; 8) emphasize functional regulation in enhancing regulatory effectiveness in the institutional framework.
Financial regulation refers to a set of rules and laws imposed on financial institutions and measures to supervise and ensure the enforcement of the rules. It is a systemic project to improve the effectiveness of financial regulation, prevent and resolve systemic financial crises, and maintain the financial system’s stability, which requires sticking to the principles of meeting the market demand, coordinating regulatory policies, consolidating regulation, and supporting innovation. To that end, policy recommendations are as follows:
I. We should step up the legislative and institutional development of financial regulation, clarify the objectives and responsibilities of regulation, and differentiate regulation from macro adjustment, economic development, and financial development.
To improve the effectiveness of financial regulation, measures need to be adopted in three stages: first, clarifying the objectives of regulatory policies and expanding the scope of regulation to all financial activities; second, giving regulators the necessary decision-making and enforcement powers; third, establishing an accountability system.
It is recommended to improve legislative and institutional development of financial regulation, transfer regulators’ responsibility of supporting the development of the financial sector, and clarify the standards and methods of financial conduct regulation when formulating the Financial Stability Law. Regulatory policies should be aimed at ensuring fair competition, protecting consumer interests, and maintaining financial stability to enhance the long-term competitiveness of the economy, whereas macroeconomic volatility, the development of the financial sector, and changes in asset prices should not be the reasons for policy adjustment of financial regulation.
Financial regulation should coordinate with the need for macro control. However, regulators should not change or adjust policies because of temporary adjustment of macro control or change the way of policy enforcement because of macro adjustment. For example, we should not loosen regulation of illegal businesses during an economic downturn, restrict or contain certain businesses through interim documents or conferences and punish relevant institutions and personnel when the economy is overheating.
Financial institutions need to support national industrial development strategy, such as supporting micro and small enterprises, agriculture, rural areas and farmers, and ecological environment. Therefore, regulatory policies should be aligned with the goals of these strategies. However, when supporting the development goals, regulation should still stick to its initial tasks and safeguard the basic financial security requirement. It is suggested that policies should be adopted to clearly restrict or prohibit the financial sector from supporting industries that will be phased out or curbed according to national industrial development strategies; market-oriented policies should be employed to guide support for important fields that are in line with national industrial development strategies, whereas administrative, mandatory policies should be avoided such as “three no-less-than requirements.”
Financial regulators should not be responsible for supporting the development of the financial sector. Otherwise, they will lower or even abolish some of the necessary regulations for industrial development.
II. We should improve the standards of micro-prudential regulation and strengthen regular and dynamic supervision of the day-to-day businesses of financial institutions.
Currently, the primary approach to financial regulation is index-based and ex-post supervision. Index-based regulation, a kind of ex-post supervision, is the method of observing the implementation of a regulatory index of financial institutions and generally prompts inspection and supervision when negative abnormal situations are found. Ex-post supervision includes two approaches: one is inspection and supervision of financial institutions after risks occur, and the other is procedural inspection.
Generally speaking, when the operation of financial institutions breaks the regulatory index, it might suggest that risks have been mounting for quite a long time to the point that regulatory intervention cannot prevent. Therefore, we need regular and dynamic supervision of the day-to-day businesses of financial institutions in order to target abnormal situations and communicate with regulated institutions more timely and professionally. Through communications, regulators can thoroughly understand some of the business innovations and changes of financial institutions, address certain doubts, and prevent possible risks in time.
Take banking supervision as an example. On the condition that regulatory indicators are executed normally, regulators should keep an eye on the sudden changes and volatility in the industry and credit concentration of financial institutions; monitor the relations between credit and bond investment businesses and any abnormal changes in the relations; observe sudden fluctuations in certain businesses; identify abrupt changes in asset management, investment banking, and interbank businesses, abnormal changes in their capital flows and their interrelationship with credit business; look at sudden sharp changes in the relative proportions of assets and liabilities as well as on- and off-balance sheet businesses; explore the model, principle, practice, potential risks and market demand of business innovation. Through normalized regulation of abnormal situations in the day-to-day banking business, we can identify potential risks and manage financial risks in a timely manner.
When implementing the regulatory index, financial institutions will set stricter standards according to their own conditions and design management index on their own. Therefore, regulatory authorities should conduct inquiry and supervision based on the specific index system of each institution instead of the existing index. Regulatory authorities should also visit some enterprises from time to time to better understand their real leverage ratios and their portfolio of investment and finance, evaluate their potential impacts on the banking system and financial market, and assess the level of prudential supervision of relevant banks.
Take Hong Kong’s experience as an example. Once the Hong Kong Monetary Authority (HKMA) identifies a new financial business model, a sudden growth of certain banking businesses, a growth of credit amount granted to certain types of enterprises, or a high concentration of certain businesses of certain institutions, it will communicate with the institutions to understand the situation and discuss with them the internal risk management mechanisms. This kind of communication will not be deemed as an “inspection.” Before the HKMA thoroughly understand certain issues, it will continue to contact the institutions and will not suspend relevant businesses abruptly.
III. We should establish a regulatory accountability system, strengthen the implementation and enforcement of regulatory policies, and clarify the departments and procedures for banning illegal financial activities (operating financial businesses without a license) in accordance with the law.
1. A regulatory accountability system should be established. Under the principle that financial business must be licensed and fully regulated if financial risks emerge because of a lack of supervision, regulatory departments should be held responsible so as to address the issue of regulatory inaction.
2. Regulatory policies should be implemented and strictly enforced. We should ensure the seriousness, authority, and predictability of regulatory policies. Only when the policies are strictly enforced will there be a reliable basis for holding regulators accountable.
3. Regulatory policies should adapt to market dynamics, and policy adjustment needs to be refined. If market conditions change and the old policies no longer fit the new situation, we need to adjust policies or roll out new policies. We must adjust them before we loosen or tighten the enforcement of policies.
Different impacts of different policy adjustments on the market should be fully taken into account, for example, determining the new policy's starting point, whether an existing business is rectified and the rectification period, and the time point of accountability under the new policy. Previously, the new policy was frequently required to be immediately implemented in order to correct the existing business and achieve immediate results. Some industries have a limited spread effect, and immediate rectification generally affects only individual institutions and businesses. However, many financial businesses now have strong market risk contagion, such as stock allocation ratio adjustment; if the new ratio is stipulated to begin at a specific point, and the stock business will naturally end when it expires, the shocks to the market will be very mild.
4. Clarify the relationship between regulators and the institutions they regulate. Separate them in terms of administration, personnel, and interests. On the basis of standardized supervision, regulatory agencies should create a fair market environment for the market and protect the legitimate rights of financial consumers and investors. There is a clear definition of illegal financial activities (operating a financial business without a license). Still, there is no clear regulation on which department should ban illegal financial activities and how.
Regulatory agencies only have the statutory authority to supervise licensed financial institutions, but in most cases, even if there are reports, they simply discourage unlicensed financial businesses. Only when there are risks or mass incidents will the government step forward and organize departments of financial supervision, industry and commerce, public security, local financial supervision bureaus, courts, and so on to deal with them, classifying them as illegal operations and initiating legal proceedings.
Therefore, the leading department and procedures for banning illegal financial activities should be clarified as soon as possible. It is suggested that the relevant business supervision department be responsible for the identification of illegal financial activities and the leading law enforcement department ban them according to law. After entering the procedure, other departments, such as industry and commerce, public security, and courts, will complete relevant legal procedures.
Ⅳ. Improve the "dual-pillar" macro-control framework, clarify the responsibilities and the division of powers for macro-prudential policies, and enrich the macro-prudential policy toolbox.
The "dual-pillar" framework is a policy innovation with Chinese characteristics, as well as the direction of global policy reform. Its primary cause is that the Federal Reserve's loose monetary policy prior to the global financial crisis created significant financial risks. Under the "dual-pillar" framework, monetary policy is responsible for currency stability, and macro-prudential policy is responsible for financial stability. They work together to maintain economic and financial stability. To ensure the independence and cooperation of the currency and macro-prudential policy decision-making mechanisms, it is proposed that the primary task of macro-prudential supervision be to monitor and evaluate systemic financial risks and to continue to enrich and improve the macro-prudential policy toolbox on this basis.
Although China has established a "dual-pillar" regulatory framework, it is still in its early stages. It still needs to be improved in the following areas:
1. Strengthen the coordination between monetary policy and macro-prudential policy. Strengthen the regularity and transparency of monetary policy operations, and promote the transformation of monetary policy from quantity-based to price-based regulation. Macro-prudential policy measures should be adopted in a timely manner to prevent systemic risks in areas such as real estate, bond markets, and cross-border capital flows
2. Create a reliable financial risk monitoring and early warning system. Focus on improving monitoring of leverage behavior, debt, and the financial cycle, as well as developing macro-prudential stress testing tools and gradually integrating important and systemically influential financial institutions, financial markets, and financial infrastructure into macro-prudential management.
3. Many policy tools also have a strong "administrative nature." Taking cross-border capital flows as an example, some policy tools are very close to capital account control measures. Some more "market-oriented" policy tools, such as reserve requirements, the Tobin tax, and the debt ratio, should be considered. Simultaneously, if financial stability is to be maintained, consideration may be given to retaining controls on some short-term cross-border capital flows that are prone to large inflows and outflows.
V. Unify the standards and policies of local financial supervision, clarify the matching of powers and responsibilities of local financial supervision, and strengthen the supervision and coordination between the central and local governments.
Create and put into effect local financial regulatory standards and guidelines that are unified nationally. First, many local financial regulatory bureaus lack corresponding regulatory capabilities due to the significant regional differences in the regulatory capacity. Second, as regions become more financially intertwined, regulatory arbitrage can easily result from policy differences. Third, some local governments are unable or unwilling to take full ownership of local financial risks; as a result, the central government must still shoulder a sizable portion of the blame.
Specifically, consider the following:
1. National legislation should be strengthened. The "Local Financial Supervision Law" ought to be enacted into law as soon as possible. The regulatory matters, responsibilities, and law enforcement authority of local financial regulatory agencies should be outlined in legislation on the basis of adhering to the central authority of financial supervision in order to ensure that local regulatory law enforcement is grounded in evidence and to provide higher-level legal support for local financial supervision.
2. Formulate unified operating rules and regulatory rules. The China Banking and Insurance Regulatory Commission has established operating and regulatory guidelines for microfinance firms, financing guarantee firms, pawn shops, financial leasing firms, commercial factoring firms, and local asset management firms. As soon as possible, the China Security Regulatory Commission should develop operating and regulatory rules for regional equity markets, investment companies within jurisdictions, social crowd funding institutions, and various local exchanges. Increase cooperation between central and local governments, as well as between local governments, in financial oversight, risk management, and information sharing.
3. Consolidate the responsibilities of local governments and separate the development function from local financial supervision. Adhere to the principle of central authority in finance. Local financial supervision undertakes the tasks of financial development and mobilizing financial institutions to support local economic development, as well as the task of maintaining financial stability. Regulation and stability often give way to industry development. As a result, a lot of licenses for quasi-financial institutions have been issued without adequate supervision, which leads to financial risks.
VI. Support responsible financial innovation with financial regulatory innovation and empower regulation with digital technology; at the same time, substantially increase the investment in financial regulatory resources, including staffing establishment, funding, and technology, and improve regulatory capabilities.
Attaining a dynamic balance between financial innovation and financial stability will put global regulators to the test. The primary goal of financial supervision is to ensure the financial system’s overall stability and to protect the legitimate rights and interests of financial consumers through prudential and behavioral oversight. Based on this, it should encourage responsible financial innovation and the efficiency of financial services to the real economy, thereby improving the economy's long-term competitiveness. Regulation and innovation do not have to be mutually exclusive. Finding a proper balance between the two can result in a mutually beneficial effect, with regulation creating a suitable environment for innovation and innovation providing advanced regulatory means.
Financial regulation should not compromise financial efficiency or competitiveness. China has produced global influence by being at the forefront of the world in the development of mobile payment, Internet banking, and large technology platform companies. The steady and healthy development of the platform economy and digital finance can help my country achieve high-quality economic development, support RMB internationalization, and increase its international financial influence. As a result, regulatory agencies must maintain financial security while also increasing China's global competitiveness and influence, encourage responsible innovation, avoid excessive regulatory processing, and properly supervise the platform economy and digital finance.
The integration with technology represents a trend of financial development, which can greatly improve financial efficiency in the long run, driving financial and economic progress. Regulators should adhere to technological neutrality. Financial regulation should adapt in a timely manner to cover new services, activities, and products that have risk concerns brought about by the rapid integration of financial services and digital technology. It is essential to start the research of improving data quality and building a penetrating regulatory information system. China can draw on the practice of regulatory sandbox to encourage financial institutions to make innovations to improve financial efficiency and increase effective financial supply while regulators should have the risks of new products and businesses related to financial technology well controlled.
At the same time, digital technology should be adopted to enhance regulatory efficiency. For example, for complex connected transactions and multi-layered nested financial products, blockchain can be used to ensure the technical features of reliable transaction data, monitor the destination of transaction funds and the quality of underlying assets, and improve regulatory effectiveness.
Over the past forty years, starting from a single institution, China's financial industry has formed a complete financial system featuring a large scale, a great number of institutions, and complex products. Currently, the sector has seen an accelerated pace of development. This has placed higher demands on the continued improvement of financial regulatory capabilities. In the process of rapid integration of digital technology and financial business, financial innovation continues to speed up, the scale of finance expands rapidly, and the complexity of financial products keeps increasing. At present, the central and local financial regulatory departments, considering their staffing, business funding, and technical capacity, can hardly regulate emerging institutions, businesses, and products in a timely and effective way. So it is a must to invest more resources in these aspects.
Ⅶ. The central bank, regulatory and financial departments should work together to build a national financial safety net and establish a risk disposal fund while relying more on market approaches to replace implicit government guarantees to prevent and resolve systemic financial risks.
Building and improving the national financial safety net is an important step in building a modern financial system. In the past, the core of the national financial safety net was the implicit guarantee backed by the state credit. With the market-oriented reform and financial opening, this safety net can easily cause new instability as it is not sure when the government can step in, how much responsibility it should take, and how much loss institutions and investors will suffer. At the same time, this safety net, characterized by implicit guarantees, leaves room for local governments, markets, and market players to play games with the central government. Such a game, in turn, often magnifies financial risks and increases the cost of regulation and implicit guarantees.
A complete national financial safety net should include the following five aspects: first, micro-prudential and behavioral regulation to ensure stability and fairness at the individual level; second, macro-prudential management to reduce or even avoid the accumulation of factors leading to systemic risks; third, the central bank to play the function of the final lender and ensure market liquidity; fourth, market-based mechanisms, such as the deposit insurance system to deal with risks. At present, the funds of the deposit insurance system are seriously insufficient and can hardly assume the responsibility of dealing with bank risk events. On the one hand, the deposit insurance agency should take an active role by implementing differentiated rates to raise more insurance funds; on the other hand, it should also actively participate in bank regulation. Fifth, the central bank and the financial department should cooperate with each other in response to systemic financial risks.
It’s easy to see that when financial risks break out, it is the central bank and the financial department that assume the main responsibility. The central bank should be ready to adjust its monetary policy to provide sufficient liquidity to markets and institutions to ensure the normal operation of the financial system. However, if the local government debt deteriorates, the rate of non-performing loans rises, or the risk of capital outflow magnifies, the responsibility should not go to the central bank alone. The government could consider using fiscal funds to set up a "financial risk management fund" to keep things under control in the event of a capital shortage that could trigger systemic financial risks. More importantly, the establishment of such a fund could help boost the confidence of institutions and the market. With confidence, there may not really be a need to use large amounts of money to stabilize the financial sector.
Ⅷ. China should emphasize functional regulation in enhancing regulatory effectiveness in the institutional framework and draw upon the Twin Peaks Approach to strengthen prudential and behavioral regulation.
With competition and innovation going on, the types of financial products and services provided by financial institutions are constantly changing, and the boundaries between financial institutions and the market are gradually blurred, so traditional regulators will face the co-existence of regulatory overlap and regulatory gap. Functional regulation means as long as financial institutions of various types carry out financial business of the same nature, they will be subject to the same regulatory standards and regulatory bodies, which will not only effectively reduce regulatory gaps but also help promote fair and healthy competition in the market.
There are various models of financial regulation, and each has its own advantages and disadvantages. According to our research, financial systems that adopt Twin Peaks Approach prove to be more robust. Prudential regulation can be seen as a doctor whose job focuses on examining whether financial institutions are healthy and sound, while behavioral supervision is like a police officer who focuses on regulating the behavior of financial institutions, correcting their improper and irregular conduct, and imposing penalties for violations, thus protecting the legitimate rights and interests of investors and consumers. Prudential regulation and behavioral regulation should each play its role on the basis of cooperation to ensure the healthy operation and proper behavior of financial institutions so as to enhance the stability of the entire financial regulatory system.
Therefore, in the long term, the Twin Peaks Approach that features the separation of prudential and behavioral regulation could be the direction of reform of China's financial regulatory structure. In the short term, it is recommended that a supervision and coordination mechanism for behavioral regulation be established within the framework of the Financial Stability and Development Committee to strengthen financial consumer protection.
In the medium to long term, referring to the Twin Peaks Approach, it is recommended to integrate existing departments of financial consumer protection under the PBC, the CSRC, and the CBIRC and establish a national financial conduct regulatory bureau, which would work in conjunction with the macro-prudential regulation of the central bank and the micro-prudential regulation of the CSRC and CBIRC.
The Financial Stability and Development Committee is responsible for strengthening policy communication and coordination, information and data sharing; the PBC is responsible for formulating and implementing monetary policy and carrying out macro-prudential regulation of the entire financial system; the CBIRC and the CSRC can implement micro-prudential regulation on financial businesses to maintain the safety and sound operation of these financial institutions; the to-be-established financial conduct regulatory bureau is to oversee the behavior of financial institutions. While strengthening conduct regulation in terms of information disclosure, product pricing, and product sales of cross-cutting financial products and services, the bureau also has to spread financial knowledge among consumers, improve consumer understanding of financial products and financial transactions, and give more play to market mechanisms to enhance financial consumers' awareness and ability to take risks.
The article is part of the 2022 CF40 China Financial Reform Report: Finance in Support of High-quality Development, released on April 24, 2022. The views expressed herewith are the author’s own and do not represent those of CF40 or other organizations. It is translated by CF40 and has not been reviewed by the author.
