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China’s emerging super-regulator: a bold, dangerous step

By Paolo Danese
19 Jul 2017

China made a clear step towards creating a financial super-regulator last week, when it created a new oversight commission within the central bank. The mega-merger of China’s many competing regulators is a good idea – but it is also fraught with risks.

China announced over the weekend that it was creating a Financial Stability and Development Commission (FSDC), a segment within the central bank that will oversee the country’s alphabet soup of different market regulators, including those overseeing banking, insurance and capital markets.

The decision came at the tail-end of a ‘financial work’ conference held in Beijing and was a key part of a speech by China’s president Xi Jinping. The meeting led to a plethora of macro and micro recommendations, but particularly noteworthy were the government’s new priorities for regulators — the need to focus on serving the real economy, the need to contain financial risks in the system, and the need to deepen financial reform.

These vague-sounding pledges would be meaningless in many countries, but Xi is not known for empty talk. The FSDC was designed to help the country fulfil these goals, in part by addressing the chaotic mix of financial and capital markets regulators in China.

Three decades of economic growth and financial liberalisation in China have left behind a regulatory landscape that is, to be blunt, a complete mess. Regulators remain charged with overseeing sectors of the market simply because of legacy, with little consideration for whether such responsibilities are appropriate or efficiently allocated.

The bond market is perhaps the clearest example. The China Banking Regulatory Commission (CBRC), the China Securities Regulatory Commission (CSRC) and National Association of Financial Market Institutional Investors (Nafmii), officially an industry body but in fact tightly-controlled by the PBoC, all regulate different parts of the domestic debt market.

It may have made sense to have the banking regulator oversee the so-called ‘interbank’ bond market when that term meant something, but now the interbank market includes corporate issuers and non-bank investors, the rationale appears shaky. Local DCM heads asked to explain the regulatory overlap often react with little more than a shrug.

It is surely time to streamline the process. With the Chinese market growing increasingly integrated with global financial markets, thanks to MSCI's inclusion of A-shares in its indices, and both bond and equity markets opening up to foreign investors through the Connect programmes with Hong Kong, the sense of urgency should be increasing.

China’s government is hardly a beacon of transparency and, right now, the details on the new commission are few and far between. But it is understood that the FSDC will sit within the central bank, which will have a key operational role in the functioning of the commission.

The new commission will coordinate financial supervision and will be involved in or consulted with on monetary policy decisions that impact financial stability in China. In a sign of how powerful the commission may be, China's premier Li Keqiang is being mooted to chair the new team (although the job may end up going to one of the country’s four vice premiers).

This is all good news for those hoping for an easier time navigating China’s labyrinthine regulatory system. But it should not be overlooked that the move is fraught with potential pitfalls.

Fed up

The immediate worry is one that governments and regulators around the world have long grappled with – does it make sense to make the central bank the main regulator of the banking system?

Although there is intuitive logic to housing monetary policy and regulatory functions under one roof, it can create a conflict of interest.

In particular, monetary policy decisions – which can impact the health of the banking system – may start to be increasingly judged with the eyes of a regulator. That would be fine if the health of banks were a perfect indicator of the health of the real economy, but this is far from the case.

The merging of the two functions can also challenge the reputation of a central bank, a crucial factor for wider confidence in the economy. When the central bank fails in its regulatory function, it erodes the trust market participants have in it to shepherd the economy. The blowback against the US Federal Reserve after the global financial crisis provides a good example.

The Fed can at least claim central bank independence. This old principle of market capitalism has never quite taken off in China and looks unlikely to do so under the leadership of Xi Jinping. That, in itself, weakens the argument for putting the regulator under the aegis of the central bank.

Zhou Xiaochuan, governor of the PBoC, is potentially another risk factor. He is set to retire this year and, with little clues as to his successor, the appointment of a less reform-oriented figure at the head of the central bank or new super regulator would be counterproductive to the reform process. China’s regulatory system may be chaotic, but competition between regulators has undoubtedly helped drive innovation.

None of this is to say that a super-regulator is a bad idea. Putting the regulators of the bond market under one roof makes perfect sense; the sheer size of the market and its importance to the economy means that innovation should now take a back-seat to clear and transparent standards. But there are risks as undoubtedly China inches closer to a broader tie-up of regulators.

The Chinese financial markets have expanded tremendously, giving rise to the third largest bond market and the second largest equity market in the world, and they are set to continue such growth.

The time is right for a fresh approach.

By Paolo Danese
19 Jul 2017