Abstract: The article analyzes the new regulation mindset in this round of financial institutional reform, i.e., clarifying the important strategic position of finance in contemporary national development, differentiating the responsibility of macro control from financial supervision, and differentiating different scopes and functions of supervision to realize full coverage of financial regulation. Looking ahead, the key is to implement these new concepts, and the article suggests several areas to pay attention to.
I. NEW REGULATION MINDSET IN THE FINANCIAL INSTITUTIONAL REFORM
1. Clarifying the important strategic position of finance in the contemporary national development
The modern economy and world originated from the industrial revolution or technological revolution, but the driver behind it is finance. Without the modern financial sector, the industrial revolution could not gain such immense momentum.
At present, finance has already become the main instrument and carrier of effective resource allocation. Meanwhile, the operation of the modern economy is also built on the financial infrastructure dominated by bank accounts. When we enter the stage of high-quality development, we must fully understand the critical role of finance in the economy and society.
Because of the comprehensive role of finance in driving and supporting the modern economy, finance has permeated every aspect of modern society. If financial risks are not accurately identified and properly dealt with, the extent of the damage may transcend institutions or industries and spill over into society. For example, customer risks or market volatility that lead to asset quality risks in financial institutions may trigger systemic risks if they are not handled properly; an institution's liquidity management failure may spiral into a system-wide or even society-wide risk; a minor failure in the public financial infrastructure may lead to socio-economic malfunctions, thus causing systemic risks, etc.
Finance is related to the economy as well as politics. Nowadays, financial security is important not only to a country’s domestic economic security but also to a country’s international political and economic security, as finance has become the tool and area of major power and regional competition or even confrontation. When the U.S. practiced long-arm jurisdiction to impose sanctions on other countries, finance (including financial infrastructure) was politicized and weaponized. Even those financial infrastructure institutions like SWIFT, which were established for purely economic purposes, are no longer 100% private commercial institutions but have become the tool for the U.S. and the West to clamp restrictions on other countries. Amid such pressure, financial institutions alone are unable to deal with it.
For these reasons, finance should be elevated to a strategic level and managed with greater strategic importance. The CPC should strengthen its unified overall finance management to ensure high-quality financial development and prevent systemic financial risks, which is now a national strategy.
2. Differentiating the responsibility of macro control from financial supervision
Macro control focuses on macroeconomic changes. Aside from basic concepts and principles, policies and tools of macro control are not right or wrong in and of themselves but need to be adjusted to guide market expectations and ensure the proper operation of the macro economy. Under the macro control, micro-entities might benefit or suffer losses that are not the concern of macro regulators as long as they do not affect the macro economy’s healthy operation or the economic recovery process.
Financial supervision focuses on the safe and compliant operation of financial institutions and the safe operation of financial systems. A healthy operation of the macro economy is the effect of the proper operation of financial institutions, not the direct goal of financial supervision. Financial regulations center around ensuring the safe and compliant operation of financial institutions. In general, these policies do not change with the macroeconomy. Only when the individual operating behavior or products of financial institutions might cause systemic risks and thus affect the health of the macroeconomy will some of the regulatory policies be introduced or adjusted, but the purpose of doing so is not for macro control.
This round of institutional reform further clarifies the responsibilities of the central bank and regulatory departments so as to ensure that the central bank can formulate monetary policy and conduct macro control in a more focused and professional manner. The abolition of regional branches of the PBC and the restoration of provincial branches is a way to sort out the PBC's internal management. With the widespread use of fintech, the decrease of cash circulation, the improvement of transportation conditions in counties, as well as the elimination of supervisory functions, county-level branches of PBC are no longer necessary. These adjustments are in line with the idea of strengthening the PBC's focus on monetary policy and macro-control functions.
3. Differentiating different scopes and functions of supervision to realize full coverage of financial regulation
This round of institutional reform suggests that the central government has a more comprehensive and more precise understanding of financial supervision and divides it into institutional, behavioral, and functional supervision, covering all the aspects of supervision.
The newly established National Financial Regulatory Administration will oversee all aspects of China's financial sector apart from the securities market, covering all the financial businesses and modes.
In the past, China’s financial supervision was mainly based on institutional supervision. This led to the so-called separated supervision, providing room for regulatory arbitrage of different market entities and posing financial risks.
Now the model shifts from institutional regulation to functional regulation to integrate rules of the same businesses and to eliminate the room for regulatory arbitrage due to separated supervision.
In the past, under separate supervision, the types of financial institutions eligible for licenses are fixed, and there are no applicable licenses for new kinds of institutions. This also left room for other non-financial regulators to issue financial licenses, resulting in chaos and risks in financial regulation.
In addition, regulators in the past did not have enforcement power. In theory, regulators should supervise legal, financial institutions with licenses, while illegal financial activities and institutions should be banned, and thus there is no need for regulation. This resulted in several phenomena: first, new financial modes are outside of regulation as they cannot be legalized without the recognition of regulators; second, illegal financial activities are also outside of institutional supervision. The establishment of the National Financial Regulatory Administration can fill the regulatory gap.
Functional regulation regulates financial businesses. A financial business or product should be under a unified regulation and a unified market. If the same type of business or product faces different regulations and markets, there is bound to be regulatory arbitrage; competition will emerge between different regulations and markets, lowering the regulatory standards and risk standards and triggering systemic risks. Establishing of the National Financial Regulatory Administration has laid the foundation for integrating regulations, markets, and financial businesses.
Behavioral regulation regulates financial institutions’ operation from the perspective of consumer rights. Thirty years ago, the main financial services in China were bank deposits and withdrawals, while the penetration rate of insurance and stocks was low. Not everyone had a bank account even for deposits when their salary was paid in cash. Therefore, the breadth and depth of financial consumption were very limited， and financial consumer protection is not yet widespread. Nowadays, given that salary is basically paid by banks on behalf of employers and everyone who has a job has a bank account, it can be said that everyone is a financial consumer. Financial institutions and financial products are thriving with greater professionality. The involvement of Chinese people in financial consumption is both broad and deep, and financial consumer protection has become an important part of financial supervision, requiring a professional department dedicated to this function and unifying management.
4. Strengthening the power of central government and fulfilling the responsibility of local governments
An important aspect of this reform is to “deepen the overhaul of local financial regulatory system.” On the one hand, by establishing a local financial regulatory system based on the local branch of the central financial regulatory department and coordinating and optimizing the setup and power of the local regulatory branch, the power of the central financial authority would be strengthened. At the same time, the reform clarifies the local government's responsibility to prevent and mitigate local financial risks, and financial regulatory agencies set up by local government will be dedicated to supervisory responsibility. This is in line with China's administrative and economic management system.
II. SEVEN AREAS TO WATCH FOR FINANCIAL REGULATION IN THE FUTURE
Institutional reform of financial regulation is only the first step to enhancing the effectiveness of financial supervision, and the key also lies in the implementation of the new regulatory concept after the institutional reform is in place. In the implementation of institutional reform and specific regulation in the future, there are still some issues to watch:
1. Distinguishing between national strategy, macro-control policy, and financial regulatory policies based on sectoral synergy
The institutional separation of macro-control and financial regulation is only formal, and the two functions need to be effectively differentiated in operation. Amid major economic risks, macro control and financial regulation need to coordinate and adhere to the boundaries of their respective functions.
For a common goal, all departments must work together. Coordination means that each department does its own job instead of doing the same. For example, when fighting a war, if the goal is to capture the hill ahead, all parts of the force have to work in concert, but it is unnecessary for the army cooks to also attack the hill. Each part doing its own job might seem to slow down the pace of reaching the goal, but these seemly uncoordinated movements balance speed, quality, and security, which will instead facilitate the achievement of the goal. Mechanical movements in the same direction will lose the balance, and actions taken in haste often result in waste.
This Silicon Valley Bank incident is a typical case. (→ Read more) The bank run seemed to be caused by the Fed's interest rate hike, but the root cause was Silicon Valley Bank's own mismanagement of its assets and liabilities. The Fed's interest rate hike was aimed at curbing high inflation, which was a macro-control instrument. As this measure targets the macroeconomy, it will affect all market entities. Some market entities will be cleared out of the market, and even a certain degree of economic recession will occur, which is the necessary price the macro economy must pay to return to a healthy track. The Fed does not need to focus on whether individual market entities can cope with such macro-control.
For commercial banks, it is part of their daily work to actively and cautiously respond to market fluctuations and the impact of the central bank's macro-control policies. This is also what the financial regulators need to supervise. Therefore, it can also be said that the collapse of SVB was caused by inadequate supervision. If it is attributed to the Fed's hikes, to resolve this risk, the Fed must stop the hikes or even cut the interest rate regardless of inflation. Suppose it is attributed to the inadequate management and supervision of SVB itself. In that case, it is necessary to specifically analyze the assets and liabilities of SVB, find out the risk points, and formulate or improve regulatory policies in a targeted manner.
The assets held by SVB are all high-quality assets with good liquidity. However, there are usually not enough reserve funds to meet the demand for deposit withdrawals and some low-interest trading securities were not withdrawn in time in the face of the obvious trend of hikes. When the reserves are insufficient to cope with normal deposit withdrawals, they are forced to sell depreciated trading securities, resulting in losses, panic, and ultimately a bank run. Although these assets are loss-making based on the current market fair value, they will not lose money if held to maturity at the deposit cost. This is different from most failed banks because of asset quality problems. On the other hand, nearly 90% of SVB's total liabilities are general deposits, so there are very few other liabilities, such as interbank liabilities. Even if it fails, the impact on other banks and financial institutions will be minimal.
Based on the above two points, it can be said that the collapse of SVB is an isolated case, and if it is handled well, the risk will not spread. For example, the Fed uses the assets of SVB as a pledge to provide liquidity support to meet the withdrawal needs of depositors, and the funds can be recovered when the securities mature. In this case, the Fed can continue to focus on dealing with inflation.
On the other hand, it is necessary to adjust regulatory policies timely. If the risk spreads, it may cause systemic risk and change the macroeconomic trend. At this time, the Fed needs to make a discretionary decision and adjust its macro-control policies appropriately. That is to say, whether to raise interest rates depends on macroeconomic risks, including the overall operating risks of the banking system, rather than a single bank risk. Conversely, when reviewing the omissions of existing regulatory policies that led to the collapse of SVB, what needs to be considered is whether the regulatory policies can maintain the safety of individual banks and the entire banking system rather than adjusting regulatory policies for the current macro-control.
In the same way, regulation needs to be coordinated with national strategies, but these regulatory policies that support national strategies do not reduce the risk standards of regulation.
2. Financial supervision’s full coverage of financial business requires legal and institutional guarantees.
(1) Laws and regulations must be adopted to restrict non-financial management departments from issuing financial licenses and setting up financial product trading markets. Competitively issuing financial licenses or establishing market rules in the name of reform among different departments is not truly innovative or reformative and will only increase the risk of hidden dangers.
(2) There need to be clear legal arrangements to ban and punish unlicensed and illegal financial operations. In reality, there have been cases where people rent office space in a building, put up a sign of a certain bank, and conduct banking business. Passersby may find it suspicious and consult the bank. The bank sends someone to inquire and ask them to take down the sign and stop operating. However, after the bank personnel leaves, the institution continues to operate with the sign still up. The bank reports it to the regulatory department, but the regulatory department has no enforcement authority and can only persuade them to stop, which is still ineffective. The bank reports it to the police, but without any department to prove that the institution is illegally operating, the police can only issue a warning. This example illustrates why some illegal financial cases were initially open but lacked management from any department. It is often not until risks arise and cause social events that they are punished, and there are rare cases where they are immediately banned by the law at the beginning.
Therefore, in financial supervision, it is necessary to determine which department has the authority to inspect and identify illegal financial behaviors according to law, how to ban illegal financial behaviors according to law, and how to punish illegal financial behaviors of different degrees.
(3) The local regulatory coordination mechanism needs to have feasible arrangements. The central financial regulatory agency's local branches should be given absolute power to coordinate local financial regulation and clarify the regulatory scope and content of the financial regulatory agencies established by local governments. Financial regulatory agencies established by local governments should no longer assume the responsibility for developing the local financial industry, which is conducive to preventing financial risks. For most regions in the country, the financial industry develops with economic development and does not need to be planned and promoted separately as an industry. Some local governments blindly set financial industry GDP development targets, which has resulted in the introduction of illegal financial operators and low-quality financial institutions, leading to financial risks. In addition, arrangements for banning illegal financial activities should be managed under the local regulatory coordination mechanism.
3. When introducing new regulatory policies, feasible execution plans must be determined based on the risk logic of specific financial businesses or products.
Different financial businesses or products have different risk logics and risk patterns, so other plans are needed to implement new regulatory policies. Some policies require that all new businesses be conducted and regulated under the new policy from the effective date, while existing businesses will be executed according to the original contract until the business is completed. For some existing businesses, a certain grace period can be given to gradually adjust to the new policy. In contrast, others must be adjusted to comply with the new policy on the effective date. In summary, introducing new regulatory policies is to correct the shortcomings of the original regulatory policies and prevent financial risks. Improper execution of policies can lead to secondary disasters and must be avoided.
4. Due to its unique nature, behavioral regulation for financial consumers requires professionalism and relative independence.
Consumer protection in finance is singled out twofold: on the one hand, it is because of the specialty and risk of financial products, and on the other hand, it is because of the uniqueness of consumer behavior in finance.
(1) Consumers in other industries usually "purchase" goods or services, such as buying products or purchasing services. However, in most cases, financial consumers are not buying anything. For example, in the case of deposits, consumers do not pay any fees; in the case of loans, the interest paid is not primarily the bank's service cost; when buying stocks or wealth management products, it is an investment, and the funds invested are expected to be recovered. Although management, transaction, and other fees are paid, it is different from paying for haircuts or taxi fares.
(2) The demands of financial consumers when consuming different financial products and services are different. For the same consumer, when he is a depositor, he not only hopes that deposit and withdrawal are convenient and fast but also demands absolute safety of accounts and funds and also hopes that the deposit interest rate is as high as possible. However, as a borrower, he also requires the loan to be convenient and fast, and he hopes that the bank's risk admission criteria are as low as possible. He also wants the loan interest rate to be as low as possible.
(3) While consumers in other industries often consume products or services with clear quality and specification standards, consumers of financial products are more concerned about the potential gains and losses in the market fluctuations of their investments. There are no specific standards for this; financial institutions only provide transaction convenience services as intermediaries. Therefore, consumer protection in the financial industry is not just about protecting vulnerable groups but also legitimate rights and interests based on professional expertise and contractual obligations. It cannot protect financial consumers' investment decision failures.
Another financial regulation outside of behavioral regulation is aimed at ensuring the safe operation of financial institutions and the financial system. Although some regulatory requirements may limit the profitability of financial institutions to some extent, they are fundamentally consistent with the interests of financial institutions. Therefore, in response to the demands of financial consumers, general financial regulation may unconsciously first consider the problem from the perspective of safeguarding the safety of financial institutions. In contrast, behavioral regulation must have a certain degree of independence and must stand on the perspective of financial consumers to regulate the business behavior of financial institutions, forming a certain balance with other financial regulations. This is more conducive to the stable operation of financial institutions and the financial system.
5. Financial regulatory coverage should not suppress financial innovation and new forms of finance.
After achieving full coverage of financial business regulation in the legal sense, there will be issues concerning identifying and regulating new businesses and innovative financial institutions. The following options are typically available:
(1) Based on the basic nature of innovative business and the basic business nature of new institutions, classify them into existing business and institutional categories for management. However, if this approach is applied to all innovative businesses or new institutions, it may lead to some innovative businesses or new institutions being unable to obtain regulatory recognition because they cannot be classified, thereby stifling innovation. It may also distort innovative activities by forcibly incorporating them into existing business and institutional categories for regulation, ultimately leading to the stifling of innovation.
(2) For relatively simple innovative businesses, timely recognition should be given, and existing institutions do not need business licenses for management, while new institutions require special licenses.
(3) For some complex business innovations, corresponding license or qualification management must be carried out based on timely recognition of the business itself.
(4) Regulatory policies and rules for new businesses and new types of institutions must be timely updated and continuously improved to avoid negating new businesses and new types of institutions due to unclear regulatory policies. In this regard, the regulatory policies for some newly licensed innovative businesses and new types of institutions still need to be continuously improved. For example, third-party payment accounts, which operate differently from bank Type I and Type Ⅱ accounts and other companies' advance payment accounts, and also have cross-border payment functions, may require special business licenses and regulatory standards.
6. Guarantee the safe operation and innovative development of public financial infrastructure.
The State Council's institutional reform plan stipulates that market-oriented institutions managed by central financial regulatory departments will be divested, and related state-owned financial assets will be transferred to state-owned financial capital trusteeship management institutions, which will be authorized by the State Council to perform the responsibilities of investors uniformly. This is conducive to clarifying the relationship between financial management and operations, allowing regulatory departments to focus on financial management, and facilitating the unified management of state-owned capital.
It is unclear which institutions belong to the "market-oriented institutions" that need to be divested according to the plan. However, based on what is currently known, most of the operational institutions managed by central financial regulatory departments are public financial infrastructures. Under normal circumstances, the operation of financial infrastructure goes unnoticed by the economy and society, but once there is a malfunction, it could lead to systemic risk.
Therefore, it is necessary to handle the relationship between "the unified management of institutional financial assets" and "the professional supervision and management of daily operations of institutions." This includes professional management and supervision of institution personnel, operations, assessments, and development. What needs special consideration is: 1) Who should initiate and decide the adjustment of operating rules for financial infrastructure? 2) Who should initiate, decide, and invest in the upgrading and renovation of financial infrastructure? 3) Who should initiate, decide, invest in, implement, and manage the construction of new financial infrastructure and the establishment of new operational institutions to meet market demand? In response, an appropriate separation of capital management and operational management could be considered.
7. Strengthen the professional personnel of financial regulatory departments and improve the professional capabilities of regulatory personnel.
The fact that financial work and the prevention of financial risks have been elevated to the level of national strategy demonstrates the importance of finance in modern economic society. Further, it illustrates the complexity and professionalism of finance itself.
Financial regulation is to ensure the safety of financial institutions and the financial system, but financial regulatory work itself is highly challenging and risky, and improper regulation can also trigger systemic financial risks. The financial sector is also constantly innovating and evolving, requiring regulatory agencies and personnel to keep pace with innovation.
Therefore, while carrying out institutional reforms, it is necessary to supplement the professional personnel of regulatory agencies and strengthen training for existing personnel to improve their professional capabilities. In particular, there is a need to supplement the professional personnel of financial regulatory departments established by local governments soon.
This article was released on CF40’s WeChat blog on March 27, 2023. 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.
